What Are Smart Contracts? (+How Do They Work on Ethereum)

Patrick Szakiel
Patrick Szakiel  |  December 11, 2018

Smart contracts, which are contracts written into code (usually in Solidity, Ethereum's programming language) and housed on a blockchain, present massive potential for multiple industries.

We touched on the basics of smart contracts in our introductory guide to fintech. Now it’s time to delve deeper into the many applications of this technology.

What Are Smart Contracts?

Smart contracts eliminate the need for intermediaries and automatically carry out contract terms once requirements are met. Directions are written into the contract to represent possible outcomes of the transaction (if it was completed within the required timeframe, if it was only partially delivered, etc.) and are automatically executed depending on what happens.

how-smart-contracts-work

For example, a contract is drawn up between an importer and an exporter. Written into code and housed on a blockchain, it stipulates that the exporter must deliver 30 pounds of pomegranates to the importer by a certain date. The exporter delivers the goods on time and receives automatic payment. Regulators use the blockchain to study the transaction and ensure that all regulations were observed throughout.

A more commonplace example is a vending machine. A person puts in the required amount of money and punches in the number of the item they want to purchase. Once they input the number, they receive their item automatically. The vending machine is designed to produce an outcome automatically as long as the buyer takes the required steps.

Beyond vending machines, smart contracts are already in use. AXA, a French airline, is using an application called Fizzy to automatically reimburse passengers whose flight is more than two hours late. If a passenger is registered, a late flight that meets contract requirements acts as a triggering event to release funds directly to the passenger. As technology improves and industries become aware of the potential, smart contracts usage should increase.

TIP: Centralize, store, and manage your company contracts with G2 Track.

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Smart Contract Applications

Many smart contracts are built and housed on the Ethereum blockchain. This is ideal for the development of smart contracts in part because of Solidity, its programming language. The entire goal of Ethereum is to allow programmers to build and deploy smart contracts.

Solidity is tailor-made for the creation and deployment of smart contracts. It is a scripting language similar to Javascript, but verifies and enforces the constraints built into the contract at compile time, not at runtime. Compile time refers to the process of compiling the source code, which is written in script akin to English of a program into machine code, which is binary (made of ones and zeros). This means that any errors in the code (contract) are caught prior to execution (runtime) where they would cause many more problems.

Solidity is great for smart contracts because it allows contracts to be linked and related to each other in many different ways. For example, you may not be able to change a contract on the blockchain, but you can create another contract referencing and the linking the two. Many business interactions and transactions are complex, requiring multiple contracts in order to function properly. Solidity was built with this in mind, and provides users with the tools to create contracts that interact with and reference a base contract.

TIP: Learn how an RFP can help your business negotiate the best contract in 2019.

Smart Contract Applications

Data warehouses rely on structure and clean data, whereas data lakes allow data to be in its most natural form. This is because advanced analytic tools and mining software intake raw data and transform it into useful insight.

Mortgages

The mortgage industry is massive, with over $15 trillion of mortgage debt in the U.S. alone as of 2018 Q2. It has a complex ecosystem of processes and middlemen who carry out tasks like background checks and income verification. Introducing smart contracts into the mix could save lenders over $1.5 billion annually in the U.S. alone. Lenders and borrowers could interact directly, reducing the costs associated with originating, processing and servicing mortgages.

Intellectual Property Protection

Smart contracts help creators protect their copyrighted works. Any piece of content that is created is assigned ownership rights depending on its contributors and their parts. Any time the content is purchased, royalties are automatically released to the correct party. The clear outlining of ownership and  automatic payment eliminates the ambiguities that often accompany creative property.

Supply Chain (Import/Export)

One of the benefits of smart contracts is increasing transaction transparency. This is particularly useful in complicated import and export transactions, which involve many stages and parties. The Internet of Things (IoT) also plays a role in this by making monitoring easier. Information gathered from IoT-connected devices is transmitted to the blockchain and triggers events coded in a smart contract. For example, a good is transported from a warehouse to a ship. The ship’s system sends confirmation of the receipt of the item in fine condition, which triggers the release of payment to the manufacturer. These transactions can become extremely complicated; a smart contract simplifies the process.

Insurance

The goal of smart contracts is to increase efficiency and eliminate unnecessary third-party interactions. In the insurance industry, smart contracts automate at least part of the administration process. For example, say you’ve purchased a natural disaster policy for your home. As soon as a disaster hits your area, it would automatically trigger the creation of a claim. This would begin processing immediately, quickening the entire process.

TIP: For more information on contract technology, learn about the best electronic signature software in 2019.

Benefits of Smart Contracts

Smart contracts have a host of potential benefits. The major ones include increased efficiency, more autonomy through the elimination of third parties and improved transparency.

Transparency – Because smart contracts are created and housed on a blockchain, the transaction record is available and (theoretically) immutable. This eliminates ambiguities that may exist in paper trails. Regulators can also review transaction records during audits.

Autonomy – Intermediaries, a commonplace aspect of typical contract execution, are ultimately nonessential to the execution of the terms included in a contract. Instead of third parties holding stores of value in escrow, smart contracts only involve the two signing parties.

Efficiency – Because smart contracts automatically execute terms written into the code, they are highly efficient. Involving only the main parties saves time and resources. The automatic execution of terms also speeds up the process.

Lower Cost – By cutting out third parties, you lower transaction costs. In certain industries, like real estate and lending, third-party fees may be steep, so eliminating them can lower costs significantly.

Drawbacks of Smart Contracts

While smart contracts have many benefits, no technology is perfect. There are a couple of drawbacks, mostly the potential for human error and ambiguity in regulation.

Human Error

Once it’s created and housed in the blockchain, everything about a smart contract is automated. However, the actual code is still written by human programmers. This means that the potential for human error is not eliminated, and contracts may contain mistakes.

Regulation

Or rather, lack thereof. Smart contracts, much like a variety of blockchain-based technologies, are not yet comprehensively regulated by government agencies. While this can be a positive, it’s a dangerous game to play given the precedent set with fintech regulation. Should a government organization decide to lay the legislative hammer down, those relying on smart contracts may find themselves navigating murky regulatory waters.

The Future of Smart Contracts

Smart contracts look to be here to stay. They save users time and money and improve efficiency. Some estimates place the compound annual growth rate (CAGR) of the smart contract market at 80 percent over the next six years. While blockchain technology adoption has experienced ups and downs, the vast potential of the technology should be enough to catalyze significant adoption over the next five years.

Smart contracts are one part of a larger fintech ecosystem. For a deeper dive into fintech, learn about the major fintech trends in 2019. 

Patrick Szakiel
Author

Patrick Szakiel

Patrick Szakiel is a Research Specialist at G2 Crowd. He focuses on the vertical software space, with particular emphasis on the legal and education industries, and recently helped launch G2’s Greentech space. You can find Patrick on LinkedIn.