Glossary

What are Smart Contracts in Blockchain and How Does it Work?

It all started with ‘Smart Phones.’ A few years later, we evolved into smart TVs. Today, we have everything smart. From vacuum cleaners to air purifiers. From dishwashers to perfume dispensers. Today, we are adding something really smart to this collection. Smart contracts. Probably the biggest innovation in the blockchain space after the advent of blockchain itself. 

Blockchain, at its heart, tries to take away the power of a select few and disseminate it into the hands of individuals. Smart contracts are a big driver of this cause. They try to automate redundant human interventions and thus create a seamless experience for the end user. But what are smart contracts? How do they work? Is it just theory, or does some real action back it up? We’ll find out. Read on!

What Are Smart Contracts in Blockchain?

Smart contracts are self-executing pieces of code. These codes execute automatically when predetermined conditions are met. This leads to the automation of trivial tasks that involve human intervention. As a result, each party involved in a contract can predict the outcome without the help of any intermediary. And since all these codes are executed on a blockchain, it makes them transparent, traceable, and irreversible. 

How Does Smart Contract Work?

Smart contracts run on the ‘if this, then that’ model. In other words, these are ‘if and but’ conditions written on a blockchain. Nodes (a network of computers) validate these conditions and execute the outcomes based on that. These outcomes can vary from paying someone, levying a penalty, notifying, or issuing a certificate. Once the conditions are met and the outcome is executed, the transaction results are stored on the blockchain in an immutable form, and authorized personnel can see the results. 

By adding multiple iterations and stipulations, the strength and legitimacy of a smart contract are enhanced.For example, logic could be written to define the quality of the work done for releasing a payment. In other words, bringing an element of standardization and reducing subjectivity through conditions is the core of the success of smart contracts. 

Once these conditions are defined, a smart contract developer writes them down from scratch. However, you can easily customise smart contract business templates available these days to a specific use case. It is advisable to check them out before reinventing the wheel altogether. 

Types of Smart Contracts

Depending on the legality and use case, smart contracts can be of different types. Let us look at them in detail:

A. Smart legal contracts

These contracts are legally enforceable. That means if either party violates this contract, they are liable for legal action. These contracts can be really helpful as they save a lot of time and money by automating the outcomes through a well-recorded, immutable database. 

For example, a typical court case related to IP infringement takes months to solve. However, if all the patent filers could timestamp their innovations on a blockchain, it would be easy for the court to give a ruling. 

B. Decentralized Autonomous Organization (DAO)

DAOs or Decentralized autonomous organizations are blockchain-based organizational structures. It aims to solve for lack of accountability, transparency, and ownership in a traditional organization. The way it works is that a few individuals hold tokens of a DAO and get to vote on the key decisions. 

If these decisions fall in place, the token appreciates and hence the value of the DAO. In essence, you have created a democratic organization where everyone has a share of the pie. 

Smart contracts tend to replace the manual approval mechanisms in a traditional organization. You can pre-set some rules, and the contract will take care of everything else. This ensures complete transparency and biasless decision-making. 

C. Application Logic Contracts (ALC)

ALCs allow devices to leverage smart contracts to become autonomous and secure. ALCs ensure better automation, cheaper transactions, and higher security. These contracts contain an application-based code that is fed data from other smart contracts. 

To visualize it, let us think of a thermostat that regulates the temperature of a shipment containing fish. It constantly records temperature changes (external and internal). Let us assume that fish goes bad on the journey. Eventually, an insurance company can use that data to decide if the premium needs to be paid for rotten fish. Because this ALC was transparent and immutable, it acts as a legitimate record. 

Difference Between Smart Contracts & Traditional Contracts

Now that you get the hang of smart contracts, it is time to understand how they differ from traditional contracts. The table below compares these two

ParameterSmart ContractsTraditional Contracts
TimeA smart contract is instant. As soon as the conditions are met, smart contracts are invoked. This means the turnaround time for smart contracts is nearly zero.Traditional contracts need to be presented to an authority that will decide the fate of the parties involved. This typically takes 1-3 days.
RemittanceJust like everything else, remittance is automated in a smart contract. Remittance is manual in a traditional contract. At times, even after the contract is invoked, remittance requires additional follow-ups. 
CostSmart contracts are cheap and cost-effective. Essentially, a code is written once, and everything else is taken care of. Traditional contracts require multiple intermediaries to be compensated. Even when enforcing them, you need a lawyer to represent you. As a result, they are expensive. 
TangibilitySmart contracts can be signed digitally and have no physical counterpartsTraditional contracts can be physical and digital both
EscrowSmart contracts do not need any escrow or a third party for their execution. Traditional contracts often rely on infrastructures like courts, police, etc., for enforcement. 

What Are the Advantages of Using Smart Contracts?

It is evident that smart contracts have a clear edge over traditional contracts. It is time to understand these advantages in detail. 

A. Fast and efficient

When the conditions are met, smart contracts are executed immediately. This saves a lot of time that goes into paperwork and reconciliation otherwise. Apart from that, since smart contracts are purely digital, they are far less prone to errors than manual contracts. 

B. Transparency

Smart contracts are written on blockchains. Since these contracts are open-source, anyone is free to audit before using them. Other than that, the change resistance is a part of the design. No one questions the legitimacy of a blockchain-based transaction. 

C. Security

Smart contracts are based on blockchains. Therefore, the records are protected by strong cryptographic algorithms. Also, one cannot alter the data in the blockchain without getting caught. Since every node in the chain has a copy of all transactions on the network, it requires them to change the copy with every node, which is impossible. This makes blockchain and hence smart contracts highly secure. 

D. Savings

A lot of costs are saved in the process since you remove all the intermediaries. Secondly, making the system completely digital eliminates errors and saves time. 

What Are the Use Cases of Smart Contracts?

Yeah, yeah! I get it. Smart contracts are a notch above traditional contracts. But where do I use them? After all, that is where the juice is! So let us talk about some of the hot use cases of smart contracts. 

A. Legal use cases

In the legal world, you can use smart contracts big time. Once the legal processes are mapped in an automated contract, we can do away with intermediaries. This can improve speed and efficiency. Apart from that, trust is an inherent feature of smart contracts. You need not escrow this trust to a third party to enforce it. 

For example, think of real estate. Currently, real estate brokers are a necessary evil. An average individual needs to rely on these brokers for wrapping their head around the complicated documentation and processes. This results in a waste of time and money due to multiple intermediaries. 

On the other hand, imagine that a house registry is tokenized on the Ethereum blockchain. Once you plan to sell it, a smart contract escrows the registry until the buyer releases the funds. Once the funds are secured, the registry is automatically transferred to the buyer’s name. It is a win-win situation for both parties. 

B. Economic use cases

These use cases enable easy movement of money with the help of smart contracts. The current trust problems are tackled using a third party (bank etc.) as an escrow. But then, these third parties can be influenced to take sides. 

Smart contracts do away with this element of ambiguity. Consider this. You purchase raw materials for your tire company from overseas. What if you pay the seller in advance and they do not ship your material? Alternatively, what if the seller does not want to send material as he is unsure if he will receive the payment?

Smart contracts can solve this problem. The seller can simply create a digital twin of the shipment (that’s a digital version of shipment location on the Ethereum blockchain,) and you can create a smart contract that releases the payment as soon as the shipment is received. 

Real-Life Examples of Smart Contracts Implemented Successfully

Blockchain technology has entered the boardroom of some of the top conglomerates in web 2. This paves the way for some real-life examples of smart contracts. This adoption is converting the theory we discussed above to practice. Let us talk about one such example in depth:

IBM Maersk TradeLens

IBM came up with a product called TradeLens in 2018. This product leverages smart contracts to solve inefficiencies in the global shipping industry. Below is a summary of those problems:

A.1 Communication

Most communication was linear. Each player only has information about the immediately preceding and succeeding parties. There was no way to visualize the overall picture. 

A.2 Information exchange

EDI (Electronic data interchange) is used for paper documentation. 50% of the industry runs on EDI. However, the problem is that EDI is a point-to-point linear solution. This means the info is shared with the party before you and after you. That’s all. EDI messages are also sent in batches. Not in real-time.

A.3 Manual process 

Inefficient, error-prone manual processes. There was a problem despite the availability of information. Information used to be at the source and not the destination or vice-versa. Similarly, some issues arose due to information being in the wrong hands at the wrong time.

A.4 People-driven system and not process driven

It required connections to know when customs will release a particular shipment. Therefore, no transparency despite the reception confirmation from the shipping line.

For example, to move avocados from Kenya to the Netherlands, 30 people, and 200 types of documents are required. Goods spend more time in ports than in the ocean.

Solution

IBM and Maersk collaborated and developed a solution called GTD, or the Global Trade Digitalization platform. From an opportunity perspective, it could boost global trade by 15% and impact 5% of the world’s GDP.

IBM created a permissioned blockchain for this purpose. Permissioned blockchains are different from public blockchains as they need permission to log in, and all the participants are KYCed. This blockchain is equipped to run smart contracts in the same way as public blockchains. 

Apart from that, architecture was such that participating orgs could not view each other’s data. It is like FM. You can’t hear 92.7 (Company A) while being plugged into 94.3 (Company B). However, the radio authority (Customs) could hear everything.

The first pilot was conducted in June 2016 between Houston and Rotterdam. There was improved process flow and visibility across the supply chain. They also co-ordinated with govt agencies to address privacy and security concerns.

IBM planned to move from EDI to GTD in March 2017. GTD is a global trade digitization platform that ensures simplicity and transparency in the movement of goods. The platform was made available to freight forwarders, ports, shippers, customs authorities, and rival shipping lines.

Instead of peer-to-peer messages, GTD would become a network of information transfer (back and forth) from one party to another. Rather than MAERSK controlling the ecosystem, GTD becomes a single neutral source of truth.

GTD is comprised of two commercial products based on blockchain and smart contracts:

A. Shipping information pipeline

  • End-to-end visibility across all actors by tokenizing the shipment journey.
  • Real-time information tracking.
  • One-stop tracking tool.
  • Being on a blockchain, individual shipping lines don’t need to develop their own tool to manage this. All players would simply update the shipment’s status as it exits their purview, and all the parties would know the real deal.

B. Paperless trade

  • Ability to trade across organizational boundaries without physical documentation. Blockchain would help secure the signing of documents and timestamps so that authorized personnel can act without physical docs.
  • Also provides room for faster corrective action as the digital mode is way quicker than the physical mode. Traditionally, mistakes would stop the movement of goods.

As a result of these products, one could easily track shipments across the globe. Apart from that, smart contracts can also automate all the approvals. For example, earlier customs would take days to evaluate and release a shipment. But now, after meeting a few conditions written in smart contracts, approvals are done automatically. 

Few Limitations and Challenges Faced by Smart Contracts

Until now, smart contracts look like a promising proposition offered by the blockchain realm. However, that does not mean there is no scope for improvement. There are some limitations of smart contracts as well. Let us talk about them in detail. 

A. Scalability issues

Smart contracts are as good as the blockchain itself. To further aggravate this problem, they are not interoperable. This means that a smart contract deployed on Ethereum would need to be rewritten to enable them on Solana. 

As far as Ethereum is concerned, it can process only 15 transactions per second. If you compare that with the likes of Facebook and Uber, which process thousands of concurrent transactions, this is far from the dream of blockchain-based internet. 

Due to these scalability issues, the cost of running a smart contract-based blockchain app goes up multifold. 

B. Adaptability

Smart contracts are extremely objective. However, the law leaves room for some subjectivity. Each real-life contract needs to be customized to a certain extent. If smart contracts were to become the new law, it would be really hard to configure automation as long as the element of subjectivity exists. 

C. Security

Blockchains are a great example of democratic technology. This means any individual can create and execute a smart contract. While this sounds like a win-win, there are certain risks associated with it. A smart coder with dubious intentions may deploy a smart contract that results in the loss of wealth for unwitting users. 

Conclusion

We believe that due to the sheer irreversibility and immutability of the code, smart contracts are an extremely powerful tool to transform the world as we know. Imagine not having to spend a single minute in due diligence before entering into a transaction that requires trust. 

If you believe in this vision and are unsure of where to start, we’ve got you covered. Smart Contracts Coin Sets is a brilliant tool to invest in it. These are managed crypto baskets to ease your crypto investing journey.

FAQs

1. What are smart contracts in blockchain examples?

Smart contracts are self-executing pieces of code that work on ‘if and but’ conditions. For example, Uniswap, a decentralized exchange on Ethereum, is a bunch of smart contracts allowing users to swap their assets on Ethereum. 

2. Why does a blockchain need a smart contract?

Smart contracts are the backbone of any blockchain. Blockchain comes with different properties like immutability, security, decentralization, etc. Smart contracts leverage all these properties to automate the world as we know. It aims to create the next version of the internet powered by blockchains. 

3. How many smart contract platforms are there?

Currently, there are six smart contract platforms or blockchains that have this capability. These are Ethereum, Polkadot, Solana, Hyperledger, Tezos, and Stellar. Recently, Cardano also launched this functionality for their testnet. 

4. What is the best smart contract blockchain?

Smart contracts are in an evolutionary stage. Therefore, all blockchains are at par when it comes to execution. However, despite its slow speed, Ethereum has the largest number of smart contracts deployed on the platform. 

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