What is a Smart Contract in Blockchain and How Does it Work?

Learn the Ins & Outs of Software Development

Caltech Coding BootcampExplore Program

What Is Smart Contract?

Smart contracts are computer programs or protocols for automated transactions that are stored on a blockchain and run in response to meeting certain conditions. In other words, smart contracts automate the execution of agreements so that all participants can ascertain the outcome as soon as possible without the involvement of an intermediary or time delay.

• Smart contracts are self-executing contracts in which the contents of the buyer-seller agreement are inscribed directly into lines of code.
• According to Nick Szabo, an American computer scientist who devised a virtual currency called "Bit Gold" in 1998, Smart contracts are computerized transaction protocols that execute contract conditions.
• Using it makes the transactions traceable, transparent, and irreversible.

Benefits of Smart Contracts

Accuracy, Speed, and Efficiency

• The contract is immediately executed when a condition is met. 
• Because smart contracts are digital and automated, there is no paperwork to deal with, and 
• No time was spent correcting errors that can occur when filling out documentation by hand.

Trust and Transparency

• There's no need to worry about information being tampered with for personal gain because there's no third party engaged and 
• Encrypted transaction logs are exchanged among participants.

Security

• Because blockchain transaction records are encrypted, they are extremely difficult to hack.
• Furthermore, because each entry on a distributed ledger is linked to the entries before and after it, hackers would have to change the entire chain to change a single record.

Savings

• Smart contracts eliminate the need for intermediaries to conduct transactions, as well as the time delays and fees that come with them.

How Do Smart Contracts Work?

A smart contract is a sort of program that encodes business logic and operates on a dedicated virtual machine embedded in a blockchain or other distributed ledger.

Step 1: Business teams collaborate with developers to define their criteria for the smart contract's desired behavior in response to certain events or circumstances.

Step 2: Conditions such as payment authorization, shipment receipt, or a utility meter reading threshold are examples of simple events.

Step 3: More complex operations, such as determining the value of a derivative financial instrument, or automatically releasing an insurance payment, might be encoded using more sophisticated logic.

Smart Contacts and Flight Insurance

Let's consider a real-life scenario in which smart contracts are used. Rachel is at the airport, and her flight is delayed. AXA, an insurance company, provides flight delay insurance utilizing Ethereum smart contracts. This insurance compensates Rachel in such a case. How? The smart contract is linked to the database recording flight status. The smart contract is created based on terms and conditions.

The condition set for the insurance policy is a delay of two hours or more. Based on the code, the smart contract holds AXA's money until that certain condition is met. The smart contract is submitted to the nodes on EMV (a runtime compiler to execute the smart contract code) for evaluation. All the nodes on the network executing the code must come to the same result. That result is recorded on the distributed ledger. If the flight is delayed in excess of two hours, the smart contract self-executes, and Rachel is compensated. Smart contracts are immutable; no one may alter the agreement.

Voting and Blockchain Implementation of Smart Contracts

Using Blockchain in the voting process can eliminate common problems. A centralized voting system faces difficulties when it comes to tracking votes – identity fraud, miscounts, or bias by voting officials. Using a smart contract, certain predefined terms and conditions are pre-set in the contract. No voter can vote from a digital identity other than his or her own. The counting is foolproof. Every vote is registered on a blockchain network, and the counting is tallied automatically with no interference from a third party or dependency on a manual process. Each ID is attributed to just one vote. Validation is accomplished by the users on the blockchain network itself. Thus, the voting process can be in a public blockchain, or it could be in a decentralized autonomous organization-based blockchain setup. As a result, every vote is recorded on the ledger, and the information cannot be modified. That ledger is publicly available for audit and verification.

Smart contracts allow you to create voting systems in which you can add and remove members, change voting rules, change debating periods, or alter the majority rule. For instance, you can create a vote for a decision within a decentralized autonomous organization. Rather than a central authority making a decision, a voting mechanism within the organization can determine whether the proposal is accepted or rejected.

Blockchain Implementation of a Smart Contract and Crowdfunding

Ethereum-based smart contracts may be used to create digital tokens for performing transactions. You may design and issue your own digital currency, creating a tradable computerized token. The tokens use a standard coin API. In the case of Ethereum, there are standardizations of ERC 2.0, allowing the contract to access any wallet for exchange automatically. As a result, you build a tradable token with a fixed supply. The platform becomes a central bank of sorts, issuing digital money.

Suppose you want to start a business requiring funding. But who would lend money to someone they don't know or trust? Smart contracts have a major role to play. With Ethereum, you can build a smart contract to hold a contributor's funds until a given date passes or a goal is met. Based on the result, the funds are released to the contract owners or sent back to the contributors. The centralized crowdfunding system has many issues with management systems. To combat this, a DAO (Decentralized Autonomous Organization) is utilized for crowdfunding. The terms and conditions are set in the contract, and every individual participating in crowdfunding is given a token. Every contribution is recorded on the Blockchain.

Limitation of Smart Contracts

• Because smart contracts can't send HTTP queries, they can't acquire information about "real-world" events. This is by design.
• Using external data could jeopardize consensus, which is critical for security and decentralization.

Use Cases of Smart Contracts

• The use cases for smart contracts range from simple to complex. 
• They can be used for simple economic transactions, such as moving money from point A to point B, as well as for smart access management in the sharing economy.
• Smart contracts could disrupt many industries. 
• Banking, insurance, energy, e-government, telecommunications, the music business, art, mobility, education, and many other industries have use cases.

Master Java programming and elevate your career with the Java Certification Course by Simplilearn. Gain in-demand skills and become job-ready. Enroll now and transform your future!

Conclusion

Blockchain is the underlying technology enabling the growth of smart contacts. Simplilearn's Full Stack Java Developer was designed for developers who want to decipher the global craze surrounding Blockchain, Bitcoin, and cryptocurrencies. You'll learn the core structure and technical mechanisms of Bitcoin, Ethereum, Hyperledger, Dogecoin, and Multichain Blockchain platforms. Simplilearn will provide the latest tools to build Blockchain applications, set up your private Blockchain, deploy smart contracts on Ethereum, and gain practical experience with real-world projects. 

Hope you liked this tutorial on what is a smart contract. In case of any doubts, please ask your questions in the comment section below.