Smart Contract

Self-executable contract based on programs stored on a blockchain

Author: Almat Orakbay
Almat Orakbay
Almat Orakbay
Almat currently works as a Financial Advisory Services (Business Valuation) Consultant 2 at Deloitte Kazakhstan, where he works with clients across multiple industries. Prior to joining Deloitte, Almat spent 9 months as an Audit Assistant 1 for KPMG Caucasus and Central Asia, where he focused on the asset management and banking services industries. Almat has a Bachelor of Finance from KIMEP University.
Reviewed By: Matthew Retzloff
Matthew Retzloff
Matthew Retzloff
Investment Banking | Corporate Development

Matthew started his finance career working as an investment banking analyst for Falcon Capital Partners, a healthcare IT boutique, before moving on to work for Raymond James Financial, Inc in their specialty finance coverage group in Atlanta. Matthew then started in a role in corporate development at Babcock & Wilcox before moving to a corporate development associate role with Caesars Entertainment Corporation where he currently is. Matthew provides support to Caesars' M&A processes including evaluating inbound teasers/CIMs to identify possible acquisition targets, due diligence, constructing financial models, corporate valuation, and interacting with potential acquisition targets.

Matthew has a Bachelor of Science in Accounting and Business Administration and a Bachelor of Arts in German from University of North Carolina.

Last Updated:October 31, 2023

What Is a Smart Contract?

A Smart contract is a self-executable contract based on programs stored on a blockchain that runs when the agreement conditions are met.

Unlike a traditional contract, these contracts are written with code and are stored on the blockchain network. As a result, all participants will have access to the information. In addition, the code will control the execution of the contract. Once the code is written, the transactions are irreversible.

The information stored in these contracts is accessible to parties on both sides. That reduces the need for a central authority, external enforcement mechanism, or legal system.

Blockchain technology built the foundation for Bitcoin. But, the technology goes above and beyond cryptocurrency. So, smart contracts are one of the products of this technology.

So, Almat, why are intelligent contracts necessary?

Programmers can use them to build Decentralized Apps ("DApps") and tokens. But, once that app is built into the blockchain, people can't change it quickly.

The decentralized apps include decentralized finance (DeFi) technology. That technology aims to change banking radically. Cryptocurrency owners can make complex financial transactions (saving, lending, insuring, and investing) with each other. 

The most notable smart-contract powered applications are:

  • Uniswap: The platform allows people to exchange cryptocurrencies without third parties or central authority.
  • Compound: Investors and borrowers can interact in the savings and loans market without banks or lending institutions.
  • USDC: This cryptocurrency is pegged to the U.S. Dollar. It's a stablecoin, the new category of digital money.

You can use a combination of these platforms. For example, you can exchange your Ethereum to USDC in Uniswap. Then, your money is sent to your USDC wallet. Then, you can invest it in different loans on the compound platform and earn interest.

Key Takeaways

  • Smart contracts are self-executable agreements based on code stored on a blockchain, running automatically when conditions are met.
  • Smart contracts provide transparency and eliminate the need for intermediaries, central authorities, or a legal system.
  • Smart contracts have various applications, including decentralized finance (DeFi) technologies like Uniswap and Compound.

How do smart contracts work?

The concept was first introduced in 1994 by American computer scientist Nick Szabo. He was also the inventor of the first digital currency, "Bit Gold," in 1998. According to rumors, people consider him the real Satoshi Nakamoto, but Nick denied all of those assumptions.

Also, Szabo wanted to extend the usefulness of electronic transaction methods in the digital world. He suggested using intelligent contracts in bonds and financial derivatives in his research. He said that the sophisticated payment systems of these securities could be:

  • Standardized
  • Traded at a low cost

Szabo referred to buying and selling derivatives that have complex terms. Many of Szabo's predictions about blockchain came true. Today, computer networks conduct the trading of products using complex term structures.

Innovative contracts can automate anything in the world. So, they follow "if/when…then…" statements in the blockchain code. When the contract conditions are met, the network executes all relevant actions. These actions include the following:

  1. Allocating funds to the appropriate parties
  2. Registering a vehicle
  3. Sending notifications
  4. Issuing a ticket

All these actions complete the transaction and update the blockchain. In other words, usually, you cannot change the transactions. Once it is recorded, only authorized parties can see the results. 

Parties can include as many conditions as they desire. To establish those terms and conditions, they have to:

  1. Determine how their data and transactions are represented
  2. Agree on the terms described in the "if/when…then…" rules governing the transactions
  3. Explore all possible exceptions
  4. Define a plan to resolve misunderstandings and other disputes

Then, the smart technology is programmed by developers.

Also, many people confuse the term with "legal contracts" or "smart legal contracts." These contracts refer to only agreements reinforced by the law and government regulators. 

Furthermore, smart contracts are not always legally enforceable since the algorithm already ensures execution.

Smart Contract Benefits

There are four ways this technology benefits businesses:

 1. Speed, efficiency, and accuracy

The only thing you need is to meet all the conditions. Once it is completed, the transaction is executed immediately. The lack of paperwork and high automation decreases the time spent on contracts. Also, automation and digitization reduce possible errors.

 2. Trust and transparency

The contract is executed by the algorithm rather than by third parties. Also, the data is shared only with authorized parties. That is why there is no risk that someone can alter the information for personal benefit.

 3. Security

The transactions based on blockchain are strongly encrypted. Therefore, it is tough to hack such contracts. Furthermore, all transactions are connected and recorded in a distributed ledger. Thus, hackers must alter the entire chain to change a single record.

 4. Savings

There is no need for intermediaries to handle the type of contracts. That is why the fees are low, and the time delays are close to zero. 

All of these advantages make the technology addressable to many practical problems. We will discuss it in the next section.

Smart Contract Applications

There are three most common ways to apply this technology in reality:

 1. Safeguarding the efficacy of medications

This innovation increases the transparency in the medicine supply chain (specifically, the transportation of lifesaving medications). Blockchain-based platforms can track temperature-controlled pharmaceuticals through the supply chain.

Blockchain technology provides reliable and accurate data and increases trust between all related parties.

 2. Increasing trust in retailer-supplier relationships

Retailers use these contracts to resolve any disputes with vendors quickly. One of the most prominent users in retail is Home Depot. They are building strong relationships with suppliers due to increased transparency in the supply chain and real-time communication.

These actions are crucial to building a foundation of effectiveness and innovation.

 3. Making international trade faster and more efficient

Businesses can join the trade finance network convened by Blockchain technology providers. That way, they create a trusted ecosystem for global trade. In addition, blockchain-based platforms typically use standard rules and simple trading options to reduce risks and disputes.

At the same time, they simplify the trading process and enlarge the opportunities for member companies and banks.

Challenges with smart contracts

Sure, this technological innovation is revolutionary. But, there are some practical drawbacks. So, let me explain those challenges.

First, these contracts are based on codes. Humans write those codes/programs. So, the "free of human errors" program is, in fact, "susceptible to errors" with massive consequences. 

In 2016, there was an attack on Ethereum, the decentralized autonomous organization (DAO). First, hackers targeted the vulnerable points of the DAO's fundraising smart contract. Then, they used it to create funds for the project.

That's one issue that many people overlook. The other problem with the concept is the regulatory ambiguity of autonomous agreements. 

Sure it is great to have a secure way of agreement execution, but we should not forget that taxation and government regulation are also factors we should consider.

How would government parties react to this technology?

Also, many of these contracts can't embed outside information from the internet. Oracles are the only way to do so; off-chain nodes can get the info from the internet and make it compatible with the blockchain.

Another issue with this innovation is its scalability or lack of it. Blockchain networks mostly struggle with scalability. Due to a lack of scalability, the transactions might take minutes and even hours. But it is still faster compared with the traditional transfer of money.

Ethereum 2.0 is supposed to solve this problem and make transaction processing faster.

Although there are many issues, these are the major ones with this type of contract.

Programming skills are vital for today's world, and Python is one of today's most popular and accessible languages. Our Machine Learning - Python Fundamentals will equip you with the relevant knowledge for your work in IT.

Researched and authored by Almat OrakbayLinkedIn

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