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Created on 13.03.2024

Smart contracts: more than just digital contracts

Smart contracts are one of the pioneering developments from the world of blockchain. These programs, which are automatically executed on the blockchain when certain conditions are met, provide an efficient, transparent and secure method for executing predefined functions and automating business processes. In the following article, we shed light on how smart contracts work, show examples of how they can be used and discuss their advantages and disadvantages.

Smart contracts are self-executing programs that are stored on a blockchain and execute one or more transactions or functions when predefined conditions are met. Once executed, transactions are traceable and irrevocable. Furthermore, the terms and functions are transparent and can be viewed at any time. This enables trustworthy transactions and agreements between different parties without the need for a central authority.

The history of smart contracts

The concept of smart contracts was first developed in 1994 by Nick Szabo, an American computer scientist. This makes smart contracts older than Bitcoin, which was created in 2008. Szabo defined smart contracts as computerized transaction protocols that execute the terms of a contract.

How smart contracts work

Smart contracts work based on blockchain technology and can be illustrated using the example of a vending machine: imagine you want to buy a bottle of water from a smart vending machine. The smart contract, which is stored on the blockchain, contains predefined conditions that must be met for the transaction to take place. In this case, the condition could be that you transfer a specific amount of cryptocurrency to the wallet embedded in the smart contract.

Once you have made the payment, the blockchain will verify the transaction and check whether the conditions have been met. If verification is successful, the smart contract is automatically activated, and the vending machine dispenses the bottle of water. The special characteristic of smart contracts is that they work without human intervention and can conclude and execute agreements automatically and securely. This decentralized and transparent way of processing contracts offers an efficient method for concluding transactions without having to rely on traditional intermediaries.

What can smart contracts be used for?

The possible usages for smart contracts are almost endless. Wherever more than two parties are involved in a transaction, smart contracts can be a more efficient and transparent alternative. Well-known areas in which smart contracts are already used include DeFi (decentralized finance) stock exchanges, jewellers tracking gemstones transparently and pilot projects in supply chain management.

Smart contracts and DeFi

Smart contracts play a vital role in the field of decentralized finance (DeFi). DeFi refers to financial services that are based on blockchain technology and circumvent traditional intermediaries. In this context, smart contracts enable automated and programmable financial services that do not necessarily go through traditional banks. For example, loans, cryptocurrency trading and liqudity provision can be automated using smart contracts.

In DeFi protocols, smart contracts are responsible for setting conditions for transactions and ensuring that they are processed transparently, immutably and efficiently. Smart contracts can also hold, create or send tokens themselves if certain conditions are met. In addition, they enable development of decentralized apps (DApps) that give users access to various financial instruments without having to rely on traditional banking infrastructures.

Smart contracts enable more efficient supply chains

Smart contracts have enormous potential, particularly in the field of supply chain management. Many supply chain processes are lengthy, complex and also highly opaque. Smart contracts can help to reduce complexity and improve transparency throughout the supply chain. This is made possible thanks to the automated checking and execution of many processes.

By linking IoT devices that can track the location of goods, smart contracts enable inventory and supply chain tracking along the entire supply chain. Companies can use this information to react better to disruptions or incidents such as recalls. It also reduces the risk of theft or fraud along the supply chain. A decentralized, unchangeable data set also ensures that all participants have equal access to information and helps to establish trust. Equally, smart contracts improve the transparency, traceability and efficiency of a supply chain, make it more flexible and strengthen the relationships between the parties involved. Smart contracts allow companies or consumers to track the transportation route of goods and also to check the origin of the goods. Companies such as Walmart, Maersk, BHP Billiton and Everledger are already using smart contracts to track a variety of goods, including meat, shipping containers, mining samples and even diamonds.

Smart contracts may revolutionize the real estate industry

In the future, smart contracts could be used to automate and simplify the transfer of ownership when buying a house, to take one example. When a home buyer pays the purchase price, the smart contract could automatically transfer the mortgage certificate to them. The smart contract could also automatically transfer ownership of the property as soon as the purchase price has been paid. Smart contracts make it possible to process promissory notes and house purchases faster, more securely and more efficiently. Digitizing promissory notes and automating the transfer of ownership in home purchases could also help to reduce fraud and errors. In addition, fractionation enables investors to participate in the real estate market with small amounts of money. This allows investors to acquire partial ownership of real estate and to benefit from the increase in value and rental income without having to invest large amounts. Combining smart contracts and tokenization could therefore fundamentally change the real estate industry and make it accessible to a wider audience.

Smart contracts increase efficiency in the insurance industry

Smart contracts could also be used in the insurance industry − for example, to automate claims processing in order to increase processing speed and efficiency. Smart contracts could process claims automatically and enable transparent and irreversible documentation of information in the event of a claim settlement.

Advantages and disadvantages of smart contracts

Smart contracts offer numerous advantages, but also some disadvantages that need to be taken into account.

Advantages of smart contracts

  • Increased efficiency thanks to automation: smart contracts enable automatic and immediate execution of contracts or transactions, as they are activated as soon as the specified conditions are met. Unlike conventional contracts, they eliminate time-consuming processes and help to avoid manual errors. The blockchain handles the validation of transactions, which relieves the burden on third parties such as banks or notaries.
  • Trust and transparency: as the transaction data on public blockchains is visible to all participants, there is no doubt about the accuracy of the information. This prevents manipulation for personal gain, strengthening the trust of all parties involved.
  • Security: smart contracts are based on blockchain technology, which is protected by cryptographic encryption. This measure protects transaction data against unauthorized access and manipulation, as smart contracts are immutable and it is not possible to make subsequent changes to the contract terms. At the same time, smart contracts minimize possible interpretation errors in the contract terms as far as possible and offer comprehensive and transparent documentation on the blockchain.

Disadvantages of smart contracts

Despite their promising benefits, smart contracts still face a number of challenges that need to be overcome before they can be used more widely in practice:

  • Complexity and the need for technical expertise: the development and implementation of smart contracts requires a high level of technical expertise and understanding. Ultimately, smart contracts are only as good as the developers who write the code.
  • Immutability and risk of code errors: we know that smart contracts can no longer be changed once they have been stored. Errors or gaps in the program code can have unintended consequences. If, for example, a price is incorrectly stored in the program code, this can lead to the incorrect value being used for the calculation (e.g. 50 centimes for a concert ticket instead of 50 francs). Any payments will then also be made incorrectly. Code errors also mean that the system is more susceptible to hacking attacks and errors can no longer be rectified retrospectively. This is why checking and validating the code is crucial − however, it requires time and resources.
  • Limited applicability: smart contracts are not suitable for all types of agreements, as not all agreements can be implemented effectively in smart contracts, especially those that require complex or subjective conditions.

Smart contract dependencies

Oracles are indispensable for many of the applications in which smart contracts are used, as they bridge the gap between the blockchain and the real world. Oracles are services that feed external data (such as temperatures, prices or the result of a football match) securely into the blockchain. They enable smart contracts to access information that exists outside their native blockchain. This significantly expands the possible applications of smart contracts, as they can now react to real-world events. For example, insurance policies can automatically trigger payments if an oracle confirms that an insured event, such as a natural disaster, has occurred. Oracles thus strengthen the functionality and scope of smart contracts and blockchain technologies by providing them with reliable and real-time data from the real world. Although oracles are essential for connecting blockchains to the real world, they also have specific disadvantages. One of the main disadvantages is the problem of trustworthiness. Because oracles feed external data into a blockchain, the security and accuracy of smart contracts depends on the reliability of these external data sources. If an oracle provides inaccurate, manipulated or distorted information, this can lead to incorrect executions of smart contracts, potentially resulting in significant financial and operational damage.

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