How do Smart Contracts Work?

What is a Smart Contract?

A smart contract can be described as a protocol based on a computer code that is intended to digitally facilitate, verify and/or enforce the negotiation or performance of a contract on the parties to the transaction. Transactions that take place via smart contracts are trackable, irreversible and enforceable without the need for intermediaries or any third parties. These transactions can vary from legal processes to insurance premiums and even crowdfunded agreements or financial derivatives. While various cryptocurrencies have implemented these contracts, the most popular smart contracts being used operate on the Ethereum protocol and are the primary point of discussion in this topic.

Ethereum runs on a Smart Contract-based Protocol

Ethereum is an open-source, decentralized, blockchain based distributed ledger which supports a modified version of the Nakamoto consensus via transaction-based state transitions. However, unlike its more prominent counterpart, Bitcoin, Ethereum runs on a smart contract-based protocol, thereby eliminating the possibility of any kind of fraud or third-party interference. Ethereum was created by Vitalik Buterin in July 2015 in an attempt to make transactions more transparent and efficient.

It is important to note that smart contracts were first envisioned as far back as 1994 by Nick Szabo, a legal scholar and cryptographer. Szabo realized that a decentralized ledger could be used to run self-executing smart contracts and in this format – can be converted to a computer node. Following this, they can be stored and replicated on the system. The contracts can then be supervised by the network of computers and users who run the blockchain network, and can be used for the transfer of assets or to receive the products or services in question.

Autonomous, Encrypted and Highly Secure

Smart contracts on the Ethereum network are autonomous, which means that any changes to the contract cannot be approved without the consensus of the operating network. Additionally, due to the fact that they operate on the blockchain protocol and use the highest level of encryption, they are also extremely secure. This, thereby, eliminates any risk of the contracts being manipulated or subject to any form of bias. The blockchain protocol also maintains a detailed record of all the terms and conditions of any contracts which are executed on the network, which eliminates any possibility of miscommunication.

As a result, smart contracts work to drastically cut down inefficiency caused due to errors, which the conventional trading systems in place are often plagued with. Since these contracts are executed instantaneously on the system and obligations are enforced on all parties, the need for any third-party clearinghouses is eliminated. This makes transactions cost-efficient and reduces the time taken by intermediaries to execute transactions.

Immutable and Inflexible, lack of International Regulations

Smart contracts are aimed at eliminating the high expenses incurred by organizations relating to legal fees and transaction costs. This can serve to reduce compliance and the need for lawyers and auditors while simultaneously making the execution of contracts more reliable and efficient. However, they possess a few drawbacks that need to be taken a look at:

  1. The most prominent drawback is the fact that they are inflexible as they are impossible to modify. Hence, adding new terms or amending any part of the contract is not possible.
  2. There is a fundamental lack of international regulations focusing on the blockchain protocol, thereby making smart contracts and related technologies difficult to monitor globally.

It is evident, however, that these contracts are set to serve an important role in the future of financial transactions due to their various merits and levels of efficiency, and will be implemented in some way or another. This will serve to usher in a new era of transparency, accountability and reliability when executing contracts.

Can smart contracts someday completely replace traditional contracts as we know them? Will they truly manage the levels of efficiency that they promise? Will legal and auditing issues be drastically reduced to their implementation?

We’d like to hear your thoughts in the comments section below.

This article is a transcription of Andreas Antonopoulos’ explanation about smart contracts.

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