Smart Contracts Explained – The Ultimate Beginner’s Guide

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Smart contracts are the buzzwords of the investment sector. Depending on which side you’re on, it is positive or negative. They are the latest adaptation in a growing line of technological age developments known as web 3.0. Many in traditional industries are fearful their roles will become redundant.

But those who will succeed are open to change, not resistance. Smart contracts are giving businesses opportunities to develop in ways never seen before. But like many, you’ll be wondering what a smart contract is at this point.

Well, to answer your burning questions, here’s everything you need to know about smart contracts.

What Are Smart Contracts?

smart contracts eplained

Understanding the meaning of smart contracts is, on the surface, a simple concept. It creates an agreement between several parties that agree on specific events in the past, present, and future. Yet, unlike a paper contract or verbal contract, a smart contract exists in a digital format.

Digital contracts currently use e-signature software and technology to identify an individual. In most cases, this requires human intervention and these need pre-registration and verification. That said, these types of contracts more often than not rely on mediating governments to protect the validity of the contract.

In the smart contract, the need for a middle man to act as a validator removes since the technology automates that role by writing the contract into lines of code locked upon creation. The great thing about smart contracts is their ease of use. It helps to understand the technology beneath the surface. Still, like any computational technology, not everyone needs to know how to code to use a computer.

Smart Contracts vs Blockchain

Smart Contracts operate on blockchain technology. Blockchain is a cryptographic technology that uses mathematical code to establish a database. By design, the blockchain reduces any possibility of manipulating the data since it uses complex mathematics to solve a puzzle beyond human comprehension.

The idea of using technology to decentralize finance is traceable back to the 1990s. In the 90s, the “cypherpunk” movement existed online. The movement included coding experts such as developer Nick Szabo, who publicized the idea.

Bitcoin itself, though, derived from an unknown entity named Satoshi Nakamoto in 2009. Bitcoin was a reaction to a distrust in the financial system during The Great Recession.

The underlying technology secures the Blockchain against human intervention. Ethereum, like Bitcoin, uses Distributed Ledger Technology, or DLT. This tech ensures that the software code remains tamper-proof. Networks of computers, known as nodes, hold copies of the digital ledger. They can detect fraudulent activity.

If you need more information about blockchain technology, read our Blockchain Basics webpage has all the info you need.

How do Smart Contracts Work?

how smart contracts work

Smart contracts began life on the Ethereum blockchain. They were first presented in 2013 in a white paper by Canadian-Russian Vitalik Buterin. And while intelligent contracts can exist on Bitcoin, it wasn’t created with these in mind. For various reasons, it has remained a store of value rather than a utility like Ethereum.

The Ethereum blockchain, thus, acts as the ledger. The ledger keeps a historical record of all contracts that preceded it. In doing so, any new agreements can use relevant data from existing contracts to trigger a result.

In a financial example, Bob has lent Alice $20. This exchange is on condition that the funds return to Bob on 26th November 2024 at 10:00 EST. The contract can also state that it can only return if Alice has more than $500 in her wallet.

Note in this example, the use of dollars is there to illustrate. Currently, USD exists in smart contracts as a stable coin, a blockchain that pegs its value to FIAT money, i.e., USD. And the best thing about digital ledger technology, or DLT, is its immutability. The code for the currency is such that it matches.

Smart Contract Use Cases

60 Use Cases for Smart Contract

Skeptics opposed the idea that there was no human interaction in the validation process. The only technology people had heard of before smart contracts was Bitcoin. Consequently, many advocates wanted to break the stigma and establish a purpose beyond currency.

In smart contracts, the technology executes when participants agree on terms in the agreement. The idea behind a digital execution of contracts eliminates the need for a third party validating the data.

In this situation, the third party is the technology itself. The distributed ledger, aka the nodes, talk to each other to confirm the contract exists, legitimate, and meets all the criteria required to add it to the ledger. Smart contracts are used for initial coin offerings, e-voting systems, CBDC’s, track and trace, or any other kind of application where assets can be exchanged digitally.

Benefits of Smart Contracts

advantages of smart contracts

One of the undoubted benefits of technology is the security layer that prevents bad actors from hacking the system. That said, the technology only prevents the ledger itself from changing. It doesn’t stop participants from using other means to manipulate, for example, classic website phishing techniques.

But even that is a security concern that exists in all walks of life. Smart contracts work only in ways that provide advantages to both the end-user and the contract creator. Because of the lack of intermediaries, it is cheaper and more efficient than hiring or paying for a third party’s services. 

In itself, this is life-changing for those in developing countries. Many all over the world don’t have access to a bank account. By having a decentralized ledger and smart contracts, these people don’t need to exchange money for goods. Smart contracts can account for all kinds of assets.

It would be instrumental in exchanging goods and services and assets for another, especially in developing countries. In these countries, there is an increasing demand for technology. It might be that a student in Africa has access to a local computer and can speak two languages, and can work as a translator in exchange for rental of the laptop or workspace. The options in developing countries are limitless for all.

Smart Contracts for Personal Use

Let’s look at an example of an automated home. The modern smart home allows for existing protocols like a smart contract. Writer code automates tasks, such as the popular app IFTTT (If This Then That). For example, “Between the hours of 7 am and 10 am, turn off my heating”.

The issue with this system is that it relies on several factors to work. Cloud-based technologies rely on server uptime, and dropouts occur. Further, these rules are prone to hacking. If someone logs in to your cloud server, they can change these rules without your permission. With smart contracts, this isn’t the case. There has to be an agreement of conditions exclusive to all parties. The following exaggerated example highlights the flexibility of the technology:

Give sister access to the front door only if the time is 4 pm on the second Tuesday of the month, the kitchen light turns on and off, the living room curtains closed, and movement triggers the upstairs camera. All while a speaker detects a 6-minute phone conversation with the eldest brother.

The smart contract would read all these conditions that are written to the Blockchain using a time stamp, and as a result, trigger a new deal that gives the sister access to the front door. This event can happen in real-time with smart contracts and can even occur offline if the internet is down with the right hardware. That way, it validates when the system reconnects to the internet.

Smart Contracts for Business to Consumer

The supply chain industry can significantly benefit from the benefits of smart contracts. Here, technology is a viable option for authentication purposes. Events in the chain confirm throughout the process. A universal acceptance exists amongst all validators, verifying the product for its uniqueness and value.

An excellent use case for supply chain authenticity would be in the luxury watch brand industry. Every single watch has its serial number and unique properties that identify that watch. If someone steals a watch, the ledger’s analysis will bring up if any attempts to manipulate the smart contract code happened. For example, it could inform the analyst which bad actors conducted the change.

Decentralized finance, or DEFI as it’s known, is another emerging use case for smart contracts. DEFI enables anyone to use their existing assets as collateral towards borrowing assets the same as a traditional contract for a secured loan. Due to the volatility of crypto assets and tokens, most of these contracts have liquidation terms encoded. If the collateral drops’ value, the loan is repaid in full to keep the smart contract withheld.

Smart Contracts for B2B and Internal Use

Smart contracts in businesses reach further than only commercial use cases. An immutable contract’s security advantages make smart contracts the perfect choice for creating a legal framework with trust at the forefront. Writing the contract law into a smart contract creates a legal agreement between two parties.

Further, by using different encryption technology, contracting parties who rely on top-level security can use encrypted blockchains to send essential data without fear of exposure. This same high-privacy level is also an exciting technology for business departments. Those with trust issues with existing methods need reassurance that any documented evidence isn’t modified.

Smart contracts can also massively reduce transaction costs. It is especially the case in cross-border payments. Two parties can agree on a conversion rate written into the Blockchain with minimal transaction fees. This reduction in resources and costs passes down to the consumer since a reduction in overheads exists.

How to create your own Smart Contract?

The great thing about the web is the wealth of information available for everyone to use. That said, it isn’t easy most of the time to understand which sources are the most reliable. Some may appear to be legitimately authorized sources, but they can reveal a wealth of bias upon investigating deeper.

There’s nothing wrong with taking all this advice on board to understand the intricacies of cryptocurrency, Blockchain, and smart contracts. But remember to look at the source of the article. Many of these informative sites are pushing an agenda.

They will often provide a negative or positive spin, depending on what they are promoting. Plus, the incentive is typically financial. Financial bias isn’t as crucial in utility tokens and smart contracts, but it is worth bearing in mind.

As a result, if you need genuine, honest advice and information about smart contracts, companies like ours are smart contract consultants. In our case, our role is to help you make the right choices for your business and advising the best implementation for these technologies at the lowest cost.

Smart Contracts and Ethereum

Whatever business you are working in, whether it’s the supply chain, law, finance, or anything that requires evidence, there is an application for smart contracts. With smart contracts, you gain access to a game-changing world where there is no end to your workflow’s productivity, security, and efficiency.

And remember, it’s not only the Ethereum blockchain allowing for smart contracts. There’s always the option for an alternative blockchain. Examples of alternatives to Ethereum include EOS, Cardano, NEO, and QTUM. Each has its advantages and disadvantages. Like Buterin did with Ethereum back in 2013, these new technologies are developing the existing technology. They are paving the way to the ultimate end-user experience.

Even today, there is much discussion around the role of all crypto assets in our society. But one thing’s for sure. Smart contracts are here to stay. For more info, please book a consultation with us today. See how we can put your business at the forefront of innovation.

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FAQ ABOUT SMART CONTRACTS

How do smart contracts work?

Smart contracts replacing paper contracts. An agreement is set by code on a blockchain network. Two or more parties can agree and sign a contract digitally while the information is stored on a public distributed ledger while all transactions are executed automatically without the need of any third-parties.

What are smart contracts in blockchain?

Smart contracts are coded and stored on a blockchain. They execute automatically when triggered terms and conditions are met. They are like programs and run by people or organizations who developed them for example on the Ethereum network.

Who uses smart contracts?

Smart contracts are used by individuals as well as corporations and governments. Starting from cryptocurrency exchanges, other financial services, e-voting systems, healthcare, supply chain, and many others.

Are smart contracts legally binding?

A smart contract must meet all the elements of a legally binding paper contract. Just because a contract is made electronically does not make it invalid. Two or more parties have to consent to the smart contract and the contract must be accessible at any time, also in the future, to become legally binding.

Can smart contracts be changed?

Smart contracts are immutable by default and therefore, cannot be changed. Once the contract is created there is absolutely no way to change it. This is an effective way of unbreakable contracts between two or more participants.

How many smart contracts on Ethereum?

At the time of writing this blog post, there are 1,536 million smart contracts on Ethereum. A total amount of 2 million user accounts found and 1,14,871,502 Ether supplied on the network.

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Marcel Isler

Marcel Isler

Marcel is a Business Economist and founder of iMi Blockchain. A Consultant and international Keynote Speaker. He studied at the University of Oxford. He helps enterprises to implement Blockchain applications. On our blog, he writes about distributed ledger technology, smart contracts, cryptocurrencies, industry news, and future trends.

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