Smart Contracts Meaning
Smart contracts are digital transaction protocols that verify, control, and self-execute an agreement, embedded in computerized codes on a blockchain, if parties meet predefined rules. Unlike traditional (physical) ones, these contracts occur among anonymous parties and are enforced automatically without the involvement of any third party.
They have three main components – signatories (parties), subject of the contract, and contract terms. The parties involved must satisfy the terms of the agreement (a set of rules and penalties) for a successful transaction. Besides eliminating the need for an intermediary, executing agreements through digital contracts is considered cost-effective and secure. More so, the decentralized blockchain network ensures that transactions remain transparent, traceable, and irreversible.
- Smart contracts definition refers to digital transaction protocols that utilize the blockchain to enforce an agreement automatically while doing away with any third party. The terms of the agreement are written in computer codes, containing rules and penalties that the parties must agree to before entering one.
- The transactions through this means are immutable and transparent, enabling the parties involved to audit and validate the data as and when needed.
- There are three categories of such contracts – Smart Legal Contracts, Decentralized Autonomous Organizations, and Application Logic Contracts.
- Even though smart contracts are irreversible, developers can adopt indirect ways for updating the codes or clauses for the terms of an agreement if required.
Smart Contracts Explained
A traditional (physical) contract involves two or more parties, such as individuals, entities, and governments. They agree to contract terms and conditions to execute transactions via a third party. This third party could be a lawyer, a government organization, or any other entity. It is there to take care of the proceedings and execution of the contract. Not only does this add to audit and enforcement costs, but it also increases the risk of loss due to fraud.
In 1994, American computer scientist and cryptographer Nick Szabo coined the term “smart contracts” while attempting to execute the terms of a contract using computerized transaction protocols and a distributed ledger. Smart or self-executing contracts are computer programs created on a blockchain that facilitate transactions when parties satisfy a predetermined set of conditions. Also, there is no need for the parties to rely on an intermediary for the agreement’s validation and execution.
Let us explain the process
- There are two parties (a buyer and a seller) interested in buying and selling an asset.
- These two parties enter a smart contract, a wholly digital and self-executing agreement, with its terms or clauses written in codes on a decentralized blockchain network.
- These codes specify the agreement’s terms, which both parties must agree to for the contract to be automatically enforced. The transaction occurs when parties meet these terms and rules.
- The smart contracts platform offers complete transparency and high-end security. Also, it restricts tampering of the data and allows the two parties to track the transaction. The identities of the parties involved, however, remain confidential.
Smart contracts examples are common in industries like property rights, intellectual property, banking and insurance, legal services, e-government, crowdfundingCrowdfundingCrowdfunding is a method through which the business can raise capital from many individuals beyond friends, family, relatives, and customers by posting the project details on the websites and other social media platforms. It does not involve banks and any other financial institutions., etc. To understand the concept better, let us consider the examples below:
- A group of investors proposes to fund a business project idea from the ABC team. Both enter a smart contract, which codifies the terms and lists down a set of rules and penalties around it. If the project idea seems valid per the codes, the blockchain will transfer the money to ABC. On the other hand, if the project idea seems unsatisfactory per the contract terms, the blockchain will return the money to the group. In this example, the contract stores and validates transaction information and self-executes the contract only if the relevant event triggers.
- Another practical example is when a buyer agrees to pay a seller for delivering some goods at a specified date. The contract outlines rules for the amount to be paid and the delivery of goods on a particular date. However, the blockchain will hold the transaction if either party fails to meet its obligations.
Smart Contracts In Finance
In finance, these contracts can help simplify and speed up various financial services. For example, insurance companies can use them to create formal agreements and settle claims. Similarly, stock marketsStock MarketsStock Market works on the basic principle of matching supply and demand through an auction process where investors are willing to pay a certain amount for an asset, and they are willing to sell off something they have at a specific price. can define securities trading rules in these contracts to issue bonds for regulatory compliant trading. In the same way, banks can deploy these contracts to process syndicated loansSyndicated LoansA loan syndication is an arrangement in which multiple lenders pool their resources to lend to a single entity. It is done to meet a borrower's large requirements, and the lenders are typically banks and other financial institutions. faster and reduce operational risksOperational RisksOperational risk is the business uncertainty a company comes across in the industry while executing its everyday business operations. Such risks arise due to internal system breakdown, technical issues, external factors, managerial problems, human errors or information gap. .
Are Smart Contracts Reversible?
Smart or blockchain contracts are unique in the way that they ensure compliance between the two parties. Immutability is one of the most remarkable features of a self-executing contract. It means it is impossible to reverse, alter, or tamper the codes, rules, and even the transactions once programmed on the blockchain.
Since these are computer programs, the automated execution of agreement happens as per the codes (contract terms) and rules defined. However, if there is still a need to update these codes and conditions, there are a few indirect ways that might help:
- Create an intermediary contract containing transaction details, such as the address, of the existing contract. Thus, any transaction made using the intermediary contract will be redirected to the active one.
- Program a new contract version and import all of the existing contract’s codes, conditions, and transaction data into it.
- Store the logic code of the existing contract in a library and use it to recall the terms, rules, and transaction data of the active agreement.
Types Of Smart Contracts
There are three types of self-executing contracts based on their applications:
#1 – Smart Legal Contracts
These contracts are legally enforceable and require the parties to fulfill their contractual obligations. Failure to do so may result in strict legal actions against them.
#2 – Decentralized Autonomous Organizations
These are blockchain communities that are bound to specific rules coded into blockchain contracts combined with governance mechanisms. Hence, any action taken by the community members gets replaced by a self-enforcing code.
#3 – Application Logic Contracts
These contracts contain an application-based code that remains in sync with other blockchain contracts. It enables communication across different devices, such as the merger of the Internet of Things with blockchain technology.
Frequently Asked Questions (FAQs)
Smart or self-executing contracts are digital versions of traditional (physical) contracts where two parties enter an agreement without requiring any third party. These contracts are self-enforced once the parties involved in a financial transaction meet the contract terms and rules.
A smart contract blockchain is a platform on which digital transaction protocols are embedded. It codifies the contract terms and specifies a predetermined set of rules around the contract. The blockchain network maintains a transparent, secure, and immutable transaction.
Since not all agreements must be in writing to be considered legally enforceable, smart or self-executing contracts would be proper and valid under contract laws in various jurisdictions. In Smart Legal Contracts, the agreement outlines its terms, and the parties involved are bound to honor them or be ready to face legal recourses.
This has been a guide to What are Smart Contracts and its Definition. Here we explain the the types of smart contracts and how it works along with examples. You may also have a look at the following articles to learn more –