What is a smart contract, and how does it work?


Hello, lads! The last time we saw each other was spring. Whaaaat? Is it summer already in full swing? Sheesh! Let's not waste a minute.

Monday with OctoStrategy is time for you to dive into the world of IT technologies. Our team is here to help you become an IT expert. We invite you to talk about smart contracts. 


But, first, we got a question. Have you heard something about Ethereum? Ethereum is the second-largest digital asset, with a huge market cap of over $149 billion. To fully understand, one should first properly understand what is a smart contract.


Ethereum is not just a currency; it is also a platform that allows other blockchain applications to be built on it. The Ethereum platform uses a currency called Ether, which is used to pay for transactions.


We’re all familiar with apps and app stores. You browse, download the app you want, and away you go.


Behind the lovely UX and UI interfaces of mobile devices, these apps are performing a specific set of instructions as laid out by their creator. It could be a game, a calendar, or a way to buy goods and services.


Smart contracts perform a very similar function.


A smart contract is a contract—expressed as a piece of code—that’s designed to carry out a set of instructions.


With smart contracts, however, there’s no middleman. There’s no person or company holding your information or verifying it. The blockchain verifies and holds information for you.


How does a smart contract work?

Let's imagine a conventional online transaction, without a smart contract. Let's say you want to buy a phone online. To do so, you need:


  • A website to hold the information on all the phones you’d like to see
  • A way of communicating with sellers
  • A payment system to allow you to buy an item
  • Some capacity to get a refund if the phone turns out to be a dud


Each of these components requires a level of trust between you and the site or service in question. In addition, each part of that process is typically controlled by a different company or individual.


It wouldn’t take much for a sneaky person or organization to meddle with any of the above elements, spoiling or voiding the whole process.


A smart contract can remove the need to trust multiple parties in the process of buying something. Why? Smart contracts are:


  • Secure: They use cryptography to prevent the alteration of records.
  • Transparent: Everyone can see what the smart contract is and what it’s being used for.
  • Third-party free: Smart contracts don’t need a middleman to verify them. The blockchain does that for you.
  • Autonomous: They work automatically, so there's no wait for human intervention.
  • Accurate: Because smart contracts are written in code, they have fewer gray areas than written or spoken languages.


If this happens, do this

Usually, at the heart of a smart contract, you'll find a mechanism that says (in computer code) “if this happens, then do this.”


These already exist today. Let’s say you want to pay for something using a debit or credit card. The software your bank runs on will use the “if this happens, then do this” function in the following way:


  • If the amount in the bank account is larger than the sum requested, release the funds.
  • If the amount in the bank account is smaller than the sum requested, don’t release the funds.


The difference with smart contracts is that instead of a bank (or any third party) being the controller of that decision, the blockchain makes the determination.


The exciting thing about smart contracts is it means anyone can enter into an agreement with anyone else, with the blockchain keeping a record of the whole thing.


Inside a smart contract

Like regular contracts, smart contracts are designed to enforce the terms of an agreement—whether this is an exchange of digital assets, tokenized rights, proof of identity, or practically anything else.


Smart contracts will automatically execute when pre-defined conditions are met. The operation of a smart contract can be briefly described with three main terms:


  • Interconnectivity: Each smart contract usually has a restricted set of functions. Several smart contracts can be set up to connect with one another and can form more complex arrangements known as decentralized applications (dApps).


  • Objects: These are the signatories that interact with the smart contract and its subjects, which are modified by the smart contract based on predefined or newly-submitted terms.


  • Environment: Smart contracts are dependent on an underlying cryptographic environment. This ensures that they can operate securely and that the data they act on is immutable and generally transparent.


For most blockchains, the code underlying the smart contracts is immutable. Several blockchains also support updatable smart contracts, however.


What would happen with more widespread smart contracts?

So, as you can see, smart contracts can make the world a better place that is free of commission. It can reduce fraud, delays, and the overall cost of many things. 


The best thing about having no middlemen is the fact that we save a lot of money. Not only that, but we would no longer need to trust anyone, either.


There is a potential downside, too, though: people may lose their jobs. A middleman is a real person, just like you and me. Why would someone pay an employee to do a job that could be done for free by using a smart contract? They wouldn’t.


Of course, no one knows what the future holds. All we can do is guess and predict, but we must be prepared for all possible outcomes.

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