What Are Smart Contracts?

Contracts are often complex — they may be between multiple stakeholders or parties, contractors and subcontractors, each with different conditions and expectations about the contract’s function. 

In an ideal situation, every party involved has access to each signed version of the contract — providing a history of the document and proof that all parties involved signed on and agreed to the terms.

However, if all parties are expected to maintain this data on their own, major problems can emerge.  Different people may disagree on which version of the contract is binding. A physical contract also isn’t a guarantee of action. Even with a signed agreement, for example, a contractor may have to chase down a client who owes a payment. This can happen even after promised that contractor delivers promised goods or services.

Smart contracts are a new way of creating self-executing, binding contracts. They rely on the blockchain, a kind of digital ledger technology best known for its role in cryptocurrencies, like Bitcoin.

These smart contracts create a kind of digital footprint, providing evidence that all involved signed on. Because the contracts are self-executing code, they can also automatically fulfill certain terms when conditions are met. 

This is what smart contracts are, how they work and why people are using them over standard contracts.

What is a Smart Contract?

Smart contracts are powered by Ethereum, a blockchain-based cryptocurrency and software platform. Each of these smart contracts are a kind of decentralized application (or dapp). These apps use the processing power of nodes, or volunteer computers that run the Ethereum client.

Each of these nodes stores some or all of the blockchain data, and every client works to validate blocks. These blocks are effectively grouped transactions that make up the blockchain.

It is extremely difficult to tamper with contracts that have been executed and stored on the blockchain — and data on the blockchain in general.

All parties have greater certainty about contract terms and accuracy since they are storing it on the public, dispersed blockchain. In the blockchain, there are always numerous third-party, volunteer computers verifying and updating every block. So, it’s difficult for anyone to make unauthorized changes to a smart contract without someone noticing.

When you need to execute a contract, you’ll pay a small fee in Ethereum’s coin (also called Ethereum, or ETH), which acts as “gas” that keeps the system running.

Advantages and Use Cases of Smart Contracts

The use of smart contracts can also help cut down on paperwork. This can reduce the need for agencies and middlemen who bring together parties to make agreements.

As a result, all the parties involved in writing and signing the contract can save significant capital on agency fees and commissions.

Because these smart contracts are effectively self-executing code, it’s also possible to chain multiple contracts or terms together. As a result, you can program the contract to autonomously execute by specifying certain activation conditions. So, for example, you may write a contract that automatically releases payment upon the completion of a certain task.

You might also write a contract that automatically bills a contractor if they fail to complete a certain project item by a given deadline.

One major disadvantage, however, is that because these smart contracts are code they operate on mathematical logic. That means you need to be able to define specific functions of the contract in mathematical terms.

For example, you may write a smart contract that releases funds on a certain date. Another might release funds once both parties agree a certain event has happened — like a client confirms they’ve received an item.

The digital nature of smart contracts has some legal experts uncertain if they are enforceable. However, laws vary from state to state, and not all agreements need to be in writing to be legally binding.

How Smart Contracts May Simplify Agreements

Soon, smart contracts may become a standard alternative to typical contracts for those who want a little more security in agreements. Both parties can rest assured they will carry out the contract terms since smart contracts are self-executing and stored on the blockchain.

While there are some potential disadvantages and risks to the tech, these smart contracts will likely be a valuable option for those who need to create binding agreements.