What is a Smart Contract, and How Does it Work?
Updated: Sep 22, 2023
Smart contracts are one of the most valuable blockchain technologies. They may facilitate the transfer of everything from bitcoin and fiat currency to commodities shipped worldwide. Smart contracts are business automation systems that run on a decentralized network like blockchain.
They are one of the most appealing aspects of blockchain technology because they eliminate administrative overhead. While blockchain serves as a database that verifies the occurrence of a transaction, smart contracts execute predefined conditions; see a smart contract as a computer that carries out conditional programming.
When specific requirements of a smart contract are met, for example, when goods arrive in a port, and two parties agree to a cryptocurrency exchange, they can automate the transfer of bitcoin, fiat money, or the arrival of a shipment of goods, allowing them to continue on their journey. A blockchain ledger preserves the state of the smart contract beneath it all.
In this article, I will explore, What is a smart contract and how does it work?
Tokens and smart contracts: What You Need to Know
Smart contracts, for example, might be used by an insurance company to automate the transfer of claim money in the event of large-scale floods, hurricanes, or droughts. A bill of lading can also be issued automatically once a cargo shipment arrives at a port of entry. Internet of Things (IoT) sensors within the container ensure the content has been unopened and stored correctly throughout the journey.
Smart contracts are also the backbone of cryptocurrency and digital token exchanges (essentially a digital representation of a physical asset or utility). For example, on the Ethereum blockchain, the ERC-20 and ERC-721 tokens are smart contracts, but not all smart contracts are tokens. In addition, other cryptocurrencies, such as bitcoin, can be transferred using smart contracts. For example, Bitcoin can be transferred from vendor to buyer once payment has been validated.
Tokens aren't used in most enterprise blockchain networks. In those that do, smart contract rules dictate how tokens are allocated and transfer requirements are defined. That doesn't necessarily imply that a token is a smart contract; it relies on how it was built. And tokens don't have to be about money; they may be something you own that allows you the ability to vote on a decision; casting your token indicates you've voted, and you won't be able to vote on this decision again as there's no economic value to it.
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How smart contracts are modeled after business rules
In the legal sense, smart contracts are neither "smart" nor "contracts." They're just software for turning business rules into executable programs. People frequently inquire about the differences between smart contracts, business rules, automation software, and stored procedures. The response is that the premise is the same. Still, smart contracts can automate operations that span corporate boundaries and include several businesses, something that traditional methods of automating business rules cannot achieve. To put it another way, because smart contract code runs on an open blockchain ledger, rules can be applied within the organization that created the smart contract and to other business partners who are allowed to be on the blockchain. They're just pieces of code that do what they're supposed to do. The result will be a disaster if the business rules are poorly defined and if the programmer needs to do a better job, and even if planned and implemented well, a smart contract isn't smart; it simply performs as designed.
The consequence of translating business norms into code is only sometimes a legally enforceable agreement between the parties involved (which is what a contract is). Although some initiatives are underway to make smart contracts automatically legally binding, this approach is difficult and risky, at least for now. This is due to the need for a universally accepted description of a smart contract.
The importance of good data and the use of 'oracles' in smart contracts
It's imperative to have good programming because smart contracts’ accuracy is dependent on the accuracy of the rules used to automate procedures. The accuracy of the data put into a smart contract is also critical. Because smart contract rules can't be changed once they're in place, it’s impossible to change a contract after it has been written by challenging the user or the programmer. So, smart contracts won't work if the data isn't correct. Just because it's on the blockchain does not automatically correct the data.
External data sources, like data feeds and APIs, are fed into blockchains and used for smart contract execution; a blockchain cannot directly "get" data. (These "oracles," or real-time data feeds for blockchains, are the middleware between the data and the contract.)
Oracles can be either software or hardware. For example, an RFID sensor in a cargo container might serve as a hardware-based oracle, transmitting location data to smart contract parties. On the other hand, a software oracle may be a program that feeds information about a securities exchange through an API, such as altering interest rates or stock price shifting.
When you're hedging risk on an exchange and the stock price rises, one party will profit while the other loses money. The smart contract that determines what happens needs market price data from the data provider's API. This creates a problem: the smart contract's participants must trust the outside data source.
Unlike blockchains, smart contracts are not decentralized over hundreds or thousands of nodes. They can only run on one node. The blockchain nodes (servers) have no access to how a smart contract functions; thus, any consortium of entity members of a blockchain network must rely on one oracle for the information being fed into the smart contract. For example, if your organization is part of a blockchain consortium supply chain, it has no means of understanding what's going on with the smart contract. There's no way of knowing whether or not it's true. Put another way; you must trust the entity running the server that holds the oracle and smart contract that the data transmitted to the blockchain is valid.
Problems of Smart Contract
1. Change is difficult
Smart contract procedures are almost hard to modify, and any programming error may be time-consuming and expensive to rectify.
2. Potential for loopholes
According to the concept of good faith, parties will deal fairly and not profit unethically from a transaction. But on the other hand, smart contracts make it difficult to ensure that the conditions are followed to the letter.
3. Third-party involvement
Although smart contracts are designed to remove third-party participation, this is hard to do. Third parties play a different role in traditional contracts than in traditional contracts. Lawyers, for example, will not be necessary to draft individual contracts; instead, developers will want their aid in deciphering the requirements to create smart contract software.
4. Ambiguous phrases
Because contracts include language that isn’t always comprehended, smart contracts can't always handle terms and conditions that aren't always understood.
Smart Contract Use Cases in Real-Time
Smart contracts have a variety of applications in the business world; it’s very likely that in the coming years, they'll have even more applications and become even more popular.
Insurance claim automation
Insurance companies today have a lot of paperwork, and transactions take a long time. Smart contracts may partially automate various insurance business operations thanks to their preset rules. This will speed up the process of transferring payments to clients. Smart contracts have a lot of potential in the insurance industry, but they need to be combined with the Internet of Things smart sensors. What's the point of it all? Assume that your automobile or home has Internet of Things (IoT) smart sensors. Sensors can promptly alert the proper authorities if an accident occurs and a car or apartment is harmed in any way. This information might trigger a condition that must be fulfilled for the smart contract to function. After receiving valid data, the money might be transmitted automatically from the insurance policy.
Improving Supply Chain Management Efficiency
Smart contract principles are straightforward in theory but not so simple to practice. The issue is this: They can include a lot of information, such as the price of the products, how long it takes to deliver them, how discounts and penalties should be applied, and what the payment terms are, among other things. Furthermore, the process becomes faster and more efficient by automating all the normal operations linked to payments and preparing documentation.
The effectiveness of a company's supply chain management is critical to its success. In this situation, smart contracts can also be used with IoT sensors. It would enable people in charge to track the location of an ordered item and arrange operations based on the warehouse's current and predicted state.
Identifying and transferring copyrights
Piracy and other forms of authorship infringement are all too common these days, and they aren't limited to the entertainment industry. Currently, copyrights are transferred using regular written contracts. However, smart contracts can not only speed up the transmission of digital items but also capture copyright information, making it hard for others to take advantage of them. In addition, royalties can be paid to the rightful owner or author via smart contracts. For example, let’s pretend you're attempting to sell online courses, magazines, or books. If the necessary application is constructed and saved in the blockchain, you may get money for downloads of your items instantly and immediately after someone pays for them.
Taking Advantage of the Data Marketplace
Is it possible to purchase data? You may not realize it, but there are platforms where individuals can buy and sell various sorts of data sets and data streams from multiple sources. These platforms are referred to as data markets. Electronic purchasing data streams and consumer data sets are automated via smart contracts.
Land Titles and Real Estate Recording
Traditional real estate transactions take a long time and require a lot of paperwork. If you wish to acquire a house, flat, or piece of land, you must always pay a fee to an intermediary who will help you through the procedure. It is pretty pricey. Property ownership can be transferred quickly using smart contracts. The process might be automated if the exchange was programmed into the smart contract. It could be triggered by a buyer making a payment. There are no middlemen and no complicated paperwork.
Smart contracts in the future: edge computing, IoT, and the future of smart contracts
The tremendous development in IoT-linked devices over the next few years may encourage more people to embrace smart contracts. According to Juniper Research, a significant chunk of the expected 46 billion industrial and enterprise devices connected in 2023 would rely on edge computing. As a result, dealing with challenges like standardization and deployment will be critical.
By eliminating the middleman: the server or cloud service that functions as the central communication for requests and other traffic among IoT devices on a network, smart contracts could provide a standardized approach for expediting data flow and facilitating activities between IoT devices. Fundamentally, the notion is that there is no central agent, no one who approves and validates every transaction. Instead, you have distributed nodes that validate each network transaction.
Blockchain ledgers reduce the time it takes to exchange and process data from IoT devices. It could be in a factory that makes automobiles. As soon as a part comes, it informs other nodes at the destination, who confirm that the part has arrived and inform the rest of the network. After then, the new node would be free to start working. According to Juniper Research, the rise of edge computing is crucial in scaling up tech deployments due to decreased bandwidth requirements, faster application response times, and improved data security.
While financial services and insurance businesses are at the vanguard of blockchain development and deployment, the transportation, government, and utility sectors are becoming more involved due to the increased emphasis on process efficiency, supply chain, and logistical prospects. This is anticipated to make smart contracts more commonplace in the coming years.
By Edith Lagunas
All Things Blockchain, crypto enthusiast and CRE Investor. #mujerinvestor #finance #investing #investor
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