Every so often, our economic landscape undergoes a profound transformation. During the pandemic, two major events were triggered; The Great Migration saw millions of people relocating their entire lives to different parts of the country. And the Great Resignation as millions of people left their jobs for a new career or retirement. Both those events represented a critical shift in our economy. And they both resulted in an injection of innovation to solve new problems, which spawned new markets, new companies, and new lifestyles.
What are smart contracts? And how do they work?
Those are the questions we'll be answering in this post.
A Bit of History
The creation of smart contracts is attributed to legal scholar Nick Szabo, who in 1996 published an article entitled "Smart Contracts" in Extropy magazine. In the article, Szabo laid out his vision for smart contracts, and how they could enable "trustless" exchanges.
He defined a traditional contract as "a set of promises agreed to in a meeting of the minds, which is the traditional way to formalize a relationship." And a smart contract was defined as "a set of promises, specified in digital form, including protocols within which the parties perform on the other promises."
The promise of smart contracts, according to Szabo, would be to improve the execution of the four main contract objectives: observability, verifiability, privacy, and enforceability. Smart contracts would enable all parties involved to observe the other parties' performance of the contract, verify if and when the contract has been performed, and guarantee that only the information required to fulfill the contract is revealed to all parties (privacy). Smart contracts would also be self-enforcing - that is, automatic and immutable (enforceability).
Smart contracts are also decentralized, enabling two complete strangers to sign a legal agreement online without requiring an intermediary to act as a law firm. In the same fashion, smart contracts allow two strangers to send and receive Bitcoin transactions without the need for an intermediary to act as a bank.
The above explains smart contracts conceptually. Concretely, a smart contract is simply a digital contract that uses the security coding of the blockchain. The smart contract contains all of the details and permissions of the agreement as part of its code. And a specific and exact sequence of events must unfold to trigger the agreement in the smart contract.
The smart contract, being embedded within the blockchain, is transparent (can be viewed by all members of the network), immutable (cannot be modified), and decentralized (does not rely on a centralized authority). Every smart contract that is broadcast over the network possesses an address in the blockchain, enabling all network members to consult the contract.
Smart contracts were first used on the Bitcoin network to transfer value from one user to another. In this context, smart contracts were used to define the conditions of the exchanges, such as ensuring that the amount of value (Bitcoin, in this example) actually exists and is available in the sender account. Smart contracts have evolved quite a bit since then. For example, they can now include time constraints as part of the conditions.
How do Smart Contracts Work?
Smart contracts work by using basic binary logic, specifically the IF-THEN operator. Here are a few examples:
- IF you send me object A, THEN X sum (in cryptocurrency) will be transferred to you.
- IF you transfer a specific amount of digital assets (in cryptocurrency), THEN object A will be transferred to you.
- IF I finish the work, THEN the digital assets mentioned in the contract will be transferred to me.
Once a smart contract is signed, it cannot be modified. The different parties agree on the conditions to include in the contract. And it will be fulfilled the instant its conditions are met. The assets you acquired (whatever they may be) are instantly transferred to you with no delays, no hidden surcharges, and without a central authority.
Benefits of Smart Contracts
Smart contracts rely on blockchain, and entries on the blockchain ledger are immutable and transparent to all nodes on the network; this makes smart contracts "trustless." There is no need to trust a central authority, let alone the other parties involved in the agreement. Also, the transparent, immutable, autonomous, and secure nature of the agreement removes any possibility of manipulation, bias, or error.
Because it's embedded in the blockchain, the smart contract can't be lost. And because of the decentralized nature of P2P networks, multiple copies of the contract exist within the network.
Speed and Accuracy
Because smart contracts are digital and automated, there is no paperwork to delay the processing time, and the chance of introducing errors while manually filing documents is also removed. As soon as the conditions within the contract are met, it is executed immediately, making smart contracts quite efficient.
Transaction data in the blockchain is securely encrypted, making it very difficult to hack and tamper with. Beyond the encryption, each entry is registered in the previous and succeeding block in a distributed structured ledger. So for a malicious actor to change one record, they would need to compromise the entire chain, which would be extremely difficult and unlikely to succeed.
There are no third parties involved in smart contracts. All parties involved confirm the agreements without recourse to any brokers or central authorities. The absence of third parties reduces the risk of data breaches. And because smart contracts are maintained and executed by all the nodes on the network, it precludes any one party in the network from having controlling power over the transaction.
So that was an overview of smart contracts. They have many benefits, and their decentralized nature is likely to create new ways of exchanging goods and services. And smart contracts are also expected to spawn new business models moving forward - such as how creatives are compensated for their work, for example. It's also probably just a matter of time before we start seeing smart contracts being used globally by corporations and governments alike. Hopefully, this post will help make smart contracts a little bit less abstract as we move into the new Web3 economy.
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