How do smart contracts work? What is a smart contract and how does it differ from a traditional contract? Let’s dive into it. To begin, let’s set the stage a bit and define some basic terms.
Smart contracts are computer protocols which allow for the execution of transactions and the negotiation of agreements, all without human intervention. Smart contracts were first conceived of in 2008, and initially gained popularity in the crypto community, especially amongst bitcoin enthusiasts. However, it wasn’t until the later years that traditional contracts began to incorporate the “smart” aspects, with the likes of Microsoft and JP Morgan establishing internal blockchain development teams, paving the way for mass adoptions.
Traditional contracts are still used today. They provide an additional level of security by requiring the agreement of both parties, and they can be handled more efficiently by our legal system. However, smart contracts offer a lot more flexibility in the way that they can be utilized. This adaptability makes them a popular choice amongst developers, businesses, and governments alike.
What Is A Smart Contract?
A smart contract is a type of contract which incorporates “smart” elements. These elements allow for the automation of processes and the minimization of errors which might arise from manual labor. In practical terms, smart contracts allow for the sharing of information without the need for third parties (i.e. middlemen) which could result in a more efficient flow of transactions. This, in turn, might lead to a more affordable and accessible global marketplace. One of the most basic and fundamental smart contract properties is the ability to create predefined conditions based on which the contract should be executed. Such conditions could include the transfer of funds or the completion of an action. Using smart contracts, it is possible to create automated processes and cut out the middlemen, resulting in more efficient and cost-effective transactions.
Smart contracts work on the basis of “if-then” statements. For example, let’s say you want to set up a contract which pays a certain amount of money to the first person to arrive at the top of a hill after a certain time. You would write a smart contract which includes the following two conditions:
- The first person to arrive at the top of the hill wins the prize.
- If the first person arrives before the time is up, the other person wins the prize.
In the above example, we have a condition which results in a win-win scenario for both parties. However, what if our condition is that the person arriving first has to buy a pizza for the person who arrived later? In that case, we wouldn’t want to have a pizza deliveryman as a winner, as this might result in the pizza being eaten by someone else. This type of situation is where state machines and auditing come into play. State machines are used to track the progress of a smart contract, and are responsible for enforcing the conditions of a contract. Auditing ensures that the data maintained by the state machine is accurate and can be trusted.
How Do Smart Contracts Differ From Traditional Contracts?
There are multiple ways in which smart contracts differ from traditional contracts. First, smart contracts tend to be shorter. This is because they are usually only concerned with the execution of tasks, and not with the negotiation of terms. As a result, smart contracts usually only include a few simple steps, and can be “executed” within a matter of minutes. Traditional contracts, on the other hand, can contain many steps and require a lot of legwork, especially if they want to be executed successfully. The second way in which smart contracts differ from traditional contracts is in the way that they are designed. Most traditional contracts include some type of “lock-in”, where one party is prevented from terminating the contract unless certain conditions are met. With smart contracts, this type of scenario is usually avoided, as once the contract is “set”, it can’t be easily modified. This is one of the major advantages of smart contracts. Modifications to traditional contracts typically require a lot of effort and negotiations, all of which could be avoided with the use of smart contracts.
Use Cases For Smart Contracts
One of the earliest use cases for smart contracts was in the crypto community. Bitcoin enthusiasts wanted to take advantage of the technology for cheaper and more efficient transactions. Amongst other use cases, smart contracts allowed for the creation of new cryptocurrencies with more efficient rules, and for the development of new applications which use blockchain technology, such as cryptocurrency exchanges and decentralized marketplaces.
Decentralized marketplaces are amongst the most popular use cases for smart contracts. This is because they allow for the efficient and cost-effective exchange of value, without the need for an intermediary. In a decentralized marketplace, all transactions are handled directly by the participants, which means that intermediary processing fees are avoided. Using smart contracts for marketplaces allows for many advantages, such as:
- More accurate measurements of supply and demand
- Elimination of inventory errors
- Reduction of costs
- Increased transparency
Use Cases For Contract Negotiation
Since the inception of smart contracts, they have also been used in the legal and business communities due to their adaptable nature and the possibility of automating routine processes. Lawyers were amongst the first to realize the potential of smart contracts and how they could be used to streamline their work. One of the most basic use cases for smart contracts in the legal community is for contract negotiation, as it can be easily automated and allows for a more efficient process. For example, let’s say you want to enter into a traditional contract with a company called “A”. To start the contract negotiations, you would issue a request for proposal (RFP), specifying the terms and conditions of the contract, including a due date. The RFQ would include all necessary information, including the required amount of money. Once you receive the RFP, you would have a specified number of days to respond. If you don’t respond within the time limit, your contract will be deemed automatically concluded.
If you want to negotiate with a company called “B”, which is offering a similar product to “A”, but with different terms and conditions, you would specify in your request for proposal that you are interested in discussing a contract with “B”, and include a similar RFP. In this case, the company with the most advantageous offer (i.e. best matching your needs) will automatically win the contract. This type of scenario is known as “mutual negotiation”, where both parties are working towards a mutually beneficial solution. To conclude a contract using smart contracts, the following two steps must be taken:
- The initiator of the smart contract submits the final terms and conditions for the contract.
- An auditor verifies that the terms of the contract have been complied with.
Smart Contracts And The Evolution Of Business
It’s only been a few years since the invention of smart contracts, but they have already revolutionized the way business is done. As previously stated, smart contracts allow for the automation of processes, resulting in less human error and more efficient operations. This, in turn, can lead to a more affordable and accessible global marketplace. With smart contracts, businesses can:
- Reduce costs
- Cut out the middlemen
- Establish better workflows
- Maximize the quantity and quality of products/services
- Rigorously enforce terms
What’s more, the adaptable nature of smart contracts means that once they are created, they can be easily updated and configured to accommodate the ever-changing needs of a business. This, in turn, makes the technology an essential part of any business which utilizes it.