How Do Smart Contracts Work?

How Do Smart Contracts Work?
Updated on
February 13, 2023

Blockchain is one of the hardest things to explain about cryptocurrency and Ethereum's smart contracts can be every bit as confusing. Part of this comes from the fact that the term confusingly describes the base interaction. They are a new interaction that comes with Etherum. A normal contract gives the terms of a relationship is backed by law. A smart contract does the same but the binding is backed by the cryptographic code. This means that a smart contract is a program which has been created to carry out exact tasks and set by the creators. They allow for goods like money or shares to be exchanged without requiring a third party.

The idea was first developed in 1993 by Nick Szabo who was a cryptographer and a computer scientist who called it a kind of "digital vending machine". As an example, you spend some Ether on this machine and the required item such as an escrow appears in your account. A smart contract will automatically enforce its term and any penalties that come from breaking them. Etherum was built explicitly to enable them.

The idea here is not for these processes to be used in isolation. Instead, they are meant to act as pieces of a much larger, decentralized system driven by autonomous companies.

How do Smart Contracts Actually Work?

Any blockchain is capable of encoding smart contracts and Bitcoin was the first cryptocurrency to utilise smart contracts in their simplest form. Bitcoin used them to transfer the value of an amount of currency from one person to another but it was limited to doing this.

What Ethereum does is replaces the limited "language" used by Bitcoin in the creation of its smart contracts and replaces it with a much more diverse one allowing for programs to be written by developers.

Smart contracts are capable of providing the following:

Autonomy - The contract's originator and primary executor are the same person. There is no need to rely on an independent lawyer or some kind of broker and this eliminates the dangers of the third party making some kind of mistake.

Trust - The information contained in the contract becomes encrypted and cannot be lost as it is stored in a shared ledger. It is also replaceable as it will be backed up along with the nodes contained in the network that stores your data.

Safety - The whole point of cryptography is to keep your information safe and this system would be incredibly difficult to penetrate.

Speed - Without the bureaucratic processes that come with paper contracts it is possible for businesses to be able to save both time and money.

Savings - The monetary savings come from legal fees such as notary/lawyer fees which would be required for the processing of a paper contract.

Accuracy - Automated contracts automate the process which avoids the chance for errors to accumulate as paperwork must be assessed and filled out by hand.

The Blockchains that are Capable of Processing Smart Contracts:

  • Bitcoin: They are a great way of processing a Bitcoin transaction but have limited capability for processing documents.
  • Side Chains: These blockchains offer a bit more processing capability when it comes to contracts and they run adjacent to Bitcoin.
  • NXT: NXT does not allow people to code their own contracts. Instead, is has a few templates of smart contracts to choose between.
  • Ethereum: This blockchain allows for total freedom when it comes to the creation and implementation of smart contracts. All that is required is ETH tokens to power then.
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