Well, what is it? You’ve heard it mentioned a bunch of times, if not a ton of times, but what is a smart contract?
What is a Smart Contract: The Basics
Imagine a regular contract, written on paper or typed up on a Word document. The conditions in the contract are enforceable, but only by law. If the terms of agreement in a contract are not met, you must typically go through the legal system to enforce the conditions/consequences for those terms not being met. This relies heavily on third parties and requires both time and money.
Now, let’s imagine that these terms and conditions were written in code in lieu of text. By this, I mean that they were programmed — that they were automated. The computer that they are programmed into automatically and instantly enforces the conditions. So, what is a smart contract? This is what a smart contract is. It’s a programmable contract.
That’s the raw concept. There’s one issue, though: what happens if the computer that runs the contract is hacked or shut down? Also, what if the person in control of the computer logs into it and edits the file?
This is where DLTs (Distributed Ledger Technologies) come into play.
You’ve probably heard of blockchain technology, the most common form of DLTs. In 2009, blockchain technology was invented by Satoshi Nakamoto, along with Bitcoin.
Blockchains (a type of database/ledger) typically run in a decentralized manner, meaning there is no central point of authority nor a central point of failure. Instead of relying on a central system, the database is maintained by a network of computers owned by a multitude of different entities.
This way, nobody is in control, and if one of the systems/computers is shut down or compromised, the database remains live and untampered.
Ethereum introduced smart contracts to blockchain technology. By building smart contracts on a blockchain, agreements can truly be trustless. Nobody can tamper with them and they cannot be shut down, reversed or deleted — they are immutable.
Smart contracts on DLTs, such as blockchains, are the smart contracts we know and love today.
(To learn more about blockchain technology, read our Blockchain Explained guide.)
Use Cases & Examples
So, what is a smart contract? Are you confident answering yet? Perhaps some real-world examples and use cases might help to further clarify your understanding.
Although this can be applied to any form of insurance, let’s take a look at flight insurance.
Using smart contracts for flight insurance offers a number of benefits:
- With the compensation reserve locked into the smart contract prior to the insurance being purchased, the customer can rest assured that the money is available for them to be compensated if needs be.
- The customer can see that the smart contract is programmed to instantly transfer compensation to them if one of the conditions is met. An example of this may be: IF the flight is more than 90 minutes late, THEN the smart contract transfers 0.5 ETH to the customer.
- The need for the customer to file a claim against the company is completely eliminated. No more tedious forms! This saves time and money for both the customer and the airline.
- When the customer purchases the flight insurance, the smart contract automatically records it on the ledger, meaning it is now immutable.
- There are no disputes, as claims are automatically filed and compensated by the smart contract.
- All of the above result in vastly improved speed and transparency, which is good for both the customer and the business (as the business can build a better sense of trust between themselves and their customers).
Again, this can be applied to all forms of sales, but let’s take a look at property sales in this example.
There are countless benefits to decentralizing property sales via smart contracts. These include:
- No currency conversion costs
- No broker fees
- No banking fees
- No cross-border fees
- No financial services needed
- Instant and trustless
Here’s how it’d look:
(We’ll use an Ethereum smart contract as our example)
- Jim lives in France and has decided to sell his property. It’s a villa. He creates a token that, by law, represents ownership of his villa. He wants to sell it for 200 ETH (Ether).
- He then forms a smart contract that states IF 200 ETH is sent to the smart contract, THEN his villa token will be sent to the address that sent the 200 ETH.
- Dan (who lives in Japan) wants to buy Jim’s villa. So, he sends 200 ETH to the villa smart contract. The smart contract executes its terms instantly and transfers the villa-ownership token to Dan, and the 200 ETH to Jim.
- As Dan is in Japan and Jim’s villa was in France, this transaction would traditionally take multiple days to process and would require numerous third parties (such as banks and brokers) as well as expensive conversion fees, transaction fees, and broker fees. Instead, it is instant and virtually free. The only fee he must pay is to the Ethereum blockchain, as the nodes that run the blockchain must pay their electricity bills. The fee is minuscule, though, often amounting to less than 20 cents.
Smart contracts are great — there’s no doubt about it. Only time will tell as to how far we go in adopting this revolutionary technology in our everyday lives, but it sure is exciting to imagine a world in which we adopt them on a mainstream level.
So far, it looks very positive.
Huge titan-sized companies — such as IBM and Microsoft — have adopted blockchain and smart-contract technology. The future is now.
Right, then, what is a smart contract? Do you feel confident in your answer now? If you don’t, feel free to shoot us some questions! We’d gladly answer.
If you do feel confident, go ahead and test yourself: see if you can summarize smart contracts into one short paragraph. Fire it our way in the comments section!
Smart contracts existed prior to Ethereum. Well, they existed in conceptual theory, at least.
That’s right, smart contracts were actually first proposed as a theoretical concept in 1998. It was Nick Szabo, a computer scientist from the U.S., who was the first to do so.
It was Vitalik Buterin and the Ethereum team, though, who first put them to use. In 2015, Ethereum was launched, providing a blockchain platform and programming language (Solidity) that developers could use to build smart contracts and distributed applications (DApps) that run on its blockchain network (Ethereum).