Ethereum Smart Contracts: How do they Work?

By |2019-03-04T10:38:17+00:00March 4th, 2019|Technology|0 Comments

For two or more parties to execute transaction seamlessly, in the present or in future, there have to be some guidelines to be followed during the transaction. These guidelines are defined in a contract, which is usually enforced and implemented by law.

Some of the common situations where contracts are needed include:

  • When an individual is buying a piece of land from another person
  • A company selling its shares to another company
  • An individual getting into a contract with the insurance company for a health cover

However, contracts require a middleman. This is a drawback due to the time and cost it takes to resolve conflicts when the agreed terms are not met. When you are buying that piece of land, you’ll have to see a notary to seal the deal. To settle an insurance claim, the insurer has to have someone to manually review and process it. It’s not always possible to account for all the risks and to detect fraud.

In 1994, Nick Szabo, a cryptographer came up with a brilliant idea: to eliminate the middleman using smart contracts, also known as self-executing contracts.

The Analogy of the Vending Machine

A vending machine is programmed such that when you enter money and key in a number that matches the product you want, you automatically obtain the selected product.

Smart contracts work in the same manner. The allow programmable transactions to go through once certain rules and conditions are met.

For a vending machine, you enter into the agreement by inserting money, if the money is sufficient, then another condition is triggered and you get your refreshment.

That’s simple, but what if every time the vending machine runs out of potato chips, it automatically and autonomously sends a signal to the supplier to replace them? That’s the true value of a smart contract. It simplifies the task by eliminating the intermediary that must monitor the machine and accomplishes more.

Nick Szabo defined a smart contract as a computerized transaction protocol that executes the terms of a contract. The general objectives are to satisfy common contractual conditions.

To make it easier to understand, in a smart contract approach, the contract between both parties is written as code into a distributed ledger (Ethereum Blockchain). The individuals involved in this process remains anonymous. In the meantime, the decentralized ledger stores and replicates the document, making the contract immutable and independent from the people who wrote it.

The asset or currency is transferred into a program. The program runs the code and at some point, it automatically validates a condition and determines whether the asset should go to one person or back to the other person.

Source: Blockgeeks


Example of how you can use a Smart Contract in the Music Industry

In the music industry, an album goes through a long queue of agencies and streaming services, who take a cut of the musician’s profit when his or her fans buy the album. The actual creator receives a small percentage at the end of the distribution process, probably after a period of 6-12 months.

Using smart contracts, the artist’s music can go directly to the consumer without the need for any intermediary. This direct relationship will ensure the artist gets paid as soon as the customer has bought his music.

Ujo Music, a blockchain-as-a-service platform has managed to do that. It’s based on the Ethereum Blockchain and the artist receives their cut in Ether (ETH).

Benefits of Using Smart Contracts

  • Reduced cost of transactions since they don’t require third parties.
  • Speed – Helps automate tasks that would otherwise be done manually.
  • Security – Since the contracts are stored on the public blockchain, they can’t be lost. Everything is recorded immutably. Nobody can change anything or delete it. This eliminates the risk of manipulation since it’s managed by a distributed network instead of a central body.
  • Strength in numbers – Most smart contracts need assistance from other smart contracts. This gives them mind-blowing capabilities. For instance, in travel insurance where a passenger is compensated for travel delay, one smart contract could be used to access an API that provides worldwide flight data, such as OAG. Another smart contract could be linked to passengers who are entitled to receive compensation in case of flight delays. So once the first smart contract detects a delay, it communicates with the other contract to reimburse the passenger for food and accommodation. Such a transaction can take place within minutes!

The Way Forward

To quote Jeff Bezos, “We are at the 1908 Hurley washing machine stage with the internet.” The same can be said of Blockchain technology and smart contracts. Ethereum was launched four years ago and I believe we still haven’t seen its full potential yet.

There’s a lot we have not figured out that will make smart contracts work more efficiently. In law for instance, how do you create a programmed blueprint of a written contract without leaving out various clauses? In this case, lawyers have to produce standardized smart contract templates. The future of smart contracts lies in entangling issues like this.

The movement has just started. The formation of The Enterprise Ethereum Alliance is a significant milestone. This meeting of minds is composed of Fortune 500 companies such as Accenture, Intel, JP Morgan, Microsoft etc. Other start-ups and academicians conversant with Ethereum subject matters are also part of it. It’s highly likely that Ethereum will be the next big cryptocurrency.

It’s exciting to know there’s potential for smart contracts to alter our society in a significant magnitude. It will provide a technical basis for all sorts of social changes.

NB: I have left out the technical part on how you actually create smart contracts on Ethereum using Solidity. If you are interested in that, see this post.





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