- A smart contract is defined as a digital agreement that is signed and stored on a blockchain network, which executes automatically when the contract’s terms and conditions (T&C) are met. The T&C is written in blockchain-specific programming languages such as Solidity.
- Smart contracts form the foundation of most blockchain use cases, from non-fungible tokens (NFTs) to decentralized apps and the metaverse.
- This article explains how smart contracts work and details their various types. It also lists the top smart contract tools available and the best practices that need to be followed.
A smart contract is a digital agreement signed and stored on a blockchain network that executes automatically when the contract’s terms and conditions (T&C) are met; the T&C is written in blockchain-specific programming languages like Solidity.
One can also look at smart contracts as blockchain applications that enable all parties to carry out their part of a transaction. Apps powered by smart contracts are frequently referred to as “decentralized applications” or “dapps.”
While the idea of blockchain is largely perceived as Bitcoin’s underlying tech driver, it has, since then, grown into a force to reckon with. Using smart contracts, a manufacturer requiring raw materials can establish payments, and the supplier can schedule shipments. Then, based on the contract between the two organizations, payments can be automatically transferred to the seller upon dispatch or delivery.
Nick Szabo, a U.S.-born computer scientist who developed a virtual currency dubbed “Bit Gold” in 1998, a decade before Bitcoin was introduced, was the first to propose smart contracts in 1994. Szabo characterized smart contracts as digital transaction mechanisms that implement a contract’s terms.
Many predictions made by Szabo in his paper are now a part of our daily lives in ways that precede blockchain technology. However, this idea couldn’t be implemented because the necessary technology, primarily the distributed ledger, did not exist then.
In 2008, Satoshi Nakamoto introduced the revolutionary blockchain technology in a whitepaper. It prevented transactions from being specified in another block. However, the emergence of cutting-edge technologies acted as stimuli for the rise of smart contracts. Five years on, the Ethereum blockchain platform made practical use of smart contracts achievable. Ethereum is still one of the most prevalent platforms enabling smart contract implementation.
Like any other contract, a smart contract is a binding contract between two parties. It uses code to take advantage of the advantages of blockchain technology, thereby unlocking greater efficacy, openness, and confidentiality. The execution of smart contracts is controlled by relatively easy “if/when…then…” statements written in code on the blockchain.
These are the steps needed for the functioning of smart contracts.
- Agreement: The parties wanting to conduct business or exchange products or services must concur on the arrangement’s terms and conditions. Furthermore, they must determine how a smart contract will operate, including the criteria that must be fulfilled for the agreement to be fulfilled.
- Contract creation: Participants in a transaction may create a smart contract in many ways, including building it themselves or collaborating with a smart contract provider. The provisions of the contract are coded in a programming language. During this stage, verifying the contract’s security thoroughly is critical.
- Deployment: When the contract has been finalized, it must be published on the blockchain. The smart contract is uploaded to the blockchain in the same way as regular crypto transactions, with the code inserted into the data field of the exchange. Once the transaction has been verified, it’s deemed active on the blockchain and cannot be reversed or amended.
- Monitoring conditions: A smart contract runs by tracking the blockchain or a different reliable source for predetermined conditions or prompts. These triggers can be just about anything that can be digitally verified, like a date attained, a payment made, etc.
- Execution: When the trigger parameters are met, the smart contract is activated as per the “if/when…then…” statement. This may implement only one or multiple actions, like passing funds to a vendor or registering the buyer’s possession of an asset.
- Recording: Contract execution results are promptly published on the blockchain. The blockchain system verifies the actions taken, logs their completion as an exchange, and stores the concluded agreement on the blockchain. This document is available at all times.
When it comes to the types of smart contracts, they are classified into three categories — legal contracts, decentralized autonomous organizations or DAOs, and logic contracts. Here, we’ll discuss each of the three in more detail.
1. Smart legal contract
Smart contracts are guaranteed by law. They adhere to the structure of legal contracts: “If this happens, and then this will happen.” As smart contracts reside on blockchain and are unchangeable, judicial or legal smart contracts offer greater transparency than traditional documents among contracting entities.
The parties involved execute contracts with digital signatures. Smart legal contracts may be executed autonomously if certain prerequisites are fulfilled, for example, making a payment when a specific deadline is reached. In the event of failure to comply, stakeholders could face severe legal repercussions.
2. Decentralized autonomous organizations
DAOs are democratic groups governed by a smart contract that confers them with voting rights. A DAO serves as a blockchain-governed organization with a shared objective that is collectively controlled. No executive or president exists. Instead, blockchain-based tenets embedded within the contract’s code regulate how the organization functions and funds are allocated. VitaDAO is an example of this type of smart contract, where the technology powers a community for scientific research.
3. Application logic contracts
ALCs, or application logic contracts, consist of application-based code that typically remains synced with various other blockchain contracts. It enables interactions between various devices, like the Internet of Things (IoT) or blockchain integration. Unlike the other types of smart contracts, these are not signed between humans or organizations but between machines and other contracts.
The uses of smart contracts are wide and varied, spread across industries.
1. Royalty payment in media and entertainment
As they enter the industry, new artists rely on revenues from streaming services. Smart contract apps can facilitate easier royalty payments. These contracts can outline, for instance, the share of royalties payable to the record company and the artist. Instantaneous handling of these payments is an enormous advantage for everyone involved.
Smart contracts could also potentially solve the challenge of royalty distribution in an over-the-top (OTT) content world where traditional network agreements do not apply. This technology allows emerging artists and lesser-known actors to get small but regular payments.
2. Decentralized finance (DeFi) applications
Using cryptocurrencies and smart contracts, DeFi apps can offer financial services without an intermediary. DeFi is no longer limited to peer-to-peer transactions. On DeFi platforms, smart contracts facilitate complex processes like borrowing, lending, or derivative transactions.
3. Conversion of assets into non-fungible tokens (NFTs)
By assigning ownership and administering the movable nature of digital assets, smart contracts have made it possible to create non-fungible tokens (NFTs). Contracts like this can also be altered to include added stipulations, like royalties, along with access rights to platforms or software. Essentially, smart contracts make it possible to treat digital assets just like physical ones, with real tangible value.
4. B2B data marketplaces
A data marketplace is a portal where users can buy and sell diverse datasets or data streams from a wide range of sources. Intelligent contracts facilitate the creation of dynamic and fast-evolving markets that support automated and secure transactions without the hassle of human intervention. Datapace is a good example of this particular smart contract use case.
5. Supply chain management
Smart contracts may work autonomously without mediators or third parties because they are self-executing. An organization can create smart contracts for an entire supply chain. This would not require regular management or auditing. Any shipments received beyond the schedule might trigger stipulated escalation measures to guarantee seamless execution.
6. Digital identity cards
Users can store reputational data and digital assets on smart contracts to generate a digital identification card. When smart contracts are linked to multiple online services, other external stakeholders can learn about individuals without divulging their true identities.
For instance, these contracts may include credit scores lenders can use to verify loan applicants without the risk of demographic profiling or discrimination. Similarly, candidates can share resumes without the risk of gender bias in hiring.
7. Electoral polls
Voting could occur within a secure environment created by smart contracts, minimizing the likelihood of voter manipulation. Due to the encryption, every vote is ledger-protected and extremely difficult to decode. Additionally, smart contracts might boost voter turnout. With an online voting system driven by smart contracts, one can avoid making trips to a polling location.
8. Real estate
Smart contracts can accelerate the handover of property ownership. Contracts can be autonomously created and executed. After the buyer’s payment to the vendor, for instance, the smart contract may immediately assign control over the asset dependent on the blockchain’s payment record.
9. Healthcare data management
Smart contracts can revolutionize healthcare by making data recording more open and efficient. For instance, they might encourage clinical trials by guaranteeing data integrity. Hospitals can maintain accurate patient data records and effectively manage appointments.
10. Civil law
Smart contracts can also flourish in the legal industry. It can be used to create legally binding business and social contracts. In certain regions of North America, governments have authorized smart contracts for digitized agreements. For example, California can issue marital and birth certificates as smart contracts.
Like any technology, smart contracts have both pros and cons. Here are the benefits of smart contracts first:
Benefits of smart contracts
The key reasons to use smart contracts include:
1. Single source of truth
Individuals have the same data at all times, which reduces the likelihood of contract clause exploitation. This enhances trust and safety because contract-related information is accessible throughout the duration of the contract. Additionally, transactions are replicated so that all involved parties have a copy.
2. Reduction in human effort
Smart contracts don’t need third-party verification or human oversight. This provides participants autonomy and independence, particularly in the case of DAO. This intrinsic characteristic of smart contracts offers additional benefits, including cost savings and faster processes.
3. Prevention of errors
A fundamental prerequisite for any contract is that every term and condition is recorded in explicit detail. An omission may result in serious issues in the future, including disproportionate penalties and legal complexities. Automated smart contracts avoid form-filling errors. This is one of its greatest advantages.
4. Zero-trust by default
The entire framework of smart contracts is a step beyond conventional mechanisms. This implies that there’s no need to rely on the trustworthy conduct of other parties during a transaction. A transaction or exchange does not necessitate faith as a fundamental component, consistent with zero-trust security standards. Since smart contracts operate on a decentralized network, every aspect of the network is more open, fair, and equitable, with no risk of privilege creep.
5. Built-in backup
These contracts capture essential transactional details. Therefore, whenever your data is used in a contract, it is stored indefinitely for future reference. In an instance of data loss, it is simple to retrieve these properties.
Challenges of smart contracts
Here are the potential downsides of smart contracts and the challenges to be aware of:
1. Rigidity and inconsistent support
Modifying smart contract protocols is nearly impossible, and fixing code errors can be costly and time-consuming. Even if smart contracts conform to the laws of different countries, it might be tough to guarantee that they are adhered to globally.
2. Difficulty in capturing unquantifiable data
For businesses with quantifiable data, such as finance and agriculture, it is relatively simple to put together smart contracts. However, not all industries use quantifiable metrics, like scenarios where creative work has to be evaluated.
3. Conflict with GDPR
The General Data Protection Regulation (GDPR) guarantees the right to be forgotten by its citizens. They can request that digital data about them be deleted. Nevertheless, if a digital legal contract binds an individual, it cannot be erased or redacted.
4. Skills shortage
The creation of smart contracts demands expertise in software engineering. Smart contract development is distinct from traditional software development in that it requires coders with organizational expertise and comprehension of non-traditional programming languages such as Solidity. These skills are hard to come by.
5. Scalability Issues
Finally, there is the question of magnitude and scale. Visa can currently process approximately 24,000 transactions per second. According to Worldcoin’s 2023 update, Ethereum, the world’s biggest blockchain for smart contracts, can only manage 30 transactions per second.
See More: Web3 for B2B: Hype Versus Reality
Some of the top tools meant for smart contract developers are:
BoringSolidity is a collection of libraries for developing Solidity smart contracts that aim to streamline and standardize routine tasks, minimize weaknesses, and enhance overall code quality. ConsenSys Diligence, a prominent security auditing company in the blockchain industry, created it.
Oracles on the blockchain aggregate real-world data from various sources and transfer it to smart contracts using the blockchain. Chainlink is among the leading Oracle solutions accessible today. It provides reliable and tamper-resistant data to support smart contracts throughout multiple blockchains.
Ethcode acts as a Visual Studio Code extension for developing Ethereum smart contracts. It provides a beginner-friendly development environment for text, troubleshooting, or unit testing contractual code. The code being used is open-source and simple for Microsoft users to use.
Octopus is a tool to perform an in-depth evaluation of smart contract source code. It offers features for evaluating code, like symbolic execution, call flow analysis or control flow analysis. This will enable you to detect and correct contract errors before it’s too late.
OpenZeppelin has become among the most prominent no-code tools employed in smart contracts. This open-source framework offers a library of easily-integrated, safe, community-reviewed smart contracts. It also provides audit and authentication services for smart contracts.
When working with smart contracts, one should remember the following best practices:
1. Prioritize simplicity
Incorporating a smart contract into an agreement adds value and unleashes blockchain’s many advantages. Complex contract logic, on the other hand, can lead to errors or wasted time. Consequently, developing simple contract logic to implement optimal digital processes is vital. It is prudent to use pre-written code as it reduces the possibility of execution errors.
2. Update contracts regularly
Staying on top of contracts allows you to identify errors or vulnerable spots that must be resolved. Additionally, safety checks and frequent upgrades to newer versions improve the user experience and safeguard transactions. Since there is no human intervention, updating smart contracts is especially important.
3. Lock compiler versions for smart contract code
Software developers frequently make the error of not securing a compiler version in contract codes. By explicitly mentioning the compiler versions, you guarantee your contracts operate consistently across environments, avoiding release and authentication challenges.
4. Conduct rigorous testing
Evaluating the contracts on the test network before deploying them on the mainnet is imperative. This should allow you to identify defects or malfunctions before they become a significant problem. This best practice is crucial since it is difficult to fix smart contracts once they go live.
5. Work with experts on independent audits
As smart contracts function on a decentralized and trustless network, the code must be trusted. A smart contract’s flaws can be attacked, and the deposited funds can be misappropriated. Therefore, security auditing is essential.
Smart contracts have the potential to transform digital transactions completely. They can enforce immutable terms and conditions, maintaining transparency across stakeholders. According to Gartner research titled “Predicts 2020: Data and Analytics Strategies — Invest, Influence and Impact,” smart contract adoption can improve data quality significantly by 2023. The technology poses a few challenges, such as skills shortage and inadequate support; however, these can be resolved with time.
Knowing how smart contracts work and the tools to develop and use them will be crucial for organizations to make the most out of technology in the era of the decentralized web.
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