The very first mention of digital contracts was back in 1996. Nick Szabo, an American scientist in the field of cryptography, proposed the use of smart business contracts. His idea resulted in a prescribed algorithm for the digital currency Bit Gold, which is considered the predecessor of the well-known BTC coin. At that time, the idea was too futuristic and no one wanted to imply it. This thought lasted until 2008 when the world was presented with Bitcoin and its blockchain.
Nick Szabo’s concept was fully realized in 2013 on the Ethereum blockchain, based on modern smart contract technology. This allowed developers to generate applications and run them without new distribution registries. Thanks to this, ETH gained the title of the first blockchain with full integration of smart contract technology.
What Does Smart Contract Blockchain Mean?
Blockchain smart contracts are a kind of algorithm for certain actions integrated into the blockchain code. If the established agreements, which are spelled out in it, are observed, the sequence is automatically triggered.
For example, take the simplest transaction – the process of buying and selling cryptocurrency between users. It takes place according to the requirements of anonymity and is not regulated by intermediary organizations. It can be executed thanks to blockchain smart contracts, which prescribe a detailed transaction algorithm between two parties. Smart contacts eliminate the opportunity for fraud on both sides and make it possible to conduct the trade in a specific formula of sequential actions.
How Do Smart Contracts Work?
Smarts are part of the blockchain software code and work directly within the network. They perform the function of paper contracts, but in the digital field. The terms are not written in pen on paper, but using mathematical algorithms and programming languages.
Just like in a paper contract, the terms are subject to mandatory execution. Only after contract signing will the transaction be realized and users will receive the conditioned result. Once the algorithm is completed, smart contracts on the blockchain become part of the registry, entering the blockchain itself. The basic principle of a smart contract is the complete implementation of a conditional sequential algorithm.
Types Of Smart Contracts
There are several basic types of smart contracts, which are classified according to different criteria:
- According to the execution environment, smart contracts can be centralized and distributed.
- By degree of anonymity, smart contracts are confidential, partially open and fully open.
- According to the mechanism of initiation, smart contracts can be limited and preset.
Also, the degree of automation of the smart contract plays an important role. It indicates whether the digital agreement can function on its own or additional physical paper-based media will be required. So, types of smart contracts in the blockchain are:
- Fully automated — no hard copy is required.
- Partially automated — a paper copy of the smart contract is required.
- Automated — mostly in storage.
Prospects And Disadvantages Of Smart Contracts
Smart contract technology is a useful system that simplifies a lot of routine processes, bringing them to full automation without human involvement. It is actively operated in most existing blockchains because of its significant advantages. The main benefits of smart contracts in blockchain are:
- Eliminating intermediaries. Smart contracts in blockchain allow customers to completely (or partially) get rid of the involvement of third individuals to control transactions. This stops the impact of human error, makes trading more secure and transparent, and significantly reduces overhead costs.
- Security. All information about the terms of the contract and how they are observed is in the distribution form (in the register). This reduces the risk of fraud and other manipulation from both sides.
- Transparency. Any participant can audit and check the correctness of the fulfillment of blockchain with smart contract conditions at any convenient time.
- Development of spheres. Smart contracts technology allows users not only to improve existing companies in different business areas, but also to create new models and financing services.
Despite the significant pluses of smart contract technology, this is a fairly new field, which has its disadvantages:
- User distrust. A rather pressing problem is the low credit of trust. Unfortunately, not everyone believes that technology can fully automate routine processes and completely eliminate the human factor in the form of an intermediary.
- Lack of legal justification. Smart contracts do not have a certain legal status, which makes the permitting process very difficult.
- Settlement in cryptocurrency. All calculations in smart contracts are made in digital assets. This point does not attract all users, as there are certain classes of people who are not interested in cryptocurrency and do not understand how it works.
- Weak oracle system. Smart contracts technology needs to acquire a more developed visionary system. This can be done by improving the quality of external information sources.
- Smart contract risk of error. In the legal component of smart contracts, it is possible to make a serious mistake when translating regulations into software code, which will have negative consequences when processing the transaction.
How Do Smart Contracts Work In Ethereum And Bitcoin Blockchains?
During the expansion phase and after the official implementation of Bitcoin, its developers didn’t intend to integrate smart contract technology. It was used only to process transaction data. However, in the BTC blockchain, it is partially possible to implement smart contract technology in some areas of activity. Such digital contracts would be spelled out based on simplified logic functions.
- Escrow. During transaction processing, coins are first deposited with an intermediary who acts as a guarantor and oversees the correct execution of the transaction.
- Safe. Access to the account is blocked until a certain time period is reached.
- Multi-signature. Confirmation of the correct execution of the operation is carried out with the involvement of several predetermined participants.
- Testament. If there is a problem because of lack of a wallet’s functioning after the set time interval, the funds involved in the transaction are transferred to another address, the so-called “heirs”. The set time counter is reset when the account holders use the vault.
Ethereum and Bitcoin have one more fundamental difference — the status of transaction definition. ETH blockchain identifies a transaction as a complete part of the network ecosystem, while BTC blockchain defines it as a standalone element.
Ethereum allows the development of smart contracts, which will then carry out the process of generating new tokens according to the ERC-20 standard. In many ways, the innovations of the Ethereum blockchain have made it possible to noticeably simplify the interaction between various platforms, services and crypto-wallets.
How Can Smart Contracts Skyrocket Businesses? Top Use Cases
Many processes in the finance industry are still accompanied by piles of related paperwork, which complicates accounts creation for a significant share of intermediaries’ revenues. The introduction of smart contracts can simplify these operations, so the major market players have begun development in this area. Insurance companies are also actively experimenting with the use of smart contracts.
- German giant Allianz used smart contracts to automate insurance payments for natural disasters.
- Barclays uses smart contracts to automate payment and change of ownership in a transaction.
- HSBC and Bank of America replaced letters of credit (a written guarantee from the payer’s bank to the payee’s bank) with smart contracts.
The full introduction of smart contracts into the election system is not yet a prospect for the very near future. However, government services are already working hard on the most obvious advantage of blockchain: the secure storage of documents.
The Swedish Cadastral Office, for example, is functioning with blockchain startup ChromaWay, consulting firm and mobile service provider on its own blockchain solution. It aims to eliminate the errors associated with manual data entry and increase the reliability of documentation transfers. ChromaWay’s smart contract system is used to digitally document the transfer of real estate ownership.
Many organizations are actively working to fix existing flaws in smart contract technology. Analysts say that in the near time, the technology will be fully legally justified, which will greatly enhance people’s credibility.
In the coming years, smart contracts will be able to replace most of the document-based transactions in finance, as many of the world’s leading banks are experimenting with blockchain technology and moving their routines to it. The time when smart contracts will also be used at the government level to streamline reporting processes and documentation is not far off. Nevertheless, whether this is true or not, we will see in a while.