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Smart Contracts Explained

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Last editedDec 20202 min read

Smart contracts use computer programming to encode, verify and enforce agreements between various parties. The involved parties can develop and monitor the contract’s performance without the need for a third party.

Smart contracts date back to 1994 when cryptographer and legal scholar Nick Szabo discovered that self-executing (digital) contracts could be used via a decentralized ledger. He realized that contract terms could be converted into code, enabling computers to monitor, store and replicate files that run a blockchain (a computer file that is used for storing data across multiple computers, which is controlled by no single authority). Smart contracts could therefore be used for security purposes to make high-value data and currency transactions.  

Smart Contracts Examples

In a smart contract, a currency or asset is programmed into a computer protocol. The program runs the code, and then validates certain conditions, determining in a transaction whether an asset goes to one party or another. For example, if money is being traded via a transaction contract, the program will determine whether the money goes to the receiving party (due to a specific criterion that has been met), or whether it goes back and is refunded to the sender because the criterion hasn't been met. At the same time, the decentralized ledger records the smart contract in the application, keeping it secure and unable to be altered.

For instance, if you decided to rent a property from a landlord and paid with Bitcoin, you'd receive a receipt for this transfer of funds via a smart contract. If you don't receive the key to your new property from your landlord (via digital entry key) by an agreed time set in the contract, the amount you have paid can be automatically released back to you, based on the digital agreement and the code within the smart contract. Smart contracts can be used for other situations, including legal processes, crowdfunding, insurance transactions, and so on.    

Uses of Smart Contracts

You can think of a smart contract in the same way as a paper contract, except that the information contained within it is digital. There are many applications and uses for smart contracts, plus many benefits including:

  • Self-verifying agreements due to the ability to set automated parameters.

  • Contracts that are self-enforcing when all parties involved meet all criteria (these could be dictated by financial markets, for example).

  • Secure data that is encrypted, and cannot be tampered with or altered.

  • Transactions that can be carried out quickly, in any country in the world, with the same level of security as cryptocurrencies.

  • The ability to store secure and sensitive information, such as personal details, domain registration, membership records, etc.

  • Terms and conditions within a contract that cannot be disputed once established, making smart contracts reliable.

  • All computers involved in the smart contract updating their ledgers accordingly once the contract has been initiated, changed, or revised. All parties involved are also kept simultaneously updated.

Negatives of Smart Contracts

A few small cons can outweigh the pros. These include weak legal regulations as to how smart contracts work and are implemented, as well as any issues that arise from processing speeds when transactions are occurring. Smart contracts need a programmer to create them, and to ensure that they are safe, secure, and properly encrypted. 

As a paperless technology, once terms are established, the contract then remains as it is until all involved parties agree to have the contract reprogrammed and terms altered – this is unlike a traditional contract, in which clauses can be simply revised. A smart contract is also at risk of hackers and bugs, hence the importance of hiring a blockchain development company or programmer to oversee its production.

Smart contracts are just one of the many ways that businesses are moving to paperless, digital solutions that streamline their working processes and how people are paid. 

We can help

If you’re interested in the possibilities of smart contracts and would like to find out more then get in touch with the financial experts at GOCardless. Find out how GOCardless can help you with ad hoc payments or recurring payments.

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