Fintech Series: Smart Contracts

How do smart contracts work?

In a nutshell, smart contracts are automatic, self-executing contracts that take the form of sequences of code – programming language written on to a blockchain (which could be a private company blockchain only accessible to users with a password, or a public blockchain such as Etherum). The three core functions of smart contracts can be summarized as follows:

Contain, or store, terms and conditions that govern parties’ relationships;

Verify said terms and conditions; 

Self-execute.

These programs are coded to adopt an ‘if-then’ logic: if something happens, then something else will happen. When certain conditions are fulfilled, a resulting event is automatically triggered. 

Let’s take an example. B works as a salesperson in a large company, Futuristic Co. B’s employment contract states that if she hits specific KPIs (such as completing a certain number of sales per year), she will be rewarded with a 10% bonus at the end of the year. This agreement is coded into a smart contract and placed on to Futuristic Co.’s blockchain. At the end of the year, the smart contract will verify whether B met her KPIs by checking, on the company blockchain, the volume/revenue generated by B’s sales (smart contracts can also be connected to external data if necessary). Once verified, the smart contract self-executes by triggering a transfer of funds in the amount of a 10% bonus on-chain from Futuristic Co. to B.

The benefits

The main attraction of a smart contract is security. Records on a blockchain are extremely difficult, if not impossible, to hack and as a result are often referred to as “immutable”: 

First, all transactions on-chain are encrypted – a digital signature called a ‘hash’ acts as the digital key for each transaction (or block of transactions). The same data will always generate the same hash. Any change in the data, even one letter, changes the entire hash. 

Second, each record of transactions is part of a block that is connected to earlier and subsequent blocks on the blockchain ledger, with the result that the hash of each block includes the hash of the earlier block – so a hacker would have to alter the entire chain to modify even a single transaction record. 

And finally, each node (computer) on the chain has a copy of all transactions recorded onto the chain. Each node on the blockchain network is also required to validate the addition of any new transaction to the chain (the ‘consensus mechanism’), which prevents fraudulent transactions and risks such as double spending.  

But there are other benefits. Blockchain transactions are considered transparent and trustworthy, so a smart contract guarantees transactional integrity. Transactions are also almost instantaneous – B’s bonus would hit her account almost immediately. And no intermediaries are needed, making smart contracts suitable for P2P, B2B and B2C transactions. 

Finally, because smart contracts are automatic and self-executing, they can serve as a one-window-operation. This means that contracting parties no longer have to involve various authorities and governing bodies to register, attest, execute, etc. their contracts.