Smart Contracts in Blockchain: What They Are and How They Work

Josiah Makori
By Josiah Makori
Joel Taylor
Edited by Joel Taylor

Published February 28, 2022.

A hologram of a contract hanging in the air

Smart contracts are self-executing computer protocols built on a blockchain network. They facilitate the execution of trusted transactions and pacts among anonymous individuals without the supervision or control of a third party. Additionally, they automate workflow and eradicate human errors by triggering the outcomes of predetermined conditions.

Smart contracts run on a blockchain network, meaning that the terms and conditions are stored in an immutable, decentralized database. All the transactions are processed and recorded on the blockchain, automating payments and counterparties.

How Do Smart Contracts Work?

Smart contracts work by obeying basic if/then statements coded into a blockchain. A series of connected computers/nodes perform the next action when the coded statements are met. Such actions include sending digital assets to a given address, voting, registering a property, issuing event tickets, or notifications. The nodes then record the actions in the blockchain; hence, they cannot be altered.

Smart contracts contain multiple options to ensure that the participants are satisfied with the task at hand. To arrive at a mutual agreement, the participants determine how transactions will be represented on the blockchain, give consent to the if/then statements that control transactions, search for ideal exemptions, and agree on a framework for determining disagreements.

Here is a simple explanation of how a smart contract works.

Assume Josiah wants to purchase a piece of land from Tyson. Instead of signing a paper-based agreement, they create a “digital agreement” and code it into the Cardano blockchain. This “digital agreement" between Josiah and Tyson contains the duration of payment, measurements, cost, and title deed of the property. In other words, the agreement looks like this: “WHEN Josiah pays Tyson 4,500,000 ADA, THEN Tyson will hand over the ownership rights to him.

Once this agreement is coded into the Cardano blockchain, it cannot be altered, implying Josiah can feel safe to pay Tyson 4,500,000 ADA for the property.

If we eliminate smart contracts from this deal, Josiah and Tyson will incur enormous fees for intermediary services, and the deal may take several months to process due to manual verification.

Why Should You Use Smart Contracts?

Smart contracts have multiple benefits over traditional arrangements, including:

  • Accuracy One of the basic requirements of a smart contract is recording all the predetermined terms and conditions clearly. This is because a slight omission can lead to severe errors. Besides, since smart contracts are automated, they eradicate human errors associated with filing mass amounts of paperwork.
  • Transparency All the participants can access the predetermined terms and conditions of smart contracts, minimizing future disputes. Additionally, the transactions are recorded for future reference.
  • Speed Smart contracts are software protocols built on Blockchain networks. Unlike traditional contracts, smart contracts perform transactions quickly.
  • Security Smart contract records are encrypted, making them difficult to hack. Besides, since each recording block is connected to the previous and next block on a blockchain, hackers would have to modify the entire network to alter a single record.
  • Savings Another significant benefit of smart contracts is eliminating expensive processes and intermediaries. They don’t require lawyers, government agencies, witnesses, and financial institutions to run.
  • Guaranteed outcomes Smart contracts significantly reduce or even eliminate the need for litigation and courts. When two or more parties use a smart contract, they commit themselves to abide by the set rules and conditions as they are already aware of the consequence of not following them.

Real-World Examples of Smart Contracts

  • Inmusik A music streaming platform that decentralizes earnings and allocates them to the right content creator. It leverages smart contracts to validate content ownership via a transparent tagging mechanism.
  • Pharma Portal Sonoco and IBM Blockchain use smart contracts to monitor temperature-controlled pharmaceuticals by increasing supply chain transparency.
  • Tracr This platform uses smart contracts to offer end-to-end tracking of diamonds from mining to retail. Maersk and Tomcar also apply smart contracts to streamline the supply chain system.

Limitations of Smart Contracts

Despite the benefits of smart contracts, they are not without their limitations. The most prominent ones include:

  • Difficulty in modifying Modifying smart contracts is almost impossible since even slight changes are time-consuming and costly.
  • Possibility of loopholes Smart contracts may contain bugs that hackers can exploit.
  • Vague terms and conditions Sometimes, smart contracts contain statements that some participants do not clearly understand or are not applicable in some jurisdictions.

Most businesses and government agencies are embracing smart contracts at a high rate because of their innovative approach and benefits. They are essential for the thriving of the digital economy as they offer the much-needed automation, accuracy, speed, safety, and transparency for peer-to-peer platforms. It is clear that they will become far more commonplace in the future.