Smart contracts explained: What is a smart contract?

29 June 2022

Smart contracts play an integral role in the blockchain ecosystem, enabling the creation of decentralised applications (DApps) and programmable payments. In this guide, we will explain how smart contracts work, highlight their unique applications, list the most popular chains they operate on, and whether they can be considered legally binding agreements under contract law.

What is a smart contract?

A smart contract is a program running on a blockchain that automatically executes an outcome when certain predetermined conditions are met. Smart contracts are commonly used to automate the implementation of an agreement so that all the parties are aware of the action without any third-party involvement. 

In technical terms, smart contracts can be described as computer code running on a blockchain that automatically executes a portion or the entirety of an agreement. The code can either be an agreement between the participants or complement a traditional contract and execute certain provisions. For instance, transferring funds from one party (A) to another party (B). 

Smart contracts share the same features a blockchain offers, such as immutability and transparency, with the code being replicated across multiple nodes in the chain. This means with each new block being added to the chain, the smart contract is also in effect and being executed. Therefore, if transacting parties have indicated certain parameters have been fulfilled, the code will execute the action based on those parameters. On the flip side, if no transaction has been initiated, the code will remain inactive. Smart contracts are like a digital handshake

How do smart contracts work?

Smart contracts operate by following input parameters that are written into a code on a blockchain. To put it simply, if condition ‘X’ happens then execute action ‘Y’. At the moment, the tasks being performed by smart contracts are fairly basic, such as releasing funds from an escrow or reserve once certain conditions are met by the transacting parties. 

Currently, smart contracts are being used to automatically execute two types of transactions: 

In the former case, the smart contract has replaced the need of a human acting as a trusted escrow. In the latter case, there is no judicial enforcer required to impose penalties. In both scenarios, the smart contract serves to reduce the administrative costs associated with execution and enforcement.

Proponents for blockchain-powered automation argue that in the future, more transaction steps will be written into code to enable smart contracts to determine legal criteria. Smart contracts can accommodate as many process stipulations as are needed to satisfy all parties that the task will be completed satisfactorily. For this to happen, the participants must determine how transactions and data are represented in the blockchain network. 

Moreover, they must agree on ‘if, then, when’ logic that will govern the transactions, handle all the exceptions and define a dispute resolution mechanism. On most blockchains, before traders can execute a compiled smart contract, traders need to pay a transaction fee for the contract to be added on-chain and executed upon. For instance, the Ethereum network requires “gas” fees when smart contracts are executed. The more complex transaction steps therein, the higher the gas fees needed to execute the smart contract. Gas fees act as a useful moderator to prevent complex or many smart contracts from overwhelming the network.

The history of smart contracts

The term “smart contract” was first used by renowned computer scientist, Nick Szabo, in the early ’90s while he was an undergrad at the University of Washington. Szabo described smart contracts as a “set of promises, specified in digital form, including protocols within which the parties perform on these promises.” Szabo uses the word ‘smart’ when comparing smart contracts to physical contracts.

In other words, smart contracts may be smarter than traditional contracts since they can automatically execute predetermined outcomes, yet they should not be viewed as intelligent tools that can break down a contract’s more subjective elements.

Szabo likes to use the analogy of a vending machine to explain smart contracts. Once traders have inserted money into the machine, it automatically executes the terms of the agreement and releases the snack. It wasn’t until the emergence of blockchain, however, that smart contracts became a reality as the technology to execute them finally came into existence.

What are examples of smart contracts being used in the world?

Smart contracts can be applied across several industries to automate and streamline how business is conducted around the globe.

Smart contracts and NFTs

Smart contracts for building DAOs

Smart contracts in real estate

What is the most popular blockchain for using smart contracts?

With the emergence of altcoins, the need and want for smart contracts has grown incredibly. Starting with Ethereum, smart contracts are now present on some of the most popular and widely used cryptocurrencies.

Are smart contracts legally binding?

According to a paper on Smart Contracts and its Limitations by the Harvard Law School Forum on Corporate Governance, for us to determine if contracts are legally binding, we must first understand the difference between an agreement and a contract. Most English speaking jurisdictions recognise that while two parties can enter into a number of agreements, a contract is a legally binding agreement that can be enforced through a court of law. But for contracts to be legally enforced, the courts have to establish whether the common law threshold of offer, acceptance and consideration have been met. Fortunately, these basic requirements can be achieved via ancillary smart contracts. 

For example, an insurer may develop a flight insurance policy that automatically provides the insured with a payout should his flight be delayed by a few hours. 

Key terms, such as outlining how the delay is determined can be written in a traditional text-based contract with the payment of the premium upon verifiable delay being handled via an ancillary smart contract. That said, a smart contract is not a legal per se contract. Instead, if all the requirements for a legal contract are satisfied (acceptance, consideration, legal intent and certainty), then a smart contract can be a legally binding contract much in the same way that binding contracts can be created electronically through online applications.

What are the benefits of smart contracts?

What are the issues associated with smart contracts?

Smart contracts have a lot of potential in today's highly interconnected world but certain clashes between how the smart contracts operate and parties transact may raise a number of issues. Let’s take a look at the main issues.

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