Smart contracts are a prospering innovation that has created a great deal of buzz in the blockchain industry. Due to digitalization in infrastructure, there is a growing need for an electronic process of entering into credible business arrangements. Smart contracts could easily replace traditional ones, as they are faster, more convenient, and economical.
Smart contracts have seen a rise in popularity because of how easy it is becoming to build them. Blockchain consortia like Hyperledger have made significant contributions to streamlining the financial and business processes in many industries.
What is a Smart Contract?
A smart contract is a computer program that uses blockchain technology to automatically execute and enforce the terms and conditions of an agreement or a contract.
The involved parties can enter into a blockchain-powered smart contract by negotiating and agreeing upon the terms and conditions of the agreement, which are then wholly or partially embedded into the smart contract code within the blockchain.
By running on a decentralized network, smart contracts eliminate the need for intermediaries to authenticate deals. They offer a more trusted method of conducting transactions without the involvement of unknown third parties.
Smart contracts automatically perform tasks based on a previously specified set of instructions when the contractual terms and conditions are fulfilled.
Features of Smart Contracts
The core features of smart contracts cover:
- Signatories, which refers to the parties involved in the smart contract, who use digital signatures to approve the terms;
- Subject, which is limited to the environment of the smart contract; and
- Specific terms, which are the contractual terms signed by the involved parties.
Additionally, it is necessary to write smart contracts using explicit mathematical terms in a programming language that can be interpreted by the blockchain so that the contract can self-execute.
How do Smart Contracts work?
Smart contracts can verify, validate and enforce the terms set according to multiple parties through blockchain technology.
Since blockchain technology ensures the transparency, traceability, and irreversibility of transactions, smart contracts enable anonymous parties to enter into agreements even in the absence of a central or legal authority figure.
Data uploaded to a blockchain becomes permanently frozen, making it the most secure platform for smart contracts. Any information stored in a block exists on an encrypted ledger, and cannot be lost or altered.
Where can Smart Contracts be applied?
Various industries could implement smart contracts to optimize processes like regulatory compliance, document management, contractual imposition, and cross-border financial transactions. Its other implementations include ownership and purchase of properties and homes.
Today, the application of smart contracts covers areas such as trade, finance, logistics, banking, supply chain management, and renewable energy.
Benefits of Smart Contracts
Smart contracts trump traditional contracts in terms of the numerous advantages it offers to various industries. As all the recorded activities are public, verified, and immutable, smart contracts provide increased security, efficiency, and trust. Due to this, firms can reduce their cost and time expenditure while optimizing their processes.
Smart contracts can bring more speed and efficiency to the execution of commercial agreements within the span of a few minutes. By eliminating the need for paperwork, they cut down the time spent on processing documentation and significantly reduce the potential for manual errors. The parties involved in a smart contract can execute it from anywhere in the world without any lawyers.
Although the contractual terms are accessible to all the relevant parties at any time, the immutable nature of smart contracts ensures that the data stored on the ledger remains unaltered. As they increase transparency and decrease the chances of manipulation and error, smart contracts can reduce the risk of cyberattacks and the cost of monitoring.
With the automatic execution of transactions based on pre-programmed instructions, smart contracts can facilitate trust among the involved parties. Since all transactions require validation from everyone in the network and are irreversible, the involved parties cannot back out of a smart contract.
As all actions are recorded publicly and verified by the involved parties, smart contracts offer more security. Blockchains can resist cyberattacks by encrypting documents and transactions, making it nearly impossible for fraudsters to hack into them. Based on the specified instructions, smart contracts could also automatically create backups or duplicates in case of damage or loss of data.
Challenges of Smart Contracts
Despite its many benefits, businesses hesitate to adopt smart contracts on a wide scale due to its various challenges.
The Oracle Problem
The biggest challenge preventing the large-scale implementation of smart contracts is the blockchain oracle problem. But, first, what is an “oracle”? An oracle is a device that provides off-chain data for blockchains using APIs and market data feeds. Typically, data within smart contracts could be information that pertains to price feeds, weather, random number generators for gambling, etc. With the help of oracles, the blockchain can connect to such data sources, which allows the smart contract to self-execute based on the information received from the feeds.
Now, what is the Oracle Problem? The primary reason behind building smart contracts is decentralization. However, to achieve this goal, data has to be retrieved from somewhere. If it is imported through a single API or data source, it takes away the key purpose of enabling blockchain. By using a centralized oracle, a single entity would gain control over the smart contract, making it only as effective as a regular contract. Further, it increases the chances of malware attacks against the smart contract.
And so, the oracle problem is that:
- Blockchains cannot access external data by themselves, and
- Implementing centralized oracles cancels the benefit of smart contracts and poses cyber risks.
The other challenges of smart contracts include:
While smart contracts can reduce the chances of manual errors, they cannot eliminate all errors, as smart contracts are still codes written by humans. If a smart contract code contains bugs, it could be delayed, intercepted, or corrupted, not unlike a paper contract.
Although smart contracts help facilitate transparency by functioning on a distributed platform, they also create confidentiality issues as all transactions are visible across the network. In particular, this issue would affect parties that are associated with known members. Further, hackers could use various identification techniques to distinguish the identities of those using pseudonyms to transact with a specific smart contract.
Lack of technical expertise
The rising implementation of smart contracts would eventually lead to the emergence of new types of cryptography and create more demand for experts who can verify and translate these codes into a readable format. However, finding expert coders with the necessary engineering expertise may prove difficult.
Legal and regulatory issues
The lack of clarity in regulatory policies over the legality of smart contracts has hindered any large-scale implementation. As there are no governmental laws that apply to smart contracts, businesses are reluctant to adopt this technology.
Although smart contracts are still in their infancy, they demonstrate a high potential for implementation in the future. However, at this moment, the technology will require more experimentation before its widespread practical application. Moreover, existing issues, in particular, the legal and regulatory challenges, must be overcome to encourage the adoption of smart contracts across several industries.