Undoubtedly, each of us at some time entered into a contractual relationship where the other party and we strived to ensure the proper fulfilment of the agreed conditions. Usually, it takes the form of a preliminary contract with its own rights and obligations. The need for contracts usually arises when it comes to complex execution mechanisms, as you need to be sure of the other side's good faith or that some key points will not be violated.
In the modern world, parties can conclude transactions on different continents using only their internet connection. Thus, modern business tools no longer limit people by location. The technological leap, the exponential growth of Internet traffic, the popularity of crypto assets, and the rapid development of the IT sector have created a need for faster and more efficient solutions. And one of such solutions is a smart contract.
Smart Contracts Explained
A smart contract is an automated agreement between the buyer and the seller integrated directly into the blockchain code. The code and the agreements exist on a decentralized network of blockchains. The parties prescribe the terms of the transaction and sanctions for their failure to comply with the smart contract. A smart contract independently determines whether everything has been completed and makes a decision: complete the transaction, issue what is required, impose a fine or penalty on participants, and close their access to assets. This technology allows to exclude the possibility of fraud on both sides and conduct a transaction in a specific algorithm of sequential actions.
Blockchain technology affects a wide variety of aspects of our daily life, and smart contracts are perhaps the most exciting feature of cryptocurrencies from consumers' point of view. Unlike classical contract law, this technology is still extremely new, its full potential has not been revealed, and its vulnerabilities have not been sufficiently explored. Experts in the virtual asset market field see great potential in it and invest in its further development. However, the world community still does not consider smart contracts a full-fledged replacement or an alternative to "paper" contracts.
To understand the nuances of smart contracts, their advantages and disadvantages, you need to take a closer look at the technology itself and its origins.
Historical Background
The term “smart contracts” belongs to the American cryptographer and computer scientist Nick Szabo. He came up with this concept back in 1993, long before the advent of blockchain technology, ahead of his time by more than a decade. According to Szabo's vision, smart contracts are digital protocols for information transfer that use mathematical algorithms to execute a transaction after certain conditions are met automatically, and the process is fully controlled.
Szabo believed that the development of smart contracts through digital security mechanisms could significantly improve traditional legal contracts. Nevertheless, in 1996, this concept could not be realized as, at that time, the necessary technologies did not exist.
At that time, the idea was too futuristic and did not find a worthy application. This continued until 2008 when Bitcoin was introduced to the world with its own blockchain. The Bitcoin blockchain does not allow you to set conditions for a transaction in a new block since it only contains information about the transaction itself. Nevertheless, the advent of technology has served as an impetus for the development of smart contracts.
The full concept of Nick Szabo was implemented in 2013 on the Ethereum blockchain, which was based on modern smart contract technology. It allowed applications to be developed and run without new distribution registries. Thanks to this, ETH received the title of the first blockchain with the full integration of smart contract technology. Today, the market offers many platforms that allow the use of smart contracts, but Ethereum remains one of the most common.
How Do Smart Contracts Work?
Smart contracts are part of the blockchain code and work directly within the network. They perform the function of paper contracts familiar to us, but in the digital form. As in a paper contract, the conditions are subject to mandatory implementation. And once the conditions are met, the smart contract executes the transaction on its own and guarantees that the agreement will be respected. After completing the algorithm and the correct operation, smart contracts become part of the registry, getting into the blockchain itself.
Smart contracts allow you to exchange money, real estate, goods and other assets. The contract is stored in a decentralized ledger where information cannot be deleted or falsified. Data encryption ensures the anonymity of the parties to the agreement. An important feature of smart contracts is that they can only work with assets in their digital ecosystem. Connecting the virtual and real-world is currently one of the main difficulties of working with smart contracts.
Thanks to the unique features of smart contracts, many industries and topics could benefit from this kind of contract and contract execution. Here are several examples: finance, insurance, government, electronic commerce, real estate, audit and taxation.
Smart Contract Advantages
Smart contract technology is actively used in most existing blockchains due to its significant advantages:
Speed. Traditional contracts can take a long time to process, verify, or even contact third parties, and therefore the completion of tasks usually is delayed. Smart contracts involve an automated process and, in most cases, do not require personal participation, which saves valuable time. This is especially important when you have small transactions that need to be verified quickly.
Independence. Smart contracts exclude the probability of third-party interference. Since the network deals with the transmission and terms of the contract, it is entirely autonomous. You do not need a bank, lawyer, or other intermediaries for a successful transaction. Thus, you can enter into your contracts, and you are not limited by local restrictions or costs associated with verifying a transaction. A transaction guarantee is a program itself, which, unlike intermediaries, will not give reason to doubt its integrity.
Trust. With every deal, it's crucial that both parties trust each other and that the deal really works. Due to the particular way of storing information, many computers exchange data and verify it in real-time. The data recorded in the blockchain cannot be changed or destroyed. If one party to the transaction fails to fulfil its obligations, the other party will be protected by the smart contract terms.
Accuracy. There can be plenty of mistakes when dealing with intermediaries or with paper documentation manually. An automatic system removes the human factor and ensures high accuracy when executing contracts.
Saving. Smart contracts can provide significant savings by eliminating costs for intermediaries, reducing transaction costs, and allowing parties to work together on better terms.
Security. The usage of very secure network protocols and cryptography, along with other layers of protection, ensures that only the parties involved can access the information. Another vital role is a secure transaction. This means not only that the document and the contract are kept in an abbreviated form but also that the information is only available when someone has access to it.
Automation. A considerable advantage of Smart Contracts is that they are automated and self-executing. You can be sure that complex contract structures are respected and you have traceability of the document and the assets.
Disadvantages
Despite their promising potential, smart contracts also have their cons:
Lack of regulation. Smart contracts do not have a specific legal status, greatly complicating the legal process. In the international legal field, there are no concepts of "blockchain", "smart contract", and "cryptocurrency".
The impossibility of changing the smart contract. Paradoxically, one of the main advantages of smart contracts can also be seen as a drawback. If the parties reach a better agreement or new factors arise, they will not be able to change the contract. These contracts are fulfilled in every case. If you set the wrong conditions, it will comply, no matter what happens.
Everything is in cryptocurrency. All settlements in smart contracts are made in digital assets. It is not attractive for all users because certain classes of the population are not interested in cryptocurrency and do not understand how it works.
The complexity of implementation. Integrating smart contracts with real-world elements often takes time, money, and effort.
Disbelief. Not everyone believes that technology can fully automate routine processes and completely eliminate the human factor in the form of an intermediary.
The Future Prospects of Smart Contracts
Smart contracts can eliminate legal and financial intermediation by simplifying and automating routine and repetitive processes that people currently pay banks and lawyers for. The role of lawyers may change in the future as smart contracts gain capabilities such as adjudication of traditional legal contracts and customizable smart contract templates.
Already, many organizations are actively working to improve the existing defects of smart contract technology. Crypto exchange companies support this technology and develop services related to it. Many traditional banks and other organizations are experimenting with blockchain technologies and smart contracts by investing in projects in this industry.
Experts say that the technology will be able to get a full legal justification in the near future, which will significantly increase people’s credibility. In the coming years, smart contracts will surely be able to replace most of the paperwork in different fields.