A Business-Friendly Introduction to Smart Contracts
Introduction
As a corporate innovation practitioner, I dedicate a significant portion of my time to evaluating the potential of new technologies for various business applications. While I find it rewarding to continuously explore how these technologies can address customer needs, I often observe that we get sidetracked by loosely defined concepts. To mitigate this, I aim to clarify some of these commonly misunderstood terms for non-technical experts, ensuring that discussions remain focused and productive.
But first, why do we need to know about smart contracts?
Understanding smart contracts is interesting because they have the potential to transform transactions across industries. They offer a potential increased efficiency, security, and cost savings by automating processes and eliminating intermediaries.
Photo by Kelly Sikkema on Unsplash
So What is a Smart Contract and How Does it Work?
A smart contract is a self-executing digital contract with the terms of the agreement written directly into code. These contracts automatically execute and enforce the “agreed terms” when predefined conditions are met, removing the need for intermediaries and ensuring trust and transparency.
When people talk about smart contracts, they usually mean decentralized programs running on a blockchain. These programs leverage blockchain’s decentralized nature for security and transparency.
However, it is important to note that not all smart contracts are necessarily decentralized or based on blockchain technology; some can operate on centralized platforms or other types of distributed ledger systems, depending on the specific use case and requirements.
What is the Underlying Technology?
Smart contracts primarily rely on blockchain technology, offering a decentralized, secure environment. However, they can also function on centralized database systems. The choice between decentralized and centralized approaches presents distinct trade-offs:
- Security: Decentralized systems are inherently more secure due to their distributed nature, reducing the risk of single points of failure. Centralized systems, while more vulnerable to targeted attacks, can implement robust security measures but rely heavily on the integrity of a single entity.
- Immutability: In decentralized systems, data is highly resistant to tampering due to the blockchain’s structure, where altering data requires changing all subsequent blocks, which is extremely difficult. However, this immutability is not absolute; under certain conditions, such as a 51% attack or a hard fork, changes can occur. In centralized systems, data can be altered more easily, allowing for corrections but potentially reducing trust.
- Flexibility: Centralized systems offer greater flexibility to correct errors or update terms, which is advantageous in dynamic situations. Decentralized systems, while less flexible and more rigid, ensure that once data is recorded, it is difficult to change, maintaining the integrity of the original information.
- Latency: Centralized systems typically offer lower latency as data processing is managed by a single authority. Decentralized systems, with their consensus mechanisms, tend to have higher latency due to the need for widespread agreement across the network.
- Scalability: Centralized systems can scale more efficiently as they don’t require consensus across multiple nodes, whereas decentralized systems face challenges in scaling due to the complexity of maintaining consensus and security across a growing network. However, the scalability challenge is relative to the scale needed for each use case — smaller applications may find current technology sufficient, while large-scale public use cases may still face bottlenecks.
After considering these trade-offs, some applications may choose a hybrid approach as a third alternative to further optimize the benefits of both centralized and decentralized systems. Hybrid use cases combine elements of both approaches, such as using oracles to provide off-chain data to decentralized smart contracts or employing permissioned blockchains for internal processes while interacting with public blockchains for broader transparency. An oracle, in this context, is a service that brings external data into a blockchain network, enabling smart contracts to interact with real-world information. It’s important to note that this concept of an oracle is unrelated to the Oracle Corporation.
What are the Most Common Use Cases?
I. Supply Chain Management:
Smart contracts can automate the tracking and verification of goods as they move through the supply chain. By recording each step on the blockchain, stakeholders can ensure transparency, reduce fraud, and minimize errors. For example, a smart contract could automatically release payment once goods reach a specific location, ensuring that all parties fulfill their obligations.
II. Financial Services:
In financial services, smart contracts facilitate secure, fast transactions without intermediaries like banks. They can be used for various applications, including automated loans, insurance payouts, and digital asset management. For instance, a smart contract could automatically release funds when a borrower meets certain predefined conditions, reducing the need for manual processing.
III. Real Estate:
Smart contracts simplify property transfers by automating the verification of ownership, payment processing, and transfer of titles. When a buyer meets the contract terms, such as payment, the smart contract automatically transfers ownership and updates the blockchain, reducing the need for intermediaries like notaries or escrow agents.
IV. Healthcare:
In healthcare, smart contracts can ensure data integrity and automate processes such as insurance claims. For example, when a patient receives treatment, the smart contract can automatically verify the treatment details and trigger the insurance payout, streamlining the claims process and reducing administrative overhead.
V. Web 3.0 Applications:
Smart contracts are integral to Web 3.0, powering decentralized applications (dApps) that operate without central authority. Use cases include digital identity management, decentralized finance (DeFi), and digital rights management. For example, in DeFi, smart contracts can manage lending and borrowing without traditional financial institutions, offering users more control and transparency.
VI. Carbon Transition and ESG Initiatives:
Smart contracts can play a crucial role in environmental, social, and governance (ESG) initiatives, particularly in carbon transition efforts. For example, they can be used to automate and verify carbon credit trading, ensuring that transactions are transparent and comply with regulations. Companies can tokenize carbon credits on a blockchain, allowing for efficient trading and real-time tracking of emissions reductions. This enhances transparency and trust in sustainability efforts, making it easier for organizations to meet their ESG goals.
VII. Digital Identity:
Smart contracts can revolutionize digital identity management by enabling individuals to have greater control over their personal information. By using blockchain technology, individuals can create self-sovereign identities where they own and manage their data without relying on centralized authorities. For example, a smart contract could verify a user’s identity for access to services without revealing unnecessary personal information. This enhances privacy, reduces the risk of identity theft, and allows users to share only the data required for specific transactions.
These use cases demonstrate the versatility and potential of smart contracts across various industries, highlighting their ability to streamline processes, enhance security, and reduce costs.
Is a Smart Contract the Same Thing as a Legal Contract?
No, smart contracts are not the same as legal contracts. While they automate and enforce terms of an agreement, they lack the legal context and adaptability of traditional legal contracts. Smart contracts are deterministic and immutable, making them complementary to but not a replacement for legal contracts.
What Are the Obstacles to Their (Wider) Adoption?
Smart contracts have become more common due to the increased adoption of blockchain technology, advancements in cryptography, and growing interest in decentralized finance (DeFi) and Web 3.0 applications. However, several obstacles remain, including the complexity of development, legal uncertainties, security vulnerabilities, scalability issues, and the lack of flexibility in handling errors or changes.
How Can Obstacles to Smart Contract Adoption Be Overcome?
Overcoming these obstacles will require advancements in smart contract development tools, clearer legal frameworks, improved security practices, and scalable blockchain solutions. Additionally, hybrid approaches that combine centralized and decentralized elements may help address scalability and flexibility concerns. As the technology and regulatory landscape evolve, smart contracts could play a significant role in the future of business and technology.
References
1. Song, Jimmy. “The Truth About Smart Contracts.” Medium, April 3, 2018. [Link] (https://jimmysong.medium.com/the-truth-about-smart-contracts-ae825271811f )
2. “10 Real-World Smart Contract Use Cases.” Hedera. [Link] (https://hedera.com/learning/smart-contracts/smart-contract-use-cases )
3. “What Are Smart Contracts on the Blockchain and How Do They Work?” Investopia, Updated June 12, 2024 [Link] https://www.investopedia.com/terms/s/smart-contracts.asp#:~:text=Smart%20contracts%20are%20scripts%20that,when%20specified%20conditions%20are%20met.&text=%22Smart%20contract%22%20is%20somewhat%20of,neither%20smart%20nor%20a%20contract)
4. “The Future of Smart Contracts: Trends and Emerging Use Cases.” Coinmonks. [Link] (https://medium.com/coinmonks/smart-contracts-for-real-estate-streamlining-transactions-and-reducing-costs-6879734ace0e)
5. “Smart Contracts Explained.” Forbes Advisor. [Link] (https://www.forbes.com/advisor/au/investing/cryptocurrency/smart-contracts-explained/#:~:text=Cost%2Deffective%3A%20By%20eliminating%20intermediaries,contract%20can%20view%20its%20terms)
6. De Filippi, Primavera, and Wright, Aaron. “An Introduction to Smart Contracts and Their Potential and Inherent Limitations.” Harvard Law School, May 26, 2018. [Link] (https://corpgov.law.harvard.edu/2018/05/26/an-introduction-to-smart-contracts-and-their-potential-and-inherent-limitations/ )
7. “Top 10 Real-World Use Cases of Web 3.0 Development in 2024.” Web3Prophet, Medium. [Link] (https://medium.com/web3prophet/top-10-real-world-use-cases-of-web-3-0-development-in-2024-408d6789bee8 )
8. “Why Blockchain’s Smart Contracts Aren’t Ready for the Business World.” Gartner. https://www.gartner.com/smarterwithgartner/why-blockchains-smart-contracts-arent-ready-for-the-business-world
9. “Smart Contracts.” Investopedia. [Link] (https://www.investopedia.com/terms/s/smart-contracts.asp#:~:text=Smart%20contracts%20are%20scripts%20that,when%20specified%20conditions%20are%20met.&text=%22Smart%20contract%22%20is%20somewhat%20of,neither%20smart%20nor%20a%20contract)
10. “The rise of smart contracts and strategies for mitigating cyber and legal risks.” World Economic Forum. [Link](https://www.weforum.org/agenda/2024/07/smart-contracts-technology-cybersecurity-legal-risks/#:~:text=Technical%20risks%20of%20smart%20contracts,misappropriation%20or%20unintentional%20legal%20disputes)
Disclaimer
This article was drafted with the assistance of ChatGPT, an AI language model developed by OpenAI. The content was reviewed and edited by myself to ensure accuracy and relevance. AI was employed to expedite the drafting process, providing a base that was refined to meet our publication standards.
