One of the key technological innovations of second-generation blockchains has been the development of what are called smart contracts.
You hear about smart contracts everywhere in the crypto space, as they comprise one of the essential parts of almost everything in blockchain. But what are smart contracts, and how do they work?
In this article, let us explore the sophisticated world of smart contracts and what makes them the most important technological advances in the blockchain industry.
What are Smart Contracts?
For a while now, contracts have been the standard way we formalize relationships in our society.
Whether you are purchasing or even selling a home, a piece of land, a car, or even digital assets, you will need to enter into a legally binding agreement with the other party.
In the traditional setting, the third party can be a lawyer, a court, or a bank, who ensures that both parties are obligated to the terms and conditions of the agreement. This is where smart contracts come into play.
A smart contract comprises an agreement between two people or entities in the form of computer code programmed to execute automatically. It has the power to execute and enforce itself autonomously and automatically based on a series of programmed parameters.
The execution of a smart contract can often lead to the exchange of money, the delivery of services, the unlocking of content protected by digital rights management, or other types of data manipulation.
How Do Smart Contracts Work?
A smart contract is a unique program that encodes business logic and runs on a special-purpose virtual machine baked into a blockchain or other type of distributed ledger.
Generally, they function on the principle of “if, when, then…” statements. These statements are then written into the code, and when certain set conditions are met and verified by the network of computers or nodes, the actions specified in the contracts are executed.
For the operations of a smart contract, they are similar to those of other blockchain transfers. The operation occurs in the following steps:
- A transaction is initiated from a blockchain wallet.
- The identity of the transaction is then confirmed after reaching the distributed database.
- The transaction is then approved.
- The transaction includes the code that defines what type of transaction is to be executed.
- The transactions are then added as a block within the blockchain.
- Any change in the contract status follows the same procedure to be updated.
Types of Smart Contracts
Smart contracts can be classified into different types based on their functionality and purpose. However, they generally fall into two main types:
Smart Legal Contracts
They are the most common types of smart contracts. The parties involved in the contract are held accountable for keeping their end of the agreement. Failure to do so mostly triggers legal action against them.
Decentralized Autonomous Organizations (DAOs)
These blockchain communities are defined by a set of rules that are coded through smart contracts.
The main participants are bound to specific rules, and their enforcement is primarily executed through smart contracts working in collaboration to watch over things that happen in the community.
Application Logic Contracts (ALCs)
They are mainly contracts that have application-based codes that are connected with other blockchain contracts. They mainly facilitate communication across different devices. An example is integrating blockchain technology with the Internet of Things (IoT).
Characteristics of Smart Contracts
There are major features that only work for smart contracts, including:
- They are immutable, which means that they cannot change once published on the blockchain. These features may appear helpful, but you might get a bug, or even the code can be inefficient. Because the code cannot be changed, it will remain inefficient forever.
- They are distributed, which easily means that there are no discrepancies. Smart contracts are created to remove human error and issues.
Smart Contract Applications
Smart contracts have major applications based on their functionality; these applications can be classified as follows:
- Payment Contracts: They primarily allow for the transfer of funds between parties based on predefined conditions. These contracts can automate payment processes, ensuring funds are released only when specific conditions are met. For instance, there can be a payment contract set up to release funds to a seller when a buyer receives the goods or services agreed on.
- Escrow Contracts: They act as intermediaries in transactions, holding funds or assets until the included parties meet certain conditions. They also act to ensure security and trust in peer-to-peer transactions. In this way, both parties are allowed to meet their obligations before the funds or assets are released.
- Governance Contracts: They enable decentralized decision-making within a blockchain network or organization. Furthermore, governance contracts pave the way for token holders in a certain blockchain network to vote on proposals or changes to the network’s rules. In this way, there is some level of democracy and transparency in governance.
- Multi-Signature Contracts: Multi-signature contracts require several people to take part in the approval of transactions before execution. Additionally, they act as an added advantage, providing an extra layer of security, and can be utilized in cases where consensus or agreement from several parties is required.
Advantages of Smart Contracts
Smart contracts offer a variety of benefits, including:
- Cost efficiency: Smart contracts operate with a promise to automate business processes that span organizational boundaries. With this, they remove the likelihood of day-to-day expenses, saving on resources, including the personnel needed to monitor the progress of a complex process.
- Processing Speed: Smart contracts lead to a rise in the processing speed of business processes running across multiple enterprises.
- Autonomy: Smart contracts are performed automatically by the network. As such, in most cases, there is no need for a third party to manage transactions between businesses.
- Reliability: Smart contracts utilize the capabilities of blockchain ledgers as well as other distributed ledger technologies as a means of maintaining a verifiable record of all activity that is related to the execution of complex processes.
Additionally, as the processes are automatic, it removes the possibility of human error, ensuring accuracy in executing the contracts.
Final Thoughts
Smart contract usage is still in its early days but presents key important usages that may transform the blockchain industry in general.
As with other technologies that are in their infancy, there may still be security issues and bug exploits, which may lead to the loss of digital assets on certain occasions.