Understanding Blockchain: What are smart contracts?

Smart contracts are a fundamental part of the blockchain network, but what are they and how do they work? (Source: Getty)

At the very basic level, a smart contract is a self-executing contract with the agreement terms between the buyer and seller directly written into the code.

The agreements in the code exist within the blockchain network so the code controls the execution of the contract and they are completely traceable and can’t be undone.

A smart contract ensures that transactions and agreements are carried out over the blockchain network between the parties involved.

You can think of smart contracts much like traditional contracts but they cut out the need for a middleman because the agreement is written into the code.

This speeds up the process and cuts down on fees and charges.

“Smart contracts permit trusted transactions and agreements to be carried out among disparate, anonymous parties without the need for a central authority, legal system, or external enforcement mechanism,” according to Investopedia.

Who invented smart contracts?

Smart contracts were first proposed by Nick Szabo in 1994 who went on to invent a virtual currency called “Bit Gold” in 1998 – a decade before Bitcoin.

It’s because of this that Szabo is sometimes rumoured to be the anonymous inventor of Bitcoin, Satoshi Nakamoto. However, he has denied these claims.

Szabo is a computer scientist and legal scholar from the United States and he developed smart contracts with the goal of bringing “highly evolved” practices of contract law to the design of electronic commerce between internet strangers.

Szabo also proposed the execution of a contract for synthetic assets, such as derivatives and bonds.

“These new securities are formed by combining securities (such as bonds) and derivatives (options and futures) in a wide variety of ways. Very complex term structures for payments can now be built into standardized contracts and traded with low transaction costs, due to computerized analysis of these complex term structures,” Szabo wrote in his paper on the subject.

And in fact, many of his predictions came true before the adoption of blockchain. A lot of derivatives trading now is conducted through computer networks using the complex term structures he proposed in 1994.

Smart contracts are complicated by their very nature – they are designed to execute complex agreements – so while it can be hard to understand all the ins and outs, hopefully this background helped a little.

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