A smart contract is an agreement between two people in the form of computer code. They run on the blockchain, so they are stored on a public database and cannot be changed.
It is a computer program or a transaction protocol that is intended to automatically execute, control, or document legally relevant events and actions according to the terms of a contract or an agreement. The objectives of smart contracts are the reduction of need in trusted intermediates, arbitrations, and enforcement costs, fraud losses, as well as the reduction of malicious and accidental exceptions.
The transactions that happen in a smart contract are processed by the blockchain, which means they can be sent automatically without a third party. This means there is no one to rely on! The transactions only happen when the conditions in the agreement are met — there is no third party, so there are no issues with trust.
How do smart contracts work?
The development of smart contracts is connected with blockchain technology. Actually, it takes place on the blockchain platform. Its content is placed in the program block, from which entry and exit points are made, allowing the smart contract to work with information outside the blockchain, including performing some actions.
For the contract to work, it is necessary the parties apply electronic signature technologies that are used when signing transactions in the blockchain applications. In order for the smart contract to work efficiently, exactly specified conditions for the execution of the contract are necessary, otherwise, it will be impossible to automate the process. Also, smart contracts receive information from outside blockchain platform through the use of Oracle programs that mediate with external databases and are entered into the blockchain technology. The basic principle of how do smart contracts work is the accuracy of the execution of the prescribed conditions, as well as full automation of this process. But of course, the best practices show that smart contract ideas have both advantages and disadvantages.
Among the advantages are:
- Reliability and immutability provided by the decentralized data storage system in the blockchain technology;
- Transparency of actions in smart contracts on blockchain in the system, along with the confidentiality of the parties to the contract;
- Automation of smart contracts work;
- Cost reduction due to exclusion from the chain of intermediaries;
- High speed of execution thanks to the use of mathematical algorithms in blockchain applications instead of bureaucratic mechanisms.
- Weak legal regulation of smart contracts work;
- The necessity to address the issue of transaction processing speed and scalability in blockchain technology;
- Inability to adjust smart contracts work;
- High dependence on programmers and exposure to bugs.
Of course, these are not all advantages and disadvantages of smart contracts. But if remember it is still developed and improved, smart contracts work have all chances to become a great replacement of standard ones. Finally, as the best practices show, it is better to apply to blockchain development companies if you have not required skills and knowledge.
The smart contract process
- Pre-defining the contract. Here the terms of engagement are established by all counterparties, e.g. currency to be used to make payments, the currency rates, and variable interest rate. The conditions for execution are also set; for example the time, date, and even the variable interest rate at a given value.
- Events — here events trigger the implementation of the contract.
The events can refer to; the information received and initiation of the transaction.
- Execution and the transfer of value — here the terms of the contract will dictate the movement of value which is based on if the conditions have been met.
Settlement of the contact — this can happen in two ways; On-chain assets (digital)– in the case of virtual assets such as cryptocurrency, the accounts are automatically settled. Off-chain assets (physical) — for assets like stocks and fiat, the changes to accounts on the ledger will match the off-chain settlement instructions.