Smart Contracts Explained: Beginner's Guide

Smart Contracts Explained: Beginner's Guide

By Ryan Osborne | RaiseHQ | 22 Jun 2020


In this digital age, where technology is simplifying and speeding up every aspect of our lives, the idea of piles and piles of paper contracts seems outdated, inefficient and unnecessary.

Enter smart contracts.

A digitally encrypted agreement that’s underpinned by blockchain, a smart contract is the easiest and safest way to make a deal. It’s traceable, transparent and removes the need for trust – everything is encoded in the original deal, then automation takes over.

No third parties, no unexpected terms or conditions and no bureaucracy.

So, let’s find out more about smart contracts and discover why they’re about to change everything.

What is a smart contract?

We all know that a contract is an agreement between two or more people. But what is a smart contract and what makes it ‘smart'?

Well, a smart contract takes the idea of an agreement and turns it directly into lines of code. So, instead of being written in ink and open to interpretation and revision like a regular old contract, smart contracts are hard-wired into computer coding.

So, the terms of the smart contract – or the coding – are set across a blockchain network. This network is distributed and decentralized, meaning there’s no all powerful authority overseeing everything. The transactions are transparent, traceable and irreversible and are triggered by the coding – there’s no external mechanism involved.

We’ll get into a more in-depth definition a bit later. But first, let’s answer the question ‘how do smart contracts work?’

How do smart contracts work?

When blockchain first came on the scene, it was touted as the future of currency. Quite rightly so. But many people overlooked the true potential of blockchain to revolutionize so many other aspects of our lives.

One of these areas is legal contracts. The potential of the blockchain mechanism to create contracts that are simple, easily understood and agreed on, traceable, transparent and ultimately safe, is one that is only now being realized.

That’s where smart contracts come in. But how do they work? Well, let’s simplify the process with an example.

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Let’s say Tom wants to borrow from Jerry. But he wants to pay back in installments. Jerry doesn’t quite trust Tom (they’ve had a few run ins in the past) so he’s not confident that Tom will pay what they’ve agreed. Even a standard contract might not help make sure he gets what he’s been promised.

With a smart contract, Tom and Jerry can map out the precise terms of the deal. Say, Tom pays Jerry 2000 USDC each month for 12 months until the full amount is paid. The terms are imprinted into the coding of the smart contract and can’t be altered. The code triggers each element of the contract… so the payments are made automatically.

No commission, no third party fees, and no bank! The code controls the transactions and the transactions are 100% traceable and transparent. Once the conditions are met, the terms of the contract are triggered.

How is it possible that no bank or third party is involved?

Aside from the host company (say, a P2P lending platform like Raise), no other company is involved in the smart contract. The host company is a facilitator, connecting the two parties instead of acting like a third party. So, how is it possible that an agreement can be made and enforced without a centralized authority?

That’s right. It’s through blockchain.

Thanks to blockchain, a meddling middleman is no longer needed. There is no external control over the deal – the deal controls itself. That’s the whole idea of decentralization – nothing is controlled by one central party, like a bank or a broker – but instead by the actual system.

Cutting out the middleman

That’s how blockchain works. Through a shared network of many different nodes (or computers). Which makes it infinitely more stable and secure.

This means that smart contracts are in fact ‘trustless’ rather than trusted. When two parties make an agreement, there’s no element of trust between the two. Blockchain removes the need for trust. This is what makes it so revolutionary. The possibilities are pretty much endless.

The history of smart contracts

But back to smart contracts. You might wonder who invented smart contracts and when they started to become popular practice. Well, let’s take a trip back through time to the mid-nineties, when the world looked like a very different place.

In 1994, Nick Szabo, an American computer scientist, lawyer and cryptographer wrote an article titled The Idea of Smart Contracts. In the article, he not only coined the term ‘smart contract’, but laid out a proposal for a future system that would enable a buyer and a seller to enter a deal through a legally binding computer program. With amazing prescience, Szabo foresaw the creation of smart contracts through blockchain.

Within his article, Szabo used a brilliantly simple example to explain his idea. He described vending machines as a primitive ancestor to smart contracts: “the machine takes in coins, and via a simple mechanism ... dispenses change and product according to the displayed price. The vending machine is a contract with [the] bearer: anybody with coins can participate in an exchange with the vendor.”

It’s a simple and effective example of a simple and effective system. Szabo even used the security of a vending machine as an analogy for the security of the smart contract system: “The lockbox and other security mechanisms protect the stored coins and contents from attackers…”

This particular lockbox continues to strengthen, as smart contracts – and, more widely speaking, blockchain itself – becomes safer and more secure with every innovation along the way.

Four years after this article first appeared, Szabo created Bit Gold, a full 10 years before bitcoin first surfaced. In fact, rumours have swept the internet that Szabo is the real Satoshi Nakamoto, the psuedoanonymous inventor of bitcoin. Szabo continues to deny this, although the rumours persist. They seem to be embedded in the code of the crypto story.

Since Szabo laid out the groundwork, smart contracts have evolved considerably. The market crash of 2008 saw a seismic shift in public perception of legacy finance. Around about the same time, blockchain was beginning to take off.

It was the appearance of blockchain that enabled Szabo’s idea to become reality and, in 2013, Ethereum introduced the first smart contracts. Jump ahead seven years some industries are already utilizing smart contracts. Still, we’ve barely scratched the surface. The potential for smart contracts to revolutionize the way we live is truly remarkable.

The advantages of smart contracts

So, why are smart contracts better than regular contracts? Let’s decode what can be a complex system, so we can understand what really makes smart contracts so revolutionary.

1. Smart contracts are fast and efficient

Free from the mountains of paperwork that weigh down standard contracts, smart contracts are streamlined and fast. Without the needless bureaucracy and input from other parties, contracts can be drawn up and realized much quicker. The speed and efficiency of smart contracts act as a great showcase for the advantages of automation.

2. Smart contracts are secure

Smart contracts are based on unalterable ledgers that are completely transparent and traceable. They’re also encrypted and virtually unhackable.

3. Smart contracts are reliable

Standard traditional contracts can, and often are, manipulated. With smart contracts, the deal can’t be retracted or changed. Once agreed upon, it’s literally written in code. If one party fails to meet the conditions of the smart contract, it’s registered on the system and the relevant clause in the contract is triggered. It’s a ‘trustless’ system, as the need for trust is completely taken out of the equation.

4. Smart contracts are overseen by an independent system

One of the huge problems with traditional contracts is the interference from third parties. Without a mob of meddling middlemen fighting over a slice of the pie, the two parties can enter a contract that’s underpinned by an independent, digital system – blockchain itself – which has no selfish interests or hidden agendas and is entirely decentralized.

5. Smart contracts can’t be lost

Whether it’s photocopying a physical contract or making backups on your hard drive, there’s always a possibility that you’ll lose a contract. With blockchain, backup is not an issue. Smart contracts are embedded in the network and transactions are duplicated, so all parties have a record.

6. Smart contracts save money

Another benefit of giving those meddlesome middlemen the elbow is saving money. Without the additional costs of brokers and bankers, financial transactions can be carried out without racking up additional costs here, there and everywhere. With smart contracts, the term ‘administration fees’ will soon be a thing of the past.

7. Smart contracts are free from error

If you set up an insurance contract with a certain company and Bob from accounts forgets to carry the 1, you could end up losing out big time. Without doubt, many people have suffered massively from human error, which is why the world is shifting more and more towards automation. When it comes to contracts, we demand the utmost accuracy. After all, we’re only human.

P2P lending and smart contracts

One way in which P2P lending – or crowdlending – is leading the way, is through the use of smart contracts. While this revolutionary way of forming an agreement will no doubt reshape many industries in years to come, P2P lending is already on board.

P2P lending platforms like Raise are harnessing the brilliance of smart contracts, with a quick, efficient, traceable, transparent agreement between borrowers and investors. The P2P smart contract removes ambiguity and complexity, automatically executing payments based on pre-agreed principles.

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Through Raise’s P2P lending platform, investors and borrowers enter a contract with a list of agreed parameters, including minimum and maximum monthly interest rates, the length of the loan term and the length of the pricing phase.

Raise’s reverse dutch auction investing and lending process enables the market to self-regulate – investors can enter their positions at a price they feel comfortable with without suffering losses for their early commitment. Loan originators, on the other hand, can still have control over their worst case scenario.

The future of smart contracts

While P2P lenders like Raise are driving change with the use of smart contracts, other industries are playing catch up. The future will bring some monumental changes for a wide range of industries, as smart contracts reshape the way we interact.

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Here are just a few of the areas that smart contracts will have a massive impact:

1. Smart contracts for voting

Smart contracts have the potential to completely revolutionize the voting process. They have a massive advantage over traditional forms of voting in two key areas: security and ease of use.

A smart contract voting system will be infinitely more secure than the current process. Blockchain, ledger-protected votes would be encrypted to an extent that would prevent hacking from even the most powerful computer. What’s more, with voter turnout a huge issue in modern democracy, the voting process would be easier than ever. The outdated system of bureaucracy, paperwork, endless queues and countless forms of ID and registering will be replaced by an innovative process that incentivizes everyone to vote. Much like Raise’s KYC process, it’s all about using technology to build a secure, streamlined system of verification.

2. Smart employment contracts

Maintaining a fair, transparent relationship between a company and their team is crucial. Smart contracts will improve life for everyone, with a clear, precise and traceable set of terms that are created together and enshrined in blockchain – free from misinterpretation or tampering by third parties.

3. Insurance companies

Each year, the global insurance industry loses an incalculable amount of money on processing claims, not to mention claims that are fraudulent. Smart contracts could stem the flow of lost revenue in a massive way, improving an incredibly outmoded and inefficient data-entry process.

That’s just the tip of the iceberg. Another area is to create an intuitive, fast KYC process, something that Raise is particularly focused on within the P2P lending industry. Error checks and payouts could also be automated, with a certain set of criteria stipulated beforehand, while overall admin costs could be reduced dramatically.

Pay-as-you-go insurance could also become the norm. As rental cars and scooters become more common, instant vehicle insurance will become a necessity. Contracts could be set up fast, with all data readily accessible (ID, licenses etc.) and ongoing recorded in real time (mileage, accidents reports etc), all stored on the decentralized blockchain network.

4. Healthcare

Healthcare’s data storage systems belong to another era. With so many incredible advances in technology across so many industries, it’s essential that perhaps the most important industry of all gets on board with smart contracts, sooner rather than later.

Blockchain can offer so much more security than current systems. It can stipulate who has access to what at any given time, all but eliminating the chances of it being hacked. Using automation, smart contracts can issue prescriptions, manage stock, store test results and generally take a huge amount of weight off a system that needs to be freed up, now more than ever.

5. Banking

With trust in traditional banking hanging by a thread, a new system is needed. An inefficient process, hidden fees (and fees that are just plain invented) and needless admin all clog up a system that’s in desperate need of reinvention.

Automated smart contracts would reshape everything from day-to-day banking to ‘smart bonds.’ A new, streamlined, error-free, secure and trustless way of banking is on the horizon.

6. Mortgage loans

Today’s mortgages are slow, inefficient and weighed down by mountains of bureaucracy. The industry is ripe for revolution and smart contracts could be the catalyst. Instead of a system that relies heavily on third party involvement, smart contracts would enable a move away from the lengthy, time consuming, paper-based process towards something far more simple, straightforward, efficient and cost effective.

A smart mortgage contract would give two parties the chance to make a direct agreement, removing mutual trust from the equation – trust is instead placed on the blockchain mechanism – with all terms and conditions encoded into the deal. Transactions will be automated, transparent and traceable. It’s only a matter of time before mortgages are revamped by smart contracts.

7. Real estate

Smart contracts would have a huge impact on the real estate industry, enabling a new, efficient system of transferring property from seller to buyer. The real estate industry is plagued with problems, from third party fees, dishonest agents, constant delays and failed agreements. A digitized registry would avoid lots of bureaucracy, while a smart contract would empower both parties, saving time and money, while focusing on their interests over those of intermediaries.

Smart contracts would also streamline and simplify rental agreements, something that would protect the interests of both landlords and renters.

8. Intellectual property or royalty payments

One area where smart contracts would really come into their own is intellectual property. A space that’s tangled up with red tape, intellectual property is tailor made for an automated process.

Content ownership rights can easily be set in stone on the decentralized blockchain ledger. Also, royalty payments can be triggered at any given time, taking every step of the process away from middlemen and instead placing trust on the automated process. Smart contracts could have a potential seismic impact on the music industry, the publishing industry and beyond.

If you want to find out smart contract use cases in real life and how they will reshape the way we interact, check out this infographic.

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Smart contracts and the IoT

Pairing smart contracts with IoT devices will be the future giant leap forward. IoT devices already play a major part in our daily lives, from sensors on our phones that monitor our daily steps to online intricate data analytical systems.

The blending of smart contracts and the IoT, two technologies with endless potential, would change the way we exchange goods and services and the way we interact on a daily basis. An example is the use of smart locks – using sensors to gain access to a particular service (such as vehicle hire), while forming an instant smart contract. This will be an improvement of efficiency on an unimaginable scale.

While countless industries will benefit from the combination of smart contracts with the IoT, the door will also be opened for emerging technologies. Smart contracts will become the pan-industry standard.

Compliance of smart contracts

Compliance teams are tangled up in never ending threads of regulations and needless bureaucracy. Instead of getting better in the modern era, things seemed to be getting worse. Until blockchain came along.

For compliance teams and regulatory agencies, blockchain is like sliced bread 2.0.

Using smart contracts through blockchain will change the way companies deal with compliance, bringing a new level of transparency and traceability to every aspect of business. In particular, there will be three key area that will be impacted:

1. Fraud reduction

Blockchain is a decentralized, distributed ledger, so all records are encrypted and verified every time a transaction takes place. Fraud is virtually impossible at the moment, and blockchain security is only going to get better.

2. Auditability

Transactions between peers on the blockchain network are transparent, secure and set in stone. Every single transaction is automatically logged – this in itself promises to reshape the very nature of auditing, leading to an unprecedented level of trust across the board.

3. KYC

KYC (Know Your Customer) procedures have traditionally been complicated, inefficient and costly. Through blockchain, companies can build with their users through an efficient, lightning-fast KYC process that follows AML regulations.

Regulating smart contracts

Smart contracts are still in their infancy. As this exciting new technology sweeps across industries, new regulations will no doubt be put in place.

As blockchain becomes an increasingly influential part of our lives, it should come as no surprise that laws and regulations adapt alongside the technology.

One thing’s for sure – smart contracts are already the fastest, safest way of making an agreement. Soon to become an integral part of everyday life, smart contracts will play a fundamental role in the shift towards a more efficient, fair and equal society.


Ryan Osborne
Ryan Osborne

Originally from the south coast of England, I moved to Barcelona to pursue the good life. As a tech and lifestyle writer, I help companies and startups develop their brand, locally and internationally.


RaiseHQ
RaiseHQ

Raise is a loan marketplace that connects individuals with investment opportunities primarily in emerging countries

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