What Are Smart Contracts on the Blockchain and How Do They Work?

What Is a Smart Contract?

A smart contract is a self-executing program that automates the actions required in an agreement or contract. Once completed, the transactions are trackable and irreversible. The best way to envision a smart contract is to think of a vending machine—when you insert the correct amount of money and push an item's button, the program (the smart contract) activates the machine to dispense your chosen item.

Smart contracts permit trusted transactions and agreements to be carried out among disparate, anonymous parties without the need for a central authority, legal system, or external enforcement mechanism.

While blockchain technology has come to be thought of primarily as the foundation for Bitcoin​, it has evolved far beyond underpinning a virtual currency.

History of Smart Contracts

Smart contracts were first proposed in 1994 by Nick Szabo, an American computer scientist who conceptualized a virtual currency called "Bit Gold" in 1998, 10 years before Bitcoin was introduced. Szabo is often rumored to be the real Satoshi Nakamoto, the anonymous Bitcoin inventor, which he has denied.

Szabo defined smart contracts as computerized transaction protocols that execute the terms of a contract. He wanted to extend the functionality of electronic transaction methods, such as POS (points of sale), to the digital realm. 

In his paper, Szabo also proposed the execution of a contract for synthetic assets, such as combining derivatives and bonds. Szabo wrote, "These new securities are formed by combining securities (such as bonds) and derivatives (options and futures) in a wide variety of ways. Very complex term structures for payments...can now be built into standardized contracts and traded with low transaction costs, due to computerized analysis of these complex term structures."

Many of Szabo's predictions in the paper came true in ways preceding blockchain technology. For example, derivatives trading is now mostly conducted through computer networks using complex term structures.

Smart Contract Uses

Because smart contracts execute agreements, they can be used for many different purposes. One of the simplest uses is ensuring transactions between two parties occur, such as the purchase and delivery of goods. For example, a manufacturer needing raw materials can set up payments using smart contracts, and the supplier can set up shipments. Then, depending on the agreement between the two businesses, the funds could be transferred automatically to the supplier upon shipment or delivery.

Real estate transactions, stock and commodity trading, lending, corporate governance, supply chain, dispute resolution, and healthcare are only a few examples where smart contracts can be used.

Smart Contract Pros and Cons

The primary benefit of smart contracts is similar to the benefit of blockchain technology—they remove the need for third parties. Other benefits of this technology are:

• Efficiency: They speed up contract execution
• Accuracy: There can be no human error introduced
• Immutability: The programming cannot be altered

Some of the downfalls of smart contracts are:

• Permanent: They cannot be changed if there are mistakes
• Human factor: They rely on the programmer to ensure the code is programmed properly to execute the intended actions
• Loopholes: There may be loopholes in the coding, allowing for contracts to be executed in bad faith

The Bottom Line

Smart contracts are code written into a blockchain that executes the actions two parties agree to outside the chain. By automating these actions, the need for an intermediary or trust between the parties is removed.