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Smart Contracts: Definition and Introduction

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08/03/2022 |

8 min read

Codete

The financial services sector is undergoing a deep transformation powered by different factors – and one of them is blockchain. Smart contracts are the cornerstone of decentralized finance and open the door to interesting hybrid implementations that connect the world of blockchain with traditional systems. 

But what exactly are they and how do they work? And what benefits do they bring to companies and users? Read this article to learn everything you need to know about this innovative technology.

 

Table of contents: 

  1. Smart contracts – what are they?
  2. How smart contracts work
  3. Smart contracts – summary

Smart contracts – what are they?

Smart contracts are self-executing contracts where the terms of the agreement between buyers and sellers are directly reflected in the smart contract code. The code and agreements included in it are placed across a distributed and decentralized blockchain network. 

It’s the code’s job to control the agreement’s execution – and all the transactions are fully trackable and irreversible thanks to blockchain technology (i.e., distributed ledger technology).

In its essence, a smart contract is a computer program hosted and executed on the blockchain network. Each contract includes a code that specifies predetermined conditions that trigger specific outcomes when met. 

Since the contract runs on a decentralized blockchain, it allows multiple parties to get a shared result in a timely, accurate, and tamper-proof way. Such contracts also increase the level of automation because they don’t need to be controlled by any central administrators like legal contracts. They reduce counterparty risk, lower transaction costs, increase efficiency, and boost the transparency of the entire process.

The technology underlying these contracts is what makes them so significant in the financial services sector. They allow users to carry out trustworthy transactions and agreements among anonymous parties without the need for a centralized authority, legal system, or any other external enforcement mechanism. 

How smart contracts work 

A smart contract is a tamper-proof piece of software that follows this logic:

if/when X event happens, then execute action Y

A single contract can have multiple conditions. And one application can include multiple smart contracts to support a range of interconnected processes. 

Developers choose from several programming languages for building contracts. Today, Solidity is the most popular smart contract platform. Practically any developer can build a smart contract and deploy it on a public blockchain for their own purpose. But many contracts involve independent parties that may or may not know one another. 

A smart contract defines how users can interact with it: who can do it, when, and what input will result in what outputs. Such multiple-party digital agreements are now evolving from a probabilistic state (where they probably execute the action) to a deterministic state – where they guarantee the execution of the action in line with what’s written in the smart contract's code.

Examples of smart contracts

1. Automating a business process between a group of entities

Imagine a group of entities that come to an agreement on the smart contract terms such as process flow, payouts, and dispute resolution. An example smart contract for a global trade company can include terms such as:

If the product arrives on time, then execute a payment from the retailer to the supplier in full amount. 

If the product arrives one day later than agreed, then execute a payment from the retailer to the supplier in 90% of the full amount.

2. Public decentralized applications (dApps)

Such public applications are often open source, so practically anyone can check how they work before deciding to interact with them. A good example of a public dApp is a decentralized lending/borrowing market. 

A smart contract can include a term like this one:

If the user deposits collateral to a specific smart contract, they receive a loan of up to 60% of the value of their collateral. 

As a result, if a user deposits $200, they can borrow up to $120. 

Benefits of smart contracts

1. Greater transparency

Since no third party is involved in the development and execution of smart contracts, the technology offers a new level of transparency. Moreover, encrypted transaction records are shared across all participants. No information can be altered by anyone for their personal benefit in this scenario. 

2. Cost savings

Smart contracts don’t require any intermediaries to handle transactions. That’s why they help to avoid fees that are part of the equation in transactions with centralized authorities that ensure contract terms are fulfilled.

3. Outstanding level of security

Because smart contracts run on decentralized blockchain infrastructure, they contain no central points of failure to attack. There’s no centralized intermediary or authority that could potentially be bribed. Moreover, nobody can expose a mechanism or centralized admin to tamper with the contract’s outcome. 

4. Reliability

Since the contract logic is processed redundantly and verified by a decentralized network of nodes, it offers tamper-proof uptime execution. It all always guarantees that the contract is executed on time and according to its terms. 

5. Equitability

By using a decentralized network to host and force the terms of the contract, the impact of a for-profit middleman who may use their position to rent seek and siphon off the value is very limited. 

6. High efficiency

By automating processes such as escrow, maintenance, execution, and settlement, smart contracts don’t involve any manual data entry. There’s no need for either party to add any data or for the counterparty to fulfill their obligations. Everything happens automatically.

Smart contract use cases

1. Decentralized finance (DeFi)

DeFi uses applications based on smart contracts to recreate traditional financial products and services like options, exchanges, asset management, and money markets. They often combine multiple services to create smart contracts and brand-new financial primitives. 

Users can already take advantage of DeFi products that utilize smart contracts to streamline lending and borrowing in a decentralized manner.

2. Rights management (tokens)

You can use a token to pay for a decentralized storage service or to take part in the governance of a protocol. Both would be impossible to build without this technology. 

3. Non-fungible tokens (NFTs) and gaming

NFTs have gained a lot of traction recently, and both they and blockchain-based games take advantage of smart contracts. The idea is to ensure that all the endgame actions are executed in a tamper-proof manner. 

A good example of this is a game called PoolTogether. It’s a no-loss savings game where every user stakes some funds in a shared pool. The money is routed to a market where it earns interest. After a set time period, the game ends, and the winner gets all the accrued.

4. Insurance

A type of insurance where the payout is directly related to a specific predefined event can use smart contract execution features as well. It’s called parametric insurance. 

In this context, smart contracts bring value because they offer a tamper-proof infrastructure for companies to create a parametric insurance contract triggered by data input. 

For example, an insurer can offer crop insurance created using a smart contract. The customer buys a policy based on weather information like seasonal rainfall in a given geographic location. At the end of the policy, the contract automatically issues a payout if the rainfall in that location exceeds the original stated amount. Users receive payouts on time with much less overhead. 

And the supply side of insurance can be opened to the public using a smart contract too. For instance, the contract may allow users to deposit funds into a pool and distribute all the collected premiums to participants based on the percentage of their contribution.

Challenges to smart contract adoption

One of the issues the space is trying to solve is that contracts run on isolated blockchain networks. This means that the blockchain doesn’t have a built-in connection to the external world. And without that connectivity, it’s impossible for a smart contract to communicate with external systems to confirm whether a real-world event occurred or not. 

They also can’t access cost-efficient computational resources. A blockchain network is like a computer without the internet. Smart contracts are limited that way because they can’t learn about the price of an asset before executing the trade or check the amount of annual rainfall before paying out a crop insurance claim. 

That’s why innovators are now exploring new possibilities of connecting smart contracts to the real world and traditional systems outside of the blockchain.

We have already seen the emergence of hybrid smart contracts that use secure middleware called oracle to combine on- and off-chain infrastructure. Oracles are going to play an increasingly important role in connecting emerging blockchain networks with legacy systems.

Smart contracts – summary

Smart contracts are on their way to revolutionizing the financial services industry. As more and more products successfully connect the on-chain contracts with off-chain systems, we can expect smart contracts to be adopted across a broader range of use cases. 

Are you planning to implement smart contract technology in your next project? Doing that is a smart move if you’d like your users to benefit from the accuracy, security, and timely nature of smart contracts. Reach out to us at Codete if you have any questions, and let’s work together on your next fintech project!

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