You may have heard of a smart contract. Its clearest definition is that of a computer program that functions as a contract with the ability to be fulfilled automatically once the parties involved have complied with the terms agreed upon and signed in the contract.
Although it seems very complex, the truth is that a smart contract is a legal contract very similar to the traditional contract that we usually make on paper.
Both options involve two or more parties agreeing to certain conditions in exchange for a product or service. Both contracts have the consent of both parties and a lawful and real cause. However, they differ in the way they are written, in the legal implication and in the way they are performed.
History of smart contracts
The idea of a smart contract was first known in 1994 thanks to Nick Szabo who referred to contracts as “a computer process capable of executing the clauses of a contract”. His main goal was to bring business practices related to protocol designs to web commerce with strangers. However, due to the technological limitations of the time, he was unable to implement his idea.
Smart contracts needed a form of online payment that worked like FIAT money and finally, in 2009, the Bitcoin blockchain emerged. This cryptocurrency was only intended to function as a payment method, but its technology, the blockchain, was of vital importance for smarts contracts.
Finally, in 2014 with the appearance of Ethereum smart contracts arrived in the technological world. Currently smart contracts are used daily on two major platforms: Ethereum and Codious, developed by the company called Ripple Labs, developer of the Ripple platform.
How does a smart contract work?
As we already know, smart contracts work through the blockchain. When creating smart contracts, one of the issues was that software could assure two parties to an agreement that it would be fulfilled without changes to the agreement. This issue was solved thanks to the blockchain.
- The blockchain is not manipulable and is encrypted. It is not managed by a single computer but by hundreds of thousands and anything can be recorded on it including an agreement, so computer manipulation is not an option.
- Another issue was the handling of assets online. How to move money from a physical deal to online? Well, thanks to the blockchain, another problem disappears with the creation of cryptocurrencies. Now we have the security that the contract is fulfilled and in addition, a monetary system that works as a digital asset with which to make online payments.
- How can we connect smart contracts with the actual assets included in the contracts? Another question why Nick Szabo could not implement his idea. However, today that problem does not exist either thanks to the Internet of Things or IoT.
This refers to, for example, connecting real assets to the Internet without that asset being a computer. We are referring to all those electronic devices that today we can connect to the Internet and control digitally.
Now that the contract is possible, let’s move on to how it works. Smart contracts are stored in an encrypted and invariable database, the blockchain, thus making the smart contract one of the most secure technologies. This same technology allows the transparent circulation of assets, ensuring the traceability of each movement.
I will explain it through an example. Party A assigns a car to party B. The condition is that if party B makes a transfer of €15,000 to A within one month after signing the contract, automatically and without the need for intermediaries or high costs the smart contract registers the ownership of the car for B in the blockchain, which will be irrevocable. Once the money is deposited in A’s account, the ownership of the car will automatically become B’s property.
In conclusion, a smart contract works as follows. Two or more parties agree on the terms of a contract. This contract is stored in the blockchain until the agreed actions are carried out and finally the results of the fulfillment by both parties are carried out.