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Smart contracts are a computer analog of regular contracts, a unique program (algorithm) that performs specific actions when the parties to an agreement fulfill certain conditions, such as sending money to a seller when goods are delivered to a buyer of good quality.
Does that sound complicated? Hi everyone, this is Alex, an enthusiast of cryptocurrency and everything related to it. In this article, we’ll break down the definition, the principles of smart contracts and areas of use.
History of Smart Contract
The principle of smart contracts was described by American cryptographer and programmer Nick Szabo in 1996, long before the advent of Blockchain technology. According to Szabo’s concept, smart contracts are digital protocols for transmitting information that use mathematical algorithms to automatically execute a transaction once set conditions are met and to fully control the process.
However, in 1996, this concept could not be implemented: at that time, the necessary technology did not exist, in particular, the distributed ledger.
In 2008, bitcoin appeared, the first cryptocurrency based on the revolutionary blockchain technology, which previously lacked a decentralized ledger. Blockchain Bitcoin does not allow to set conditions for a transaction in a new block, as it contains only information about the transaction itself. Nevertheless, the emergence of the technology spurred the development of smart contracts.
Five years later, the Ethereum blockchain platform made it possible to use smart contracts in practice. Today, the market offers many platforms that allow the use of smart contracts, but Ethereum remains one of the most common.
Types of Smart Contracts
Depending on the level of automation, smart-contracts can be:
- Fully automated.
- Predominantly paper-based, but some of the contract clauses are carried over into the smart-contract, such as conducting transactions.
- With a paper copy.
How Smart Contracts Work
In essence, smart contracts are computer protocols or computer code. The code is used to enter all of the contract terms between the parties to the transaction into the blockchain. The obligations of the parties are provided in a smart contract in the form of “if-then” (e.g., “if Party A transfers money, then Party B transfers the rights to the apartment”).
There may be two or more parties, and they may be individuals or organizations. Once these conditions are met, the smart contract itself performs the transaction and ensures that the agreement is respected.
Smart contracts allow the exchange of money, goods, real estate, securities, and other assets. The deal is stored and repeated in a decentralized ledger in which information cannot be falsified or deleted. At the same time, data encryption ensures the anonymity of the parties to the agreement. An important feature of smart contracts is that they can only work with assets in their digital ecosystem.
Advantages and Disadvantages of Smart Contracts
Like any system, Smart Contracts have advantages and disadvantages. To work with it more effectively, let’s look at all sides. The positive aspects of smart contracts can include the following points:
- Speed. Smart contracts involve an automated process and in most cases do not require personal involvement.
- Independence. Smart contracts eliminate the possibility of third-party intervention.
- Reliability. Data recorded in blockchain cannot be altered or destroyed.
- Absence of errors.
- Savings. Smart contracts can provide significant savings by eliminating costs for intermediaries and reducing transaction costs.
Despite their promising potential, smart contracts also have their drawbacks:
- Lack of regulation.
- Difficulty of implementation. Integrating smart contracts with real world elements often takes a lot of time, money, and effort.
- The impossibility of changing a smart contract. Paradoxically, one of the main benefits of smart contracts can also be seen as a conflict. If the parties reach a better agreement or new factors arise, they cannot change the contract.
Applications of Smart Contracts
The principle has become clear, but where can smart contracts be applied?
Smart contracts and blockchain are a relevant solution for serving the supply chain from raw materials to finished products. More often than not, the supporting information for each stage is stored in separate databases, and paper documents still have to be physically sent.
At each stage you have to hand over and sign documents, send invoices, transfer money, etc. All of this information can be consolidated in one registry so that all parties have access to documents, transaction history and deliveries. Smart contracts will allow payments to be automatically allocated once the right digital signatures have been agreed and obtained. In addition, it’s much easier to add new participants like suppliers and carriers to the blockchain supply chain.
Blockchain and smart contracts will create a single secure registry of medical records. Given the sensitivity of information, access to records could be restricted with a multi-signature smart contract: If a patient and his or her doctor agree to show information to another specialist, they will digitally sign and the system will allow access to that person.
Pooling into one registry will help scientific research and anonymous surveys, and if scientists decide to reward those who share information, smart contracts are the best way to ensure payment upon information transfer.
For copyright holders and content creators, the problem of royalties – fees for the use of intellectual property – is relevant. Here, smart contracts can be used to distribute funds transparently.
The same applies to other areas where it is necessary to ensure accounting and transparent payments without trust between the parties: insurance, E-commerce, auditing, taxation and so on. It also can be used for voting and government records.
Well, smart contracts can already replace a significant part of the existing document flow. Any standard insurance or property transfer agreement can be implemented as a smart contract. To dive deeper into the world of cryptocurrency and understand all the processes behind it, I advise you to read our guides on each cryptocurrency.
I have been studying cryptocurrency for over 5 years. I have accounts in every exchange and I test everything on myself.
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