Blockchain technology is transforming the way we conduct business, and its commercial value is expected to increase significantly over the next two decades. An increasing number of companies are integrating this technology into their processes, with smart contracts being one of the most widely adopted applications. This article explains what smart contracts are, how they function, and why they are becoming an indispensable element for businesses.

Distributed Ledger Technologies (DLT) are considered key technologies, with blockchain technology being a particular focus for experts. In the future, blockchain could optimize numerous processes and place decentralization at the center. A blockchain is a type of decentralized and tamper-proof database. While the use cases for such a registry are diverse, businesses are particularly interested in its automation possibilities. Using smart contracts, companies can automate numerous processes and thus create added value.

The Lenous Protocol provides insights into what smart contracts are, explaining their functionality and benefits in blockchain technology. Stay tuned to the Lenous Protocol blog to keep updated on the latest technologies and news from Lenous.

What are Smart Contracts?

A smart contract is based on computer protocols. It is a type of digital contract that relies on blockchain technology. The terms of the agreement between “buyer” and “seller” are written directly into lines of code. Smart contracts are self-executing contracts, meaning they automatically come into effect upon certain predetermined events and therefore do not require human oversight. When these entry conditions are met, the algorithm automatically initiates a transaction, which is then validated and stored in a block. Smart contracts thus enable the execution of trustworthy transactions and agreements between various parties. These digital contracts are quite comparable to classic contracts – for example, a purchase agreement or the conclusion of an insurance policy. Since such an intelligent contract is executed without human intervention, typical sources of error can also be eliminated.

The best-known blockchain platform for developing these digital contracts is Ethereum. However, Tezos is already available as a second blockchain that provides extensive functions. Such a contract can be programmed using Solidity, a specialized programming language for Ethereum.

Are Smart Contracts legally binding?

A contract is an agreement between multiple parties. Accordingly, a contract always contains the legally binding declarations of intent of the contracting parties. In principle, contracts can be concluded in writing, verbally, or through conclusive behavior. For the sake of legal certainty, contracting parties usually opt for a written form. Consequently, such a contract must always include the framework conditions in addition to explicitly naming the contracting parties.

An intelligent contract also adheres to this principle and contains the relevant contract information. However, this information is already defined in the program code during development. Consequently, for smart contracts: Code is law. Simply put, such a contract is an if-then rule that contains all the information needed to conclude the contract.

How do Smart Contracts work technically?

Simply put, a smart contract is a small program that runs on a blockchain and executes simple if-then rules. Developers define conditions and actions in advance, which are then automatically executed.

Smart contracts benefit from the blockchain and are transparent, irreversible, and traceable. Since these small programs are based on a blockchain, no intermediary can influence the execution. Instead, all transactions take place on the blockchain – thereby reducing costs. Due to decentralization, smart contracts function independently and exhibit no time delays.

Within the distributed ledger, these digital contracts are treated like a separate account with a public address, although this account doesn’t actually possess one – and thus no one holds the private key. After creation, external access is excluded. The contract contents must be defined in the form of actions and conditions so that the account can execute these automatically. In this way, it can connect with other accounts and interact with them.

What are the special advantages?

Compared to traditional contract forms, smart contracts offer several advantages. These include:

Security
Smart contracts are based on blockchain technology and are therefore secured by cryptographic encryption methods. Consequently, no one can alter the negotiated contract terms afterwards.

Efficiency

Programming a smart contract takes little time, and subsequently, processing occurs automatically. Traditional contract forms are more extensive in both creation and execution, resulting in time and cost savings through automation.

Reliability
Correctly programmed smart contracts almost completely eliminate interpretation gaps in contract terms. Additionally, all documents are recorded on the blockchain, so loss is impossible.

Decentralization
Due to the decentralized organization of an intelligent contract, third parties such as banks or notaries are not necessary. Instead, the blockchain takes over the validation of the transaction. The principle “code is law” applies – the validity of the contract depends exclusively on the fulfillment of the contract conditions.

How Do Smart Contracts Work Technically?

In simple terms, a smart contract is a small program that operates on a blockchain, executing straightforward if-then rules. Developers predefine conditions and actions, which are then automatically executed when the specified conditions are met.

Smart contracts leverage the advantages of blockchain technology, offering transparency, irreversibility, and traceability. Because these programs run on a blockchain, no intermediary can interfere with their execution. All transactions occur directly on the blockchain, which helps reduce costs. Additionally, due to decentralization, smart contracts operate independently and without delays.

Within the distributed ledger, these digital contracts function like separate accounts with a public address; however, no actual account exists—meaning no one holds a private key. Once created, external access is restricted. The contract’s content must be defined as actions and conditions, allowing the account to execute them automatically and interact with other accounts.

What Are the Special Advantages?

Compared to traditional contract forms, smart contracts offer several significant advantages:

Security

Smart contracts are built on blockchain technology, secured by cryptographic encryption methods. As a result, the agreed-upon contract terms cannot be altered after negotiation.

Efficiency

Creating a smart contract requires minimal time, and subsequent processing occurs automatically. In contrast, traditional contracts involve more extensive creation and execution processes, leading to time and cost savings through automation.

Reliability

When properly programmed, smart contracts virtually eliminate ambiguity in contract terms. Furthermore, all documents are recorded on the blockchain, ensuring that loss is impossible.

Decentralization

The decentralized nature of smart contracts eliminates the need for third parties, such as banks or notaries. Instead, the blockchain validates transactions. The principle of “code is law” applies, meaning the validity of the contract relies solely on the fulfillment of the predefined conditions.

What Are the Disadvantages of Smart Contracts?

While the advantages of these digital contracts may seem compelling at first glance, their concept is not yet fully refined. Consequently, errors can occur when using these programs. Due to the nature of blockchain technology, executed transactions are irrevocably documented, making subsequent corrections impossible.

For instance, an error in a Decentralized Autonomous Organization (DAO) on June 17, 2016, led to the theft of $50 million. This underlying flaw forced the developers of the Ethereum blockchain to implement an update, resulting in a hard fork, or a split in the original blockchain. This ultimately led to the creation of Ethereum Classic, based on the forked blockchain.

Additionally, developers may introduce backdoors in the program code. This highlights that not only the underlying blockchain is important, but also the necessity for trustworthy developers. Finally, executing a smart contract requires a functioning internet connection. Currently, this requirement cannot be met globally, limiting the worldwide adoption of the technology.

What Are the Potential Applications of Smart Contracts?

The use cases for blockchain-based contracts are virtually limitless. Here, we will focus on a selection of possible applications.

Real Estate

Digital contracts can define and regulate rental agreements. A smart contract could automatically adjust the rent based on the property’s market value or stipulations in the lease. Additionally, these contracts could significantly change the buying and selling of real estate.

Insurance

By using smart contracts, insurance companies can automatically process claims, thereby significantly reducing costs. Relevant information regarding the insurance case can be transparently and irreversibly documented on the underlying blockchain. For example, in the context of travel insurance, a smart contract could monitor flight data and directly transfer compensation in case of delays.

Supply Chains

Modern supply chains are complex and involve multiple contractual parties, including manufacturers, suppliers, intermediaries, producers, and consumers. Digital contracts enable these parties to collaborate on a common platform. Furthermore, blockchain technology allows for transparent tracking of products throughout the supply chain.

Licensing

Another application for smart contracts is the issuance of software licenses. Developers can contractually stipulate that software automatically locks itself in the event of unauthorized access.

How Are Smart Contracts Programmed?

Smart contracts are programmed using the contract-oriented programming language Solidity. This language can be utilized across various blockchains. Initially, Solidity was designed to function exclusively on the Ethereum blockchain, but it has since evolved to allow developers to create intelligent programs for multiple distributed ledger technologies (DLTs).

Developers only require a web browser for programming. To compile the code, a suitable client is necessary. The syntax of Solidity is similar to ECMAScript, and it is a deterministic language, meaning it excludes random events. After the program is executed, transaction verification occurs through the nodes in the network.

What Problems Can Smart Contracts Solve?

Businesses, regardless of size or industry, are surrounded by written contracts. Unfortunately, these contracts can often be cumbersome and a source of economic and legal conflicts.

Smart contracts offer the most effective solution to traditional contracts. They simplify business transactions between anonymous or identified parties, usually without the need for an intermediary. Additionally, they reduce the formalities and costs associated with traditional methods while maintaining credibility, security, and authenticity.

However, these are not the only advantages. Smart contracts also provide several additional benefits:

• Increased Security: Blockchain-based ledgers are tamper-proof and immune to manipulation.
• Reduced Dependence on Intermediaries: This gives parties greater freedom to negotiate agreements.
• Near Real-Time Execution: Transactions occur simultaneously for all parties as soon as the required criteria are met.
• Trust and Transparency: All participants can view contract information on the blockchain, fostering an environment of trust.
• Decentralization: Distributed across thousands of computers, smart contracts do not require management by a large company, eliminating bureaucracy, censorship, and high costs/time delays in the process.

Examples of Smart Contracts

• The first publicly recorded example of smart contracts came from Nick Szabo, a legal scholar and cryptographer, who mentioned them in a paper in 1995. Two years later, he developed a more detailed paper defining the theory, although at that time, it was impossible to implement it with the existing technological infrastructure. It wasn’t until nearly 15 years later, in 2009, with the advent of blockchain technology and Bitcoin, that smart contracts became a reality.
• Smart contract solutions can be utilized across various industries and processes. For instance, in the pharmaceutical sector, Sonoco and IBM employ smart contracts to address issues related to the transport of medications. They use a platform that tracks temperature-controlled products throughout the supply chain, providing reliable and accurate data among the parties involved.
• In retail, The Home Depot uses smart contracts to resolve disputes with suppliers quickly, thanks to a real-time communication process and increased supply chain transparency. This strengthens relationships with suppliers and allows the company to focus on important innovations and tasks.
• International trade also greatly benefits from smart contracts, as they can define standardized rules and simplified trading options, reducing friction and expanding trade opportunities for the involved companies and banks.

Why Should Companies Consider Implementing Smart Contracts?

• Smart contracts have the potential to radically transform industries such as art, retail, supply chains, manufacturing, telecommunications, and more by accelerating transactions, reducing paperwork, and creating cost efficiencies.
• In the financial sector, the market for smart contracts has grown from $500 million to over $20 billion by 2020, representing just the initial figures.
• Smart contracts address the issue of trust in the digital world, making transactions more honest, secure, and fair. They introduce protocols that ensure the integrity of multi-party agreements and automatically enforce binding commitments, such as in loan applications, intellectual property validation, insurance claims processing, and the establishment of decentralized autonomous organizations.
• If you are considering implementing smart contracts in your business, Plain Concepts can assist you in finding the most suitable solution.

Conclusion

It is not surprising that smart contracts are considered one of the most significant features of blockchain technology. These small programs enable the complete automation of contracts and provide a high level of legal security, making attacks nearly impossible.

From a business perspective, the functionalities of smart contracts are particularly appealing. Industries such as insurance, financial services, and utilities can benefit significantly from this technology. However, there are currently few examples that demonstrate successful implementations.