The smart contract concept was first proposed by Nick Szabo in 1994. Szabo is recognized as one of the first cryptographers and legal scholars to lay the groundwork for digital currencies. Due to the absence of a digital platform or distributed ledger technology to support smart contracts, there was not much interest at the time in smart contracts.
Bitcoin was developed in 2008 on a blockchain network with a distributed ledger that tracks financial transactions. With the help of this technology, smart contracts have been developed, which are used to record the terms of contracts on the blockchain.
Similarly to any other contract, a smart contract specifies the terms of the transaction. Unlike a bank or attorney's office that sets and executes smart contracts on paper, smart contracts use code that operates on the blockchain, rather than on paper somewhere else. Consequently, it became "smart". With these smart contracts, any type of trade or transaction, regardless of its complexity, can be securely automated and decentralized. Essentially, it extends the basic concept of the Bitcoin blockchain (sending and receiving money without third parties like a bank). As a result of its operation on the blockchain, it provides security, reliability, and global accessibility. Smart contracts have begun to be used extensively on the Ethereum blockchain. This has led to the development of decentralized applications (dApps) as well as decentralized finance (DeFi).
How does smart contracts work?
Smart contracts are primarily intended for automating business processes between different groups. As part of the smart contract, these groups agree on all the terms, including payments, processes, and dispute resolution. Here is a simple example of a smart contract for global trade:
- In the event that the goods arrive on time, 100 % payment is made
- In the event that the goods are delivered one day late, 95 % payment is made
Other smart contracts support dApps operation. It is often the case that public dApps are open source, so anyone can check them out before using them and decide whether or not to use them.
For example, a decentralized lending/borrowing market would have the following conditions:
- By depositing collateral, we can secure a loan for 50 % of the deposit amount (for example, a 1,000 USD deposit could result in a loan of 500 USD).
- In the event that the ratio of collateral deposited (the borrower's collateral) to the current loan amount (the unpaid value of the loan) falls below 50 %, then the borrower's collateral is automatically liquidated and transferred to the lender in order to protect the lender from losing capital.
- It is possible for lenders to deposit funds into a smart contract, from which other users can borrow under predefined collateralisation conditions, with the lender receiving a portion of the interest rate payments.
The use of smart contracts
- Token / coin management: used to create, track and assign ownership rights to specific assets that exist on blockchain networks.
- DeFi: It consists of applications that use smart contracts to recreate traditional financial products and services, such as money markets, stablecoins, exchanges, and asset management. Through the use of blockchain, they are also able to combine multiple services to create new financial products. It is possible for a smart contract to hold funds in custody for a user or to distribute them among users on a predetermined basis.
- Insurance: In parametric insurance, the payout is directly related to a specific predefined event. In order to create insurance contracts, smart contracts provide a tamper-proof infrastructure.
- Games and NFT: Smart contracts are used to perform tamper-proof gaming actions in blockchain-based games. In a similar manner, limited edition NFTs can be distributed in a fair manner. Through randomization, smart contracts can facilitate unpredictable NFT drops, ensuring that all users have an equal opportunity to acquire scarce digital assets.
- Need external information
It is important to note that smart contracts are complex and their potential extends beyond simple asset transfers. A variety of transactions can be completed by them, including legal processes, insurance contracts, crowdfunding, and financial derivatives. By automating routine and repetitive processes that people currently pay banks and attorneys to perform, smart contracts have the potential to disrupt the legal and financial landscape.
The use of smart contracts simplifies our lives. All processes are automated, and no third party is required. Until someone abuses smart contracts to enrich themselves, this automation is adequate. As automation and mass adoption of routine processes become widespread, it remains to be seen how effective they are and how much easier our lives will become as a result.