NewsWhat are Smart Contracts?

What are Smart Contracts?

By

Algorand Foundation

Smart contracts are self-executing digital contracts that automate the execution and enforcement of contractual terms and conditions. They allow parties to transact directly without requiring third-party intermediaries, eliminating many transaction costs and enabling trustless transactions through transparency and immutability. This article will introduce the concept of smart contracts in detail, explore their key advantages and considerations, and then discuss current and potential real-world use cases.

What are smart contracts?

A smart contract is a computer program or code that automates, verifies, and enforces the negotiation or performance of an agreement or transaction. At its core, it's a self-executing contract where the terms of the agreement between parties are directly written into lines of code. This code resides directly on a blockchain network, such as Algorand. It controls the execution, compliance, and enforcement of the terms defined by the parties to the smart contract.

Learn more about smart contracts on Algorand.

Consider a simplified example of a smart contract for a car purchase. 

  • Contract creation: The buyer and seller agree upon the terms of the contract, including payment details, delivery requirements, and dispute resolution mechanisms.
  • Payment deposit: The buyer initiates the contract by depositing the agreed-upon payment into a secure escrow account on the blockchain.
  • Delivery verification: The smart contract integrates with external data sources, such as IoT sensors, to verify the successful delivery of the vehicle as per the agreed-upon conditions.
  • Funds release: Upon confirmed delivery, the smart contract automatically releases the funds from escrow to the seller, ensuring secure and timely payment.

This process effectively eliminates the need for a centralized intermediary to handle funds and verify the completion of contractual terms, streamlining the transaction and enhancing security.

How do smart contracts work with blockchain technology?

For smart contracts to function, they require a decentralized network with certain technological capabilities. This is where blockchain comes in. Blockchain provides a distributed digital ledger that can record transactions and agreements in a verifiable and permanent way. The code that makes up a smart contract is embedded directly into transactions on the blockchain.

Read also: What is a Node in Blockchain? 

When conditions are met, the smart contract can be triggered and subsequent transactions on the chain implement the logic of the business trade. This makes the execution of contractual terms provable and indisputable, as they are stored immutably on the network. Popular blockchains suited for smart contracts include Algorand and Ethereum due to their Turing-complete nature, meaning they can handle any kind of logic and perform complex computations. This allows developers to create highly versatile and sophisticated smart contracts for diverse applications. 

Algorand's smart contracts are pieces of logic that reside on the Algorand blockchain and are remotely callable. They are primarily responsible for implementing the logic associated with a distributed application. These contracts can generate asset and payment transactions, allowing them to function as escrow accounts on the Algorand blockchain. 

What are the current and potential use cases for smart contracts?

Financial services  

Within open financial systems, smart contracts could streamline post-trade activities, revolutionizing how capital markets function. In derivatives markets, they would facilitate automated payments between counterparties based on price conditions. They also show potential for transforming syndicated lending by codifying obligations between multiple banks and corporate borrowers. Escrow services leveraging smart contracts could remove intermediary fees from transactions requiring secure, conditional asset transfers. By digitizing trade financing arrangements, smart contracts may further reduce paperwork burdens and processing times for international commodity shipments. Overall, the transparency and automation inherent to smart contracts are a natural fit for modernizing legacy practices throughout global finance.

Supply chain management  

Leveraging IoT sensors and digital item identifiers, smart contracts allow for the creation of distributed ledgers that precisely map the movement of physical goods between suppliers, manufacturers, distributors, and retailers across borders. By automatically processing payments upon delivery confirmation at each point, they cut costs in an industry estimated to lose over $2 trillion annually to inefficiencies. They also bring much-needed visibility into global supply networks. Pharmaceutical companies have already piloted using smart contracts on blockchain to trace drug shipments from raw material extraction to consumer markets. As the technology matures, its use for tracking higher-value items will accelerate the digitization of supply chains worldwide.

Wholechain, a blockchain-based traceability platform, is actively contributing to the transformation of supply chain management. It empowers businesses to track products from origin to consumer, ensuring transparency and ethical sourcing through its platform that facilitates collaboration among supply chain stakeholders.

Insurance  

Smart contracts show potential for streamlining many insurance processes. They could embed policy stipulations directly as code to transparently automate underwriting assessments, premium tracking, and speedier claim payouts upon pre-defined trigger conditions. This allows insurers to optimize risk assessment and offload bureaucratic functions to smart logic. Early adopters include insuring flight delays or tracking vehicle usage-based policies. Automating compliance through embedded contractual terms reduces costs for both insurers and policyholders. As a largely paper-driven industry, insurance is well-positioned to leverage the capabilities of programmable smart contracts, disrupting traditional models over the long run.

Government services  

Given the administrative costs of legacy public sector processes, smart contracts introduce compelling use cases and reduce waste. Facilitating secure digital voting without expensive physical infrastructure or postal ballot fraud risks is an obvious application. Smart contracts could also automate document notarization, registration of identifications, and tracking licenses or permits, preventing forgery. They enable transparent compliance through APIs exposing attestations of criteria like tax filings encoded directly as on-chain logic. Overall, the advantages of streamlining record-keeping while validating information immunize public databases against manipulation directed at centralized systems.

Healthcare  

By encoding consent and access policies as smart contracts, health data sharing adheres to patient privacy regulations while removing bureaucratic obstacles hindering care coordination between providers. They could automate insurance claims, facilitating payments between patients, doctors, and insurers upon treatment certification. Other potentials include tracking clinical trial participation or precision medication using blockchain identifiers. Over time, smart contracts embedded with personal health profiles introduce capabilities that revolutionize how health systems function through distributed care networks and streamlined cost accounting.

Real estate  

Securing land titles through irrefutable digital records stored on decentralized ledgers provides a natural use case for smart contracts. Automatically tracking rental income or mortgage interest payments represents applications that are achievable and easy to implement. Smart contracts also enable novel financing models like tokenizing property ownership or collateralizing home equity, unlocking its value. As regulations evolve to embrace digital transactions, the real estate industry too will witness transformative impacts from this next-generation record-keeping approach.

Platforms like Lofty leverage smart contracts to tokenize real estate assets, enabling fractional ownership and democratizing access to investment opportunities. Lofty also uses smart contracts to track rental income and mortgage payments efficiently, minimizing administrative overhead. 

Gaming and eSports  

Incorporating smart logic into distributed digital economies and item markets online opens many opportunities. The generation of provably fair random numbers for games of chance eliminates centralized manipulation risks. Smart contracts power transparent automated tournament prize pools based on match outcomes. They can also facilitate matched betting, skill gaming, and cryptographically verifying in-game achievements or tradable asset exchanges between players globally. As a vibrant proving ground, gaming will continue pioneering smart contract innovations with wider ramifications.

What are the advantages of smart contracts?

Smart contracts reduce transaction costs by automating processes and removing the need for expensive intermediaries to facilitate agreements. On Algorand, transaction fees are 0.001 Algo, orders of magnitude lower than other blockchains, unlocking immense cost savings potential for widespread smart contract usage.

    

By guaranteeing the automated execution of contractual terms without relying on fallible human enforcers, smart contracts provide confidence and certainty to all parties. Algorand's Pure Proof of Stake protocol ensures contract terms are reliably enforced through immediate transaction finality, meaning changes made by the smart contract are irreversible and guaranteed to be accurate within an average of 2.8 seconds. This eliminates the risk of transaction reversals or delays that can occur in other blockchains, creating a more trustworthy and efficient environment for smart contract execution.

    

Through increased transparency in terms and performance visibility, smart contracts build trust for all counterparties involved in an agreement. Being open source, the Algorand blockchain allows verifying contract code and activity, establishing credibility for organizations.

    

As digitized agreements that can be accessed globally, smart contracts open up new market opportunities that extend beyond geographical boundaries. Algorand's scalable, high throughput infrastructure supports complex applications serving worldwide user bases through low-friction programmable relationships.

What are the considerations for smart contracts?    

Security issues could arise if smart contracts are deployed without proper auditing and testing to ensure vulnerabilities are found and fixed before risks become exposures.

While proper testing and security validation is paramount before deployment, developers have the option to allow for smart contract upgrades. This can be a double-edged sword, so the compromise between security and trustlessness should be weighed carefully. 

With regulations still evolving to address cross-border smart contract usage and legal status, jurisdictional ambiguity exists, and continued harmonization is required.

Complex smart contracts with natural language components or external data dependencies may not be able to fully automate processes due to limitations in removing human elements or single points of failure.

Reliance on centralized oracles introduces risks that can be mitigated through the development of decentralized oracle architectures.

These challenges are not insurmountable, and the technology continues to evolve rapidly. 

Conclusion

In summary, smart contracts have revolutionary potential to streamline transactions, record-keeping and auditing by codifying agreements into decentralized and self-executing digital contracts. Their full unlocking on a mass scale depends on addressing technical standards, legal frameworks, and real-world complexities.

Read also:

What is an Oracle in Blockchain?

What Are Real-World Asssets?

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