‘What is a smart contract’ is one of the many questions we’ve been asking ourselves since the introduction of Web3. We know it’s a digital form of agreement, but what makes it special? Or important?
What is a Smart Contract?
A smart contract is a self-executing program that automates the actions required in an agreement. Once implemented, the actions are trackable and irreversible.
Smart contracts do not contain the legal language of a contract between two parties. They are scripts of code that contain if/then statements, functions, and other programming that automate the specific actions specified in a contract. In other words, what differentiates a smart contract from a traditional contract are the terms. In a smart contract, the terms are established and executed as code running on a blockchain, rather than on paper sitting on a lawyer’s desk.
How It All Started
Nick Szabo is an American computer scientist who first proposed smart contracts in 1994. He later invented “Bit Gold” the first virtual currency in 1998, 10 years before Bitcoin was introduced. Actually, rumors often hypothesize Szabo to be the real Satoshi Nakamoto, the anonymous Bitcoin inventor. But Szabo continuously denies it.
In his paper, Szabo also presented the execution of a contract for synthetic assets, such as derivatives and bonds. Szabo wrote, “These new securities are formed by combining securities (such as bonds) and derivatives (options and futures) in a wide variety of ways. Very complex term structures for payments…can now be built into standardized contracts and traded with low transaction costs, due to computerized analysis of these complex term structures.”
Szabo famously compares a smart contract to a vending machine. Imagine a machine that sells soda cans for a quarter. If you put a dollar into the machine and select a soda, the machine will either produce your drink and 75 cents in change or encourage you to make another selection or get your dollar back. This is an example of a simple smart contract. Just like a soda machine can automate a sale without a human intermediary, smart contracts can automate virtually any kind of exchange.
What are the Uses of a Smart Contract?
Smart contracts execute agreements, so, they can serve multiple purposes. The simplest of uses is to ensure the occurrence of transactions between two parties.
Let’s take the purchase and delivery of goods as an example. A manufacturer who needs raw materials can use a smart contract to set up payment. In turn, the supplier can use it to set up shipments. Depending on the agreement between the two parties, the funds would send out automatically to the supplier upon receiving of goods.
A few other examples where we can use them are real estate transactions, stock and commodity trading, lending, corporate governance, supply chain, dispute resolution, and healthcare.
Pros and Cons
The main benefit of smart contracts is ditching third-party intermediaries. But other advantages include the speeding up of contract execution. In addition to accuracy and immutability, where smart contracts allow no human error, and we cannot tamper with them.
The downfalls, on the other hand, might include the fact we cannot change them if there are any mistakes. Also, the possibility of loopholes that may allow contract execution in bad faith.