What are Smart Contracts? Benefits and Use-Cases

The concept of smart contracts was first proposed by Nick Szabo in 1994. Like many other legal institutions, traditional contracts faced several challenges which can be resolved by digitization. The introduction of smart contracts paved the way for a new era of contracting and posed a challenge to the prevailing procedures of contract law.

What are smart contracts?

Smart contracts are basically autonomous programs used to automate the execution of an agreement so that all participants can be certain of the outcome without the need for an intermediary. Simply put, smart contracts are blockchain-based programs that execute when certain criteria are met. 

Let’s take an example to understand it better 

Suppose A(buyer) has to pay B(Non-trusted company) some amount for a service/product which has to go through a third party C (intermediary). In such a transaction, C will be getting paid by B as commission after B receives the money.

As B cannot be fully trusted, there can be a chance that the service/product does not reach A even after the payment or the money does not reach B .

This is where the role of smart contracts comes into play. 

Smart contracts automate the whole process by using commands and ensure that the money reaches B while the product reaches A without the need of a third party i.e. C.

Thus, smart contracts digitize agreements by turning the terms of an agreement into computer code that automatically executes when the contract terms are met while eliminating the use of a third party

Why are smart contracts SMART?

Other than a normal contract, smart contracts basically are a set of codes, just like an “if/then“ statement, which gets executed upon fulfilment of predetermined conditions.

What it means is that as soon as the statement in the ‘if’ statement is satisfied, it triggers the command in the ‘then’ statement, hence automatically executing the contract.

As it is done automatically by the contracts which improve the processing speed of business processes and hence make it scalable to run across multiple enterprises

Benefits of Smart Contracts

Automation

As mentioned previously, there is no need for manual operation, rather smart contracts offer automatic execution when the contract conditions are fulfilled

Processing speed

Due to automation, the processing speed of transactions increases significantly

Cost efficiency

Smart contracts promise to automate business processes that span organizational boundaries. This can eliminate many operational expenses and save resources

Cost reduction

As middle-men are cut-out, the costs are significantly reduced as well.

Smart contract’s life cycle

The life cycle of smart contracts consists mainly of 4 steps i.e. create, freeze, execute and finalize.

Creation of Smart Contracts

1. Just like a traditional contract, this phase focuses on the ideation of the contract where the parties decide on the agreement- the goals and objectives.
2. This is followed by the conversion of these objectives into the length of codes.
3. The code gets published on the distributed ledger (A distributed ledger is a database that is accessible across different sites by multiple participants). 
4. As soon as most of the nodes ( node is one of the computers that run the blockchain’s software to validate and store the complete history of transactions) confirm the block, the contract is available for execution.

Freeze

Next comes the freezing phase where any transaction to the wallets of smart contracts is frozen. Any sort of funds transfer is blocked during this period, this is done so that nodes can act as a governing body that verifies whether the preconditions for contract execution have been satisfied. This framework ensures that the blockchain only has legitimate contracts.

Execution

As the name implies, this phase involves the execution of the automation process of smart contracts. As the integrity of a smart contract is verified by the authenticating nodes, the new transaction data is then added to the blockchain and is once again verified by the nodes to ensure the agreed-upon terms in the contract.

Finalize

 This denotes the final step of the life cycle where after the execution, the consensus mechanism (Consensus mechanisms are used to verify transactions and maintain the security of the underlying blockchain) verifies that the asset is received by the other party and hence unfreezes them indicating the completion of the life cycle.

Smart Contracts Real-life uses

Insurance company

The insurance companies can automate the insurance procedure by writing it into a smart contract. A formal contract that ensures coverage in accordance with the stated terms is an essential requirement for insurance companies. In addition, they must handle the claims resulting from various incidents and life events that result in the agreement’s activation. 

Smart contracts are capable of carrying out the business process, including the formal agreement, issuance to the insured, and claim settlement in the event that the terms of the policy must be followed. Smart contracts can also be used to detect fraudulent claims 

Example: A company called Etherisc is powered by smart contracts. Etherisc uses blockchain technology and hybrid smart contracts to make the purchase and sale of insurance more efficient, lowering their operational costs and bringing greater transparency to the insurance process. 

Supply Chain Management

Like data management, supply chain management also suffers due to the traditional paper-based systems that many businesses still use. Smart contracts automate the supply chain hence increasing efficiency and transparency.

Example: A business can use smart-contract-powered supply chains and improve its inventory tracking. A company called De Beers uses smart contracts to monitor the diamond production process and track the transit of diamonds from the mine to retail outlets.

Trading

Trades can be automated without the need of intermediaries.

Example: Uniswap runs on two smart contracts; an “Exchange” contract and a “Factory” contract. These are automatic computer programs that are designed to perform specific functions when certain conditions are met. The exchange contract facilitates all token trades without the need for any intermediary.

Smart contract Challenges

High stake flaws

Flaws in smart contracts may result in costly errors and potentially the loss of users’ assets. There have been many recent examples of hackers exploiting errors in smart contract coding to drain users’ accounts.

A Blockchain startup MonoX Finance said that a hacker stole $31 million by exploiting a bug in software the service uses to draft smart contracts.

Confidentiality Issue

 Users can interfere with the blockchain application to reveal the state of the contract. So, it would mean that the privacy and confidentialityof the user’s data are violated.

Security Issue

Security remains one of the main concerns regarding smart contract technology. A small error in the code of a smart contract can result in millions of dollars in loss. Therefore, when it comes to writing a smart contract, security should always be the developer’s top priority.

According to a report from the Guardian,  more than $300 Mn of cryptocurrency was once lost after a series of bugs in a popular digital wallet service led one curious developer to accidentally take control of and then lock up the funds. This shows that a small error in a code can also create some major security issues.

Conclusion

It can be concluded that there is no doubt that smart contracts have been and will be a very effective way to manage processes as it greatly reduces cost and time, but this does not mean that it doesn’t come without limitations. The confidentiality and security issue still exists which are being resolved as the technology is getting more and more advanced.

Coming onto the application, smart contracts are being introduced in people’s daily lives that may include automated insurance claims, improving the efficiency of supply chain management, etc. which clearly indicates the use of blockchain technology and its potential for the future. With its advancement, it will be exciting to see the full prospects of these smart contracts as more and more companies adopt and implement them in their business operations.