A smart contract is a computer code running on top of a blockchain containing a set of rules under which the parties to that smart contract agree to interact with each other. If and when the predefined rules are met, the agreement is automatically enforced. The smart contract code facilitates, verifies, and enforces the negotiation or performance of an agreement or transaction. It is the simplest form of decentralized automation.
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. They render transactions traceable, transparent, and irreversible.
In 1994, Nick Szabo who was a cryptographer came up with the idea of being able to record contracts in the form of computer code. This contract would be activated automatically when certain conditions are met. This idea could potentially remove the need for trusted third-party companies such as banks.
Szabo proposed the execution of a contract for synthetic assets, such as derivatives and bonds. In a paper, he argued that 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. In simple words, he was referring to the sale and purchase of derivatives with complex terms.
Many of Szabo’s predictions in the paper came true in contexts preceding blockchain technology. For example, derivatives trading is mostly conducted through computer networks using complex term structures.
Although Szabo had an idea of how transactions could be handled without the need of third parties, the problem was that there was no blockchain technology back then to implement the ideas.
How Smart contracts work
The best way to describe how smart contracts work is to compare the technology to a vending machine. Ordinarily, you would go to a lawyer or a notary, pay them, and wait while you get the document. With smart contracts, you simply drop a bitcoin or other acceptable coins into the vending machine, in this case, the ledger, and your escrow, driver’s license, or whatever drops into your account.
More so, smart contracts not only define the rules and penalties around an agreement in the same way that a traditional contract does, but also automatically enforce those obligations.
You can use smart contracts for all sort of situations that range from financial derivatives to insurance premiums, breach contracts, property law, credit enforcement, financial services, legal processes, and crowdfunding agreements.
How are Smart Contracts Created?
Smart contracts can be built on multiple blockchain platforms, including Ethereum, EOS, and NEO. Contracts can be encoded on various blockchain networks, but Ethereum is the most used since it gives unlimited processing capability.
Smart contracts are developed using Ethereum’s original coding language, called Solidity. The best thing about smart contracts is that they help eliminate middlemen and third parties. Having no middlemen helps in saving a lot of money. Not only that, but we no longer need to trust anyone, either.