Smart Contract in Blockchain: How Does it Work?

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Last updated on
25th Nov, 2022
Published
25th Nov, 2022
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Smart Contract in Blockchain: How Does it Work?

Most business works on signing agreements and contracts, specifying the terms and conditions of their deal. As these contacts are handwritten, there could be chances of having a different interpretation from both parties. Whenever the complexity of the contract increases, the risk of disagreement will also increase. Thus, with time, it is essential to have a third party who can impose laws and streamline the agreement process without dispute.  

Smart contracts are small codes based on logics executed whenever the given conditions are true. Know that Smart contracts were introduced to secure blockchain. 

Today, Smart contracts are being used everywhere, thus increasing their importance. People are learning Smart contracts in blockchain to update their skills. We recommend you Blockchain Developer Certification to get started with blockchain learning.  

What is Smart Contract?

A smart contract is an encrypted agreement specifying all the essential details approved by both parties. Its logic contains results for every possible situation within an agreement. Either the agreement fails or succeeds, it contains scenarios for both, making it easier for you to avoid disputes.

These contracts are generally associated with Ethereum, specially designed to support smart contracts. But you can simply use this concept with any blockchain platform or network. The code specified within the smart contract ensures the performance of an agreement.  

Smart contracts are immutable and irreversible and are written in Solidity or Go programming languages. But Smart contracts, despite their name, are not legally enforceable contracts. Their primary job is to programmatically implement business logic that performs several types of activities, processes, or transactions that are included in them based on some parameters.  

Different types of smart contracts: 

  • Smart Legal Contracts 
  • Decentralized Autonomous Organizations (DAO) 
  • Application Logic Contracts (ALC) 

1. History of Smart Contracts

In 1994, American computer scientist Nick Szabo introduced us to the smart contract. He mentioned smart contracts as a computerized transaction protocol performing the terms of a contract,” with primary goals to “satisfy common contractual conditions, reduce both malicious and accidental exceptions, and eliminate the need for trusted third parties.” 

Blockchain created the foundation of smart contracts. Bitcoin also supports the first protocol, smart contracts, specifying the conditions that must be met while transferring bitcoins among users on the network, such as you must have enough funds to make the transfer. You can see this logic in vending machines where a specific code brings out a particular snack. 

In 2012, a new smart contract was introduced: multi-signature transaction. It needs a specific number of people to sign the transaction using private keys to be a valid transaction. This is done to improve the security factor of the funds, especially in the case of stolen or lost private keys. 

Blockchains continue their experiment and have added new programmatic conditions (operation codes or opcodes). In 2015, a new blockchain was introduced, Ethereum, for programmable smart contracts. Unlike blockchain, the Ethereum smart contract can execute multiple individual smart contracts simultaneously. 

2. Characteristics and Traits of Smart Contracts

Smart contracts are widely accepted due to the following characteristics: 

  • Self-enforceable- it reduces human intervention, making it executable. Smart contracts contain logic and are executed when a specific condition is met. 
  • Self-verifying- smart contracts are known for their authenticity as it check if both parties comply with the terms. In case of a breach, it will impose a penalty on the rule-breaking party.  
  • Tamper-proof- you cannot change the terms and conditions mentioned in the contract, so it eliminates the risk of manipulation. If you want to change, you must add a separate block specifying the details with mutual consent.

3. Flight Insurance

Smart contracts are used in various market vertices. Here, we will explain its use in a flight insurance company. Suppose a person is traveling and is at the airport. But the flight is delayed. That person uses an insurance company offering flight delay insurance using smart contracts. But how does that work? 

The smart contract is attached to the database of the flights and is created with some terms and conditions. These conditions are meant to be for the insurance company. Smart contracts will hold the insurance company’s money based on those conditions. Then the contracts are submitted to the nodes within the network on EVM for evaluation. The codes are executed on each node generating the same result recorded on the distributed ledger. If the flight is delayed beyond the mentioned time in the contract, the contract will execute, and the person will be compensated with the mentioned money. 

Once the agreement is made, you cannot make changes to the contract.  

How do Smart Contracts Work?

The primary goal of introducing smart contracts is to digitize the transactions and ensure trust among signing parties without requiring any third party to police the transaction. A smart contract is not a new technology and has been in the market for so long, but it has gained recent traction due to the increased popularity of blockchain. 

A smart contract includes a code that executes itself based on mentioned conditions. The code works on a specific virtual machine built on the blockchain network. But how does it work? How is the agreement done and executed on the network? Let us see. To know better, you must go for Blockchain Professional Certification Online.

  • To create a smart contract, the business collaborates with blockchain developers to explain what should be there in the contract and explain all the terms and conditions. Businesses use smart contracts in various ways, from verifying the payment to more complex events such as checking the value of a financial asset, etc.  
  • Businesses can choose any criteria to be included in the smart contracts for success. All the signing partners should agree on the transactions. Also, the contract must include the framework for resolving the conflicts, if any. 
  • Then the smart contract developer sets and tests the logic to verify if it works fine on smart contract platforms. Then the security of the contract is checked by internal professionals. After verifying, the contract is implemented on the blockchain. This ensures smart contract development. The list of smart contract platforms- Ethereum, Polkadot, Solana, Hyperledger Fabric, Tezos, Algorand, etc. 
  • Ethereum allows programmers to create and deploy smart contracts. The smart contract starts listening for the event updates from "oracle", a cryptographically protected streaming data source. The smart contract only executes when it gets the correct events through oracles. Generally, smart contracts are built on the Ethereum blockchain because of the Solidity programming language. 
  • Solidity is a tailor-made scripting language similar to Javascript, but it verifies and enforces the constraints specified in the contract at compile time, not at runtime.  
  • Then the smart contract is processed and sent to the network to perform its task. 

Implementation of Smart Contracts

Below are the steps on how to make a smart contract in Blockchain. There are different types of smart contracts available in the blockchain:

Creating smart contracts is getting popular among organizations, especially insurance companies. The complexity of any smart contract depends on what organizations want them to do. To understand the smart contracts' implementation, below are the steps to build a smart contract: 

  • Designing Tokens- To design any smart contracts, the Ethereum network has allowed the developers to create their tokens to perform tasks. All you need is to determine what tasks need to be performed and what business logic to set. 
  • Implementing Smart Contract- Ethereum offers a virtual environment, Ethereum Virtual Machine. It allows developers writing smart contracts in a solidity programming language, an object contract-oriented, high-level language. 
  • Testing- Smart contracts are being tested on the blockchain network to test their working. There could be challenges with testing. Thus, executing autotests is an excellent solution. By emulating a natural environment, autotests ensure its actual working. 
  • Acceptance and Review- however, there are no verification procedures available for smart contracts, but there are special environments that verify their code and logic. A proper review and acceptance process provides better feedback to improve. 
  • Deployment- Now, deploy the smart contract to the Ethereum blockchain to speed up the deployment process. 
  • Support- you must have appropriate support to maintain the smart contract’s infrastructure. 

Benefits of Smart Contracts

Smart contracts can be beneficial in various ways over traditional agreement methods. These benefits have increased with the improvement in technology. Below are the benefits of adopting smart contracts within your business: 

Accuracy

Smart contracts record all the terms and conditions in detail. Without proper detailing, the contract can be misleading and can cause errors. With automated contracts, businesses can eliminate the pitfalls of manual contracts. 

Transparency

Smart contracts are known for their transparency, as all the signing parties can view all the details mentioned. Thus eliminating the risk of disputes. All the terms are included upon mutual consent. 

Clear Communication

High emphasis on clear communication eliminates any misunderstanding and need for rework of the contracts. It drastically reduces the communication gap among parties. 

Speed

The logic of smart contracts runs on the internet and thus are quick to execute transactions. This exceptional speed has improved how companies work and make deals. Also, it cuts down the need to have manual documentation.  

Security

These smart contracts are highly secure with different levels of encryption. Due to its significant security, people have started dealing in crypto-currencies and smart contracts. 

Efficient

The speed and accuracy of smart contracts decide how efficient they work and help businesses to achieve their goals securely. The efficiency of smart contracts results in generating more value for businesses.

Smart Contract Use Cases

Due to the advantages of smart contracts, it has been used in different market sectors. Below are some areas that have significantly adopted smart contracts to streamline business deals. Below is some smart contract application: 

Financial Services

Smart contracts have entirely transformed traditional services in the finance sector. Such as: 

  • Trade clearing- easy management of approvals among different signing parties and then ensure secure fund transfer after calculating the trade settlement amount.  
  • Insurance claim- companies using smart contracts to perform routing, check errors, and approve the fund transfer workflow. After verifying the details, the fund will be transferred to the parties based on the policy type. 
  • Micro-insurance- micro-payments are being estimated and transferred based on the data collected from IoT devices. 
  • Transparent auditing- smart contract uses different tools for keeping records, eliminating the risk of missing details. It also helps the stakeholders contribute to the decision. 

Healthcare

Smart contracts have also made their place in healthcare by automating their work methods. 

  • EMR- It lets the providers and patients sign it to enable the transfer of the healthcare records after approval. 
  • Medical Research- lets the researchers make micropayments to the patients to get their medical details to ensure their participation. 
  • Track Health- today, users use health tracking devices and get rewards when they complete a milestone. 
  • Health Insurance- smart contracts help fill the patient details in the policy forms and eliminate the dependency on third parties. 

Media

Even media is also leveraging blockchain-powered smart contracts. 

  • Anyone is free to license media in the way they want. 
  • It has increased the automation to perform transactional tasks that were done manually. 
  • It has made processing faster, more accurate, and more efficient. 

Supply Chain

The primary use of smart contracts has been seen in the supply chain sector for the following reasons: 

  • It makes the transfer of payments secure, using multi-signature approval. 
  • Product provenance lets the user port the payments after changing the custody for the bills of lading.  

Limitations and Challenges of Smart Contracts

  • Ease of Correction- being built on blockchain, the smart contract comes with the similar benefits of immutability. Though it makes smart contracts secure, some challenges are attached to it. As you cannot change them, any single error can result in huge, costly errors. To make the changes, developers can use the De-facto mutability. It allows the developers to put some code in separate contracts stored in modifiable storage. 
  • Cases of a Loophole- partnership works in good faith where parties trust each other and do not mislead benefit from it. But with smart contracts, it might be challenging to ensure the terms are met as specified. For example- you ordered a branded shoe but got a fake one. You might not be able to solve such legal issues with smart contracts. 
  • Eliminating Third Party- it is said that smart contracts eliminate the need for third parties, but this is not all true. Somehow, there is always a dependency on third-party to get the work done via smart contracts. 

Conclusion

Today, most businesses use smart contracts to automate their tasks, saving time and money. The smart contract has streamlined the business process. As smart contracts are built on blockchain, it encompasses the benefits of blockchain, secured, tamper-proof, self-executing, business logic, security, and much more. In this article, we have mentioned how to use a smart contract. 

It has been an ideal solution for businesses that work closely with sensitive data. As technology is increasing, the demand for blockchain is getting higher. You can apply for Knowledgehut Blockchain Developer Certification to be proficient in the blockchain. 

Frequently Asked Questions (FAQs)

1. What is a smart contract in blockchain?

Smart contracts are- 

  • Self-executing contracts based on the underlying logic. It will execute when the terms and conditions are met and mutually signed by all the parties. 
  • A part of blockchain technology, smart contracts are transparent, traceable, and immutable. 

2. Why does a blockchain need a smart contract?

Smart contracts have changed the working of traditional and manual hand-written contracts. They are speedy, cost-effective, and secured agreements that cannot be altered. Below are the reasons that make it suitable for blockchain. 

  • Extreme Centrality 
  • Contract Conflict of Interest 
  • Enforcement 
  • Transparency 

3. How do you write a smart contract for blockchain?

  • Connect the blockchain developer platform to Ethereum network. 
  • Select a test network. 
  • Fund your wallet with Testnet ETH. 
  • Developers can use the Remix browser for writing a smart contract. 
  • Now create the code for your smart contract. 
  • Deploy the smart contract on the blockchain.
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Aashiya Mittal

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Aashiya has worked as a freelancer for multiple online platforms and clients across the globe. She has almost 4 years of experience in content creation and is known to deliver quality content. She is versed in SEO and relies heavily on her research capabilities.

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