They work on an if-then basis, which can be seen like this:
Where traditional contracts involve third parties such as lawyers, smart contracts rely solely on cryptographic code between two parties. The smart contract is regulated on the blockchain and though the two parties involved remain anonymous, the smart contract itself is stored in the blockchain ledger. This means that the actions that the contract does are seen by hundreds of people. Smart contracts can be coded on any blockchain, and can be used for many different scenarios.
How smart contracts work
Smart contracts are digital contracts that exist on the blockchain, they are essentially a set of rules that the participating parties agree on. When these predefined protocols are met, the code will automatically carry out its function.
They work by assets or monies being transferred to the program. After a certain amount of time, or when a certain condition is reached, the program will carry out it’s duty. This will result in the original person receiving the asset or money, a new person receiving it or a combination of both variables. The smart contract works automatically, is completely transparent and decentralised.
Smart contract examples
The founder of the concept of smart contracts, Nick Szabo gave the example of a vending machine to explain the idea behind smart contracts. The idea is that a person can add data (money) into the machine and receive an item in return (chocolate bar). In the vending machine, there is a code that tells the machine what to do if certain things happen. For instance, when 1 euro is put into the machine, and a person presses number 36, the code will tell the machine to make a flat white coffee and to return 35cents to the customer. This is all automated, cannot be adapted or changed and works for almost any circumstance.
How smart contracts can be used
Smart contracts can be used in any number of different ways, from selling cars to managing insurance claims. They can turn many things such as legal obligations into automated processes. This specific example will add more security to current legal methods and lower the need to involve other people in each transaction, thus making smart contracts cheaper to run.
The issues with Smart contracts
As with all recent and new technology or ways of doing things, there will be teething problems. One such issue has happened already. The DAO hack of 2016 is a perfect example of how this system of automated actions can backfire. The hacker managed to hack a decentralised autonomous organisation (DAO). The hack resulted in the blockchain gateway Ethereum having to create a new ‘fork’ of the platform.
Other potential issues would be the legalities of these contracts, and if they are even legal at all. The regulation of these contracts would also be an issue. And as always, there are still human error and factors that can corrupt or devalue any steps forward in technology. What if I send the wrong code? What if my capital T should be a small t and this changes everything?
At the end of it all, smart contracts are a smart technological progression, with a few adjustments, they are most likely to become normal everyday tools.