What Is a Smart Contract and How Does It Work? A Beginners Guide

Blockchain has housed many cutting-edge technologies, such as smart contracts. Smart Contracts and their utility have evolved over the years and are mainly used to create crypto. However, the roots of smart contracts come from further than that.

To begin with, you may wonder what a smart contract is, how it works, its origins, and its applications in the blockchain industry. Smart contracts existed even before the birth of Bitcoin. In this feature, we will walk you through understanding the smart contract.

 Origin of Smart Contracts

The idea of smart contracts began in 1994, much earlier than the birth of Bitcoin — as we stated earlier. Notably, experts claim that the definition of a smart contract from 1994 still remains accurate to this day.

An American cryptographer and programmer, Nick Szabo, was the genius who first proposed the idea of smart contracts back in 1994. Some blockchain community members believe Szabo to be the real identity of Bitcoin’s anonymous inventor, Satoshi Nakamoto. However, Szabo denied these rumors.

Regarding the definitions, Szabo described smart contracts as a computerized transaction protocol that executes the terms of a contract. He further explained that the general objectives of smart contract design are to satisfy common contractual conditions (such as payment terms), minimize exceptions both malicious and accidental, and minimize the need for trusted intermediaries.

Szabo tried to simplify the definition of the smart contract by comparing it to a vending machine.

Let’s say you wanted a packet of chips from the vending machine, the user inserts the correct amount of coins, then, the machine delivers the packet of chips. The machine only delivered the chips after the correct amount was inserted, ensuring that it “executes the terms of the contract”, as mentioned in the description by Szabo. There is no involvement of a third party, it is just a transaction between you and the machine with an already-written digital agreement.     

We can see that this definition of ‘smart’ is still applied even in this era, although it was proposed a long time over 30 years ago. The smart contract is now often associated with blockchain due to its decentralized features.

Moreover, Szabo’s proposals are still considered one of the earliest attempts in the crypto world. Wait “proposals, plural?” Yup, that’s true. Have you ever heard about Bit Gold? Bit Gold was considered the first virtual currency proposed by our very own Nick Szabo in 1998. No wonder some mistook him as Satoshi Nakamoto. 

What is a Smart Contract?

If you search the term “smart contract” on the internet, you will get various definitions from different sources. However, you’ll see that they all have the same concept and use the same basic terminology to describe a smart contract.

For instance, a smart contract is usually described as a self-executing contract, and the terms of the agreement between buyer and seller are usually written into the codes. So the contract is not executed by any person, but, in fact, the code written in the contract decides on the execution. Moreover, the smart contract also ensures that the transactions are trackable and that it will be almost impossible to reverse them.

The new observed definition has added that the code and agreements of smart contracts often exist in the revolutionary decentralized world of blockchain. This also gives the smart contracts the features of decentralization, thus, they are closely associated with cryptos.

Now, just in case, someone asks to give a simple definition of a smart contract, consider using the following definition from Babypips (which is my favorite definition😉):

Smart contracts are automated computer programs that are hosted and executed on a blockchain.

A sample smart contract of a Wallet

Now let’s dive deeper into the advantages and disadvantages of the smart contract.

Pros & Cons of Smart Contract

There’s no doubt that smart contract is one of the revolutionary technologies of modern times. Lo and behold the reason why smart contracts are considered the advanced technology of the new era:

Security – Since smart contracts are usually executed on the blockchain, it ensures that the transactions are transparent, making it difficult for hackers to cause disruption. Moreover, since its decentralized nature ensures that there is no interference from any central authority,  users cannot be victimized by centralized injustices.

Reliability – Another feature that also acts as a part of security, the smart contract ensures the terms of the agreement are agreeable. Utilizing the decentralized network of nodes, smart contracts are enhanced ensuring its tamper-proof.

Cost-Effective – With smart contract features, it reduces the engagement and the requirement of a middleman. Thus, a smart contract helps to reduce costs, instead of being at the mercy of the middleman. 

Increases Efficiency – Automation is one part of the smart contract, as it automatically executes contracts according to the terms of an agreement. Traditional contracts require people to type in the manual data or require the middleman to process the transaction, but the smart contract does not require any such step, reducing the time and effort and improving overall efficiency. 

Since the smart contract is still somewhat new in this world, they still face some limitations. Some experts claim that the current limitations faced by these revolutionary technologies are just areas where the smart contract could improve. However, for now, let’s take a look at the current limitations faced by the smart contract:

Lack of Privacy – While smart contracts are often praised for their decentralized feature, they can be viewed by anybody. SO! For instance, if the smart contract holds embarrassing photos of your childhood, then everybody gets to see it. In other words, smart contracts can reveal your data to the public.

Rigid – Yup, another advantage of the smart contract could also be a disadvantage. Let’s say I spilled chocolate milk on your smart contract, then the stains would remain there and it cannot be changed. Of course, we can’t spill chocolate milk on a smart contract. However, if a user needs to rectify a genuine error, it will be impossible to do so due to blockchain technology’s immutable nature.

Legal Status – This is one of the most debatable topics observed in the community. Some claim that there is no official law protecting the smart contract, even though it is considered a legally binding document. Just like the other limitations, this could be a hurdle for now.

Regulatory bodies have started to accept crypto and blockchain as part of the modern world, and many enthusiasts believe that smart contracts would count as legally binding contracts in the eyes of the court.  U.S. states such as Arizona and Nevada have recognized the importance of smart contracts and have passed legislation regarding their usage. 

Prone to bugs – BUGS! Don’t worry they are not the actual gross bugs, but the computer bugs. Since smart contracts are also computer programs, they too can be prone to bugs. The process to handle those bugs could further increase the costs.

Once again, to remind the reader, the reason why smart contracts are still being used is because of their cutting-edge features which make them stand out among other technologies. Furthermore, smart contracts offer limitless potential that has yet to be realized.

Ethereum Smart Contracts

While there are many smart contracts in various blockchain platforms, Ethereum is often considered the first smart contract platform by many reports and members within the community. It was reported that Ethereum’s first successful smart contract use case was a decentralized autonomous organization (DAO).

Bitcoin was the first to support smart contracts but had a rigid structure, making it feel limited when compared to Ethereum. Even now, Ethereum still stands out among other smart contract platforms, earning first place in the Coin Gecko’s list of “Top Smart Contract Platform Coins by Market Cap”, at the time of writing.

Furthermore, Ethereum has pointed out that they allow developer-friendly languages such as Solidity and Vyper for writing smart contracts. Reports also mentioned that Ethereum’s language is “Turing-complete,” meaning it can support a broader range of programs and run it, making it flexible and reducing the limits for programmers.

Once the smart contracts are written, the code gets compiled into the bytecode language called EVM bytecode. After that, the execution of the smart contracts in Ethereum is ensured by the Ethereum Virtual Machine(EVM).  Ethereum described EVM as:

The Ethereum protocol itself exists solely for the purpose of keeping the continuous, uninterrupted, and immutable operation of this special state machine. It’s the environment in which all Ethereum accounts and smart contracts live.

Basically, as described earlier, it is a software program where one of its functions ensures the execution of smart contracts.

Now, many of you may be wondering how we can make use of smart contracts in the real world.

Applications of Smart Contract

Smart contracts, a revolutionary technology, have their branches spread across the different industries in this world. It’s time to unveil the applications of smart contracts:

Supply Chain Industry

With smart contracts on the blockchain, it will help retailers and suppliers have complete transparency of the movement of the products, further building trust between them.

Did you know? IBM has reported that Home Depot takes advantage of this revolutionary technology to quickly resolve disputes with the vendors, which further improved the relationship between them.

The smart contract is not just meant to build trust, but it also increases the visibility of the supply chain. This will let the industry focus more of its energy on the crucial steps of the process.

Healthcare Industry

Whether to ensure the proper management of the patient’s data or to track the handling of medical supplies, smart contracts on the blockchain network are one of the best technologies in this situation. Smart contracts will also ensure that the costs are cut down on the paperwork. Providing the data at a moment’s notice will also reduce the overall time.

Breaking the Monopolistic Empires

There are still countries out there that are prone to corruption and are under the clasp of monopolistic industries. With smart contracts’ decentralization, the public has now access to a previously hidden world of profits. Ensuring that the data is open, the public can see the operations and understand accordingly, assuring the reduction of manipulation.

The possibility of smart contracts in the blockchain is endless as more industries start utilizing the technology. We can still see that real estate, entertainment, customer service, finance, insurance, and many sectors have taken their very first steps toward adopting smart contracts in their operations.

Conclusion

The idea of smart contracts, just like many revolutionary technologies, was conceived years ahead of its time and is still trying to make its mark in this ever-changing world. At the moment it was introduced, some considered it to be one of the most advanced technologies ever proposed, while others felt it was a disruption to the traditional norms and functions.

However, as years passed on, industries and individuals found it to be beneficial. As the smart contract became closely associated with blockchain, the demand started to rise for the automated computerized program. This cutting-edge technology also created a new market for smart contract blockchain platforms.

Even though many believe that smart contracts face some limitations, similar to many technologies, experts pointed out that this remains to be a temporary barrier. It is believed that even now the build phase of the smart contracts still continues. This is done in the hopes of improving smart contracts and further breaking out the limits in the future.

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