What is a Smart Contract on Blockchain and How Does It Work?

A smart contract is a self-executing seller-buyer agreement that is directly inscribed into lines of code. Traceability, transparency, & irreversibility are its hallmarks.

Automation of an agreement’s execution by a smart contract ensures 

the outcome’s certainty. Further, as no third party is involved, the transaction gets completed quickly. 

Here’s how the smart contract’s workflow is automated: the next action is triggered when certain conditions are met. While a traditional contract is enforceable by law, a smart contract on blockchain is enforceable by code. 

When was the need for a smart contract recognized?

Nick Szabo, a legal scholar and a cryptographer, first used the term smart contract in an article in 1994. His theory was that these contracts could be written in code. 

So, these can be stored and replicated on the system. Moreover, smart contracts can be supervised by a network of computers comprising the blockchain

These could also help transfer digital assets between the parties under certain conditions. 

Types of Smart Contract Based on Applications

As far as the meaning of a smart contract is concerned, there are three types:

Smart Legal Contract

It is the most common type of smart contract. When a smart contract involves legal requirements, it is legally enforceable and requires the parties to fulfill their obligations. Failure to fulfill these obligations can result in strict legal action.

Smart Contract and Its Types

Decentralized Autonomous Organization

Also called DAO, it is a community that exists on the blockchain. This community is defined by a set of agreed upon rules that are coded via smart contracts.

The rules are made up of several smart contracts and work together to watch over activities in the community.  

Distributed or Decentralized Apps

DApps run on a P2P environment and are not hosted on a central server. The data is stored on a blockchain. So, the program is not controlled by a single entity. 

DApps efficiently integrate the usage of a network on which a smart contract works.

Smart Contracting Devices

IoT-combined smart contracts allow for commercial transactions via IoT-enabled products. These contracts are used to govern and manage interactions between multiple devices. All this while satisfying the needs of monetization or security for the IoT.

What are the benefits of smart contracts?

Accuracy

A smart contract on blockchain is immediately executed when predetermined conditions are met. It ensures that all vital contractual terms are recorded in explicit detail.

So, there is no scope of problems arising due to a party forgetting to add certain details in an agreement.

Efficiency

The digital and autonomous nature of smart contracts substantially reduces the time spent filling out paperwork & fixing clerical errors.

Trust and Transparency

Encrypted transaction records are shared with the participants once an agreement is executed. Thus, all terms are fully visible and accessible to them.

Security

Smart contracts use the highest level of data encryption currently available on the market. The same standard is used by cryptocurrencies like Bitcoin.

Savings

Third-party intermediaries that charge high fees are cut out of the equation when smart contracts are used on blockchain.

Secure Backup

All documents stored on blockchain are duplicated several times. Thus, in the event of any data loss, originals can be restored.

No Paperwork

Businesses worldwide are becoming increasingly conscious about their environmental impact. Smart contracts facilitate the go-green movement as these exist digitally and not on paper.

Guaranteed Outcomes

This is perhaps their most potent feature. Smart contracts offer a way to substantially reduce or completely eliminate the need for litigation and courts.

This is because parties agreeing in a smart contract bind themselves to the rules of the underlying code. As such, they are not exposed to interpretations made by parties outside of the contractual relationship.

Coming Up of New businesses

Smart contracts ensure that transactions are completed in a cost effective and reliable manner. This will propel the coming up of new kinds of businesses – like P2P renewable energy trading and automated access to vehicles and storage units.

How does a smart contract on blockchain work?

  • These work by following simple “if/when…then…” statements written into code on a blockchain. Once specific conditions are met and verified, a network of computers executes the actions. These actions could be releasing funds to the appropriate parties, sending notifications, registering a vehicle, or issuing a ticket.
  • But before the contract’s execution and addition to specific blockchains, a transaction fee needs to be paid. For instance, on the Ethereum blockchain, smart contracts are executed on the Ethereum Virtual Machine. And the payment for the transaction is known as gas
How a Smart Contract Works

Things to Know Before Entering Into a Smart Contract

  1. The more complex the agreement, the more the gas required to execute the contract. After the fees payment, the transaction is linked to the blockchain. This means the transaction is irreversibly finalized. Only the parties granted permission can see the results.
  1. To establish the smart contract’s terms, parties must see how transactions and their data are represented on the blockchain. Moreover, they need to agree on the “if/when…then…” rules that govern those transactions.
  1. As a rule, explore all possible exceptions, and define a framework to resolve disputes. Then the smart contract can be programmed by a developer. 

What are the smart contract on blockchain use cases?

Digital Identity

A digital identity contains a person’s personal data and digital assets. It helps an individual protect their identity from counterparties. It also enables them to share it with companies that he intends.

The internet allows a user to connect to multiple services. At the same time, your identity is shared with certain companies who can now map your identity.

Here is where smart contracts come to the rescue. These help counterparties learn about the individual without knowing their true identity. This frictionless KYC improves digital interoperability, resilience, & compliance.

Cross Border Payments

There is no doubt that it can help in international goods transfer and trade payment initiations with the use of a Letter of Credit.

Using smart contracts improves the liquidity of financial assets. This in turn, improves the suppliers, buyers, and institutions’ financial efficiencies. So, smart contracts can revolutionize trade finance. H

However, for that to happen, it is necessary for the authorities concerned to find an industry standard and implement it. With proper integration, legal complications can be solved as there will be a better way to solve disputes among parties.

High Securities

With smart contracts, capitalization table management is simplified and improved. As such, there are no intermediaries between the parties, including security custody chains.

Smart contracts can also be used for dividends, liability management, automatic payments, and stock splits. Further, these reduce operational risk and make workflows digitized.

Financial Data Recording

Through smart contracts, it is easy to manage the uniform recording of data across a company. This reduces auditing costs and reporting.

Further, the company has to incur lesser accounting costs. Thirdly, there is better interoperability among legacy networks and distributed ledger networks.

Looking for Ethereum Smart Contract Development Services?

Loans and Mortgages

Smart contracts on blockchain also improve financial services like mortgages and loans. It connects the parties and ensures that the whole process is completed in a seamless manner.

Moreover, the process is also error free. Here’s how a smart contract set up will handle a mortgage: payments will be tracked and the property will be released when the entire loan is paid off.

Using smart contracts in financial services offers visibility to all the parties involved.

Government

As smart contracts help automate, these can help the government to manage operations. Further, these can facilitate land title recording with efficiency and transparency. 

This will reduce auditing costs and improve transparency within the whole system.

Employment Contracts

Using a smart contract will prove to be beneficial to both the employer and the employee. As the terms and conditions will be crystal clear, it will promote fairness.

A smart contract can record any data like salary amount, job responsibilities, and much more. If there’s any conflict, these recorded transactions can be looked into. This will improve the employee-employer relationship. Further, smart contracts can make wage payment processing easier.

Insurance

Many disputes happen in the insurance sector. In the auto insurance sector, smart contracts help settle the insurance as soon as possible.

The smart contract will facilitate the policy and ensure that all the proper documentation is there. This includes driver reports and driving records. Once the smart contract is set up with the right policy, documents, and ways to capture data, it executes itself shortly after the accident. 

Besides, a smart contract executes a transaction only when all data has been verified. So there are no chances of fraud.

Escrow

Escrows are the process of storing value between the parties when the contract is still active. For this, the payer takes the action to release the funds. 

However, when smart contracts are used in this case, the action gets automatically triggered. This happens as soon as the service provider submits the work and authenticates it.

Securing Copyrighted Content

Today, content is not just limited to the written word – it involves videos and audio clips too. 

When a content piece is released commercially, its owner theoretically receives a royalty fee. Now, as the creation process involves multiple parties, all of them are liable for royalty. 

In reality, this is not ensured as there is no set way of clearing the confusion over entitlement. Smart contracts can ensure that the royalties are paid to the desired contributor – these record the content ownership on a blockchain.

Clinical Trials

Smart contracts on blockchain improve cross-institutional visibility. Further, these automate the data sharing between institutions while maintaining data privacy

So, conducting clinical trials becomes way more efficient with smart contracts.

What is the difference between NFT and smart contract?

Comparison ParametersNFT Smart Contract
Applications Real Estate, Medical Records Verification, supply chain, gaming industryDigital Identity, cross-border payments, insurance, trading activities
Other NameAlso called a cryptographic assetAlso known as chain code
Advantage   Their capability to make markets more efficient.Security, accuracy and speed of transactions; transparency and immutability

Combining NFTs with smart contracts can give users the flexibility to unlock a wide array of use cases. Complex contractual structures & agreements can be created. 

The underlying blockchain mechanisms will make the contracts transparent, tamperproof and auditable in real time. This will simplify and speed up any arbitration process in the future.

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How can smart contracts & NFTs interact with each other?

  1. NFTs can be embedded within smart contracts. The NFT is then transferred to a user or another contract based on the rules defined in the smart contract.
  1. Smart contracts can be embedded in an NFT to call and access assets within the NFT. For instance, once the terms are agreed upon, a user can access a song embedded in an NFT through a smart contract. 

This process will run in the background when users hit play on their applications.

Future of Smart Contracts

A study by Juniper Research has revealed that the total number of connected IoT sensors and devices is set to exceed 50 billion by 2022. So, it’ll be crucial to address standardization and deployment issues. There are high chances that this need will spur a greater use of smart contracts as these accelerate data exchange in a standardized way. 

Further, smarter contracts enable quicker and smoother processes between IoTF devices by removing the middleman. 

The financial services and insurance companies are already at the forefront of blockchain development. And transportation, government and utilities sectors are also engaging more. The reason being heavy focus on process efficiency, supply chain and logistics opportunities. 

Final Note

Smart contracts have the potential to create a world that is free of commission, fraud, and delays. All of this will add up to make smart contracts even more imperative in the times to come. Book a demo with us to know how your business can benefit from smart contracts.

June 20, 2022

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