Definition

smart contract

Contributor(s): Francesca Sales and Ben Cole
This definition is part of our Essential Guide: Understanding blockchain: Tutorial for CIOs

A smart contract, also known as a cryptocontract , is a computer program that directly controls the transfer of digital currencies or assets between parties under certain conditions. A smart contract not only defines the rules and penalties related to an agreement in the same way that a traditional contract does, but it can also automatically enforce those obligations.

It does this by taking in information as input, assigning a value to that input through the rules set out in the contract and executing the actions required by those contractual clauses -- for example, determining whether an asset should go to one person or should be returned to the other person from whom the asset originated.

These contracts are stored on blockchain technology, a decentralized ledger that also underpins bitcoin and other cryptocurrencies.

What smart contracts do

Smart contracts are complex, and their potential goes beyond the simple transfer of assets -- they can execute transactions in a wide range of fields, from legal processes to insurance premiums to crowdfunding agreements to financial derivatives. Smart contracts have the potential to disintermediate the legal and financial fields; in particular, by simplifying and automating routine and repetitive processes for which people currently pay lawyers and banks sizable fees.

The role of lawyers could also shift in the future as smart contracts gain traction in areas from adjudicating traditional legal contracts to producing customizable smart contract templates. Additionally, smart contracts' ability not only to automate processes, but also to control behavior, as well as their potential with real-time auditing and risk assessments, can be beneficial to compliance.

Smart contract history and creation

The notion of smart contracts was first proposed by Nick Szabo in 1994. Szabo is a legal scholar and cryptographer known for laying the groundwork for digital currency. Back then, there was little interest or activity in smart contracts because there was no digital platform or distributed ledger that could support them.

In 2008, the cryptocurrency bitcoin was developed via a blockchain platform comprised of a digital and distributed ledger that tracks monetary transactions. This technology enabled the development of smart contract code that is used to enter all the terms of the contract into the blockchain.

Many platforms now allow for the use of smart contracts, including Ethereum, bitcoin and Nxt. Today, with the growing adoption of bitcoin and the support of blockchain technologies, smart contracts are growing in popularity, often built on top of digital currencies to trigger payments.

Smart contract applications and blockchain

Blockchain is ideal for storing smart contracts because of the technology's security and immutability. Smart contract data is encrypted on a shared ledger, making it impossible to lose the information stored in the blocks.

Another advantage of blockchain technology being incorporated into smart contracts is flexibility. Developers are able to store almost any type of data within a blockchain, and they have a wide variety of transaction options to choose from during smart contract deployment.

Blockchain process explained
A depiction of how the blockchain process works.

Blockchain-based smart contracts are helping make business and other transactions more secure, efficient and cost-effective.

For example, in 2016, Cook County, Ill., used blockchain to create a database to transfer and track property titles. When these transactions occur, in addition to the traditional paper deed, the buyer receives a digital token that can be used as proof of ownership.

A variety of industries could benefit from using blockchain-based smart contracts as part of their supply chain. Automating healthcare payment processes using smart contracts can reduce overbilling and prevent fraud. The music industry could record the ownership of music in the blockchain, and then deploy a smart contract to ensure royalties are paid when the music is used for commercial purposes. Smart contracts and the blockchain could benefit the automobile industry by storing readily available information about vehicle maintenance and accident and ownership history.

Smart contract advantages and disadvantages

There are several potential business advantages when using smart contracts.

Cost-efficiency. Smart contracts eliminate many operational expenses and save resources, including the personnel needed to monitor their progress.

Processing speed. Smart contracts run on automated processes and, in most cases, can eliminate human involvement, increasing the speed of business transactions stipulated in the contract.

Autonomy. Smart contracts are performed automatically by the network, eliminating the need and associated risk of a third party being involved in smart contract deployment.

Reliability. Data entered in the blockchain cannot be changed or deleted. If one party does not complete its obligations, the other will be protected by the conditions of the smart contract. The automated transactions also remove the potential for human error and ensure accuracy when executing the contracts.

There are numerous potential disadvantages to smart contracts, as well. A lack of international regulations focusing on blockchain , cryptocurrencies and smart contracts makes these technologies difficult to monitor in the global economy.

Smart contracts are also complicated to implement. They are also impossible to change, and while this is considered a security-related advantage, the parties cannot make any changes to the smart contract agreement or incorporate new details without developing a new contract.

This was last updated in April 2018

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