What are smart contracts?

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A smart contract is a digital protocol that ensures a contract is automatically executed when the agreed upon conditions are met. Smart contracts make it possible to process transactions, without a third party being needed to verify or enforce the agreement. The agreements are trackable and irreversible.

The goal of smart contracts is to offer better, digital security, compared to traditional contracts. In addition, you can spare costs, since theoretically you don’t need a notary anymore. Several cryptocurrencies use smart contracts as a basis for their concept, and on most blockchains you can program smart contracts.

What can a smart contract do?

These past few years, some new technologies have gotten a lot of media attention. For example blockchain, artificial intelligence, The Cloud, and last but not least: smart contracts.

That’s probably because smart contracts have a lot of potential. What could be more safe than hard-coded agreements that are recorded on the blockchain? And if this means you could save money because expensive notaries are no longer necessary, it’s even better.

The potential of smart contracts:

  • Confidential contracts that are executed automatically and impartially
  • Less middle men needed for drawing up contracts, contract execution, and maintaining contracts
  • Lawyers become superfluous

In this article we’ll explain what smart contracts are and how they came about.

What is a smart contract?

A regular contract is an agreement between two or more parties. For example: you could enter into a rental agreement with a landlord. In the agreement it will be stated that you owe a certain amount of money to the landlord to live in an apartment.

In a smart contract, all the terms and conditions of an agreement are programmed. There is no need for mutual trust anymore; the contract will only respond if the input is correct.

What happens if your rental agreement is a smart contract? Let’s say, according to the smart contract, you have to pay 500 euros per month to live in the apartment you are renting. If you don’t pay, the smart contact automatically sends a message to the debt collector, or in some cases even to the actual front door of the apartment. If the payment hasn’t been received the front door is now locked, since the terms of the smart contracts haven’t been met.

One of the most important features of a smart contract is that you don’t have to rely on a third party to execute certain conditions. The landlord doesn’t have to check his bank account every month to see if he received the money, or ask his tenant to pay their rent. The consequences of not paying have been agreed upon by both parties and are unrelenting.

In an ideal future, no lawyer or legal process is required for breach of contract anymore. The smart contract is impartial and also ensures that measures will be taken when the conditions of the contract haven’t been met.

At the same time, that is also the biggest criticism on smart contracts. A smart contract leaves no room for exceptions or nuances; it has no humanity or compassion.

Instead of actually talking to a tenant, or coming up with a payment arrangement, people that might’ve been paying their bills on time for years could all of a sudden be instantly locked out of their home.

That’s not how it works in the real world. A perfect smart contract would consider context and take distinct circumstances into account.

The history of smart contracts

Ethereum is often linked to smart contracts, but smart contracts existed way before Ethereum did. In 1996, twelve years before Bitcoin was invented, cryptographer Nick Szabo described the concept like this:

“A smart contract is a set of promises, specified in digital form, including protocols within which the parties perform on these promises.”

Smart contracts have been possible on the Bitcoin network from the very beginning in 2009. This is made possible by Script, a tool to write contracts.

The difference between the smart contract possibilities on the Bitcoin network and the Ethereum network is that Ethereum is Turing complete. Turing refers to the mathematician Alan Turing, who invented the Turing machine as a general measure of computability.

This means that in theory, each programmable calculation or data processing can be recorded on the blockchain of Ethereum.

What can you do with smart contracts?

If all parties who have agreed to a smart contract fulfill their obligations, the smart contract knows which action must be carried out. For example, it can send money to a seller once the buyer has confirmed the delivery of a package. You could also program the smart contract in a way that the money is automatically sent out, by way of tracking the shipment via the tracking number.

Still looking for more security and peace of mind? You could even think about a kind of advanced payment for both parties. This is held as a deposit in order to ensure that the agreement goes according to the rules, otherwise the false party will lose its deposit.

Currently, most examples of smart contracts relate to financial services, but with a little imagination you could come up with a lot more use cases. For example shares, crowdfunding, voting, wagers?, or auctions.

It could go wrong as well

On the Ethereum blockchain, a foundation was created to demonstrate what the platform was capable of. This was called the DAO, which stands for Decentralized Autonomous Organization. Investors could deposit money on the DAO and get a return based off on the investments made by the DAO. The decisions themselves would be crowdsourced and decentralized. Everyone was allowed to participate.

The DAO raised 150 million dollars worth of ether, back when ether was worth just 20 dollars. Unfortunately the conditions weren’t programmed sufficiently, which made it possible for someone to extract a lot of money from the platform.

This person is often called a ‘hacker’, but that’s not entirely correct. He or she didn’t break into the system, but simply found loopholes in the contract and benefited from them. It’s not very different from a smart accountant or lawyer that finds a loophole for their client.

The Ethereum Foundation decided that the code of the smart contract was no longer valid, and the money sent to the DAO was reversed. In other words, the writers of the smart contract and the investors made a mistake, and the developers of Ethereum decided to save them.

This led to a crack in the Ethereum community and, as it goes in cryptoland, a crack ultimately causes a hard fork. Ethereum Classic was born. You could even say that Ethereum Classic is the original Ethereum blockchain, and that Ethereum actually comes from Ethereum Classic. The followers of Ethereum Classic are based on the principle that a smart contract is irreversible. There a reason that they live with the mantra 'Code is Law'.

Conclusion

You now know what a smart contract is. We hope it became clear that the power of a smart contract depends on the writer of the contract and how exceptions are coded. Both Bitcoin and Ethereum still have a long road to go before they can live up to their full potential.

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