What, Exactly, Is a Smart Contract?

7 min readNov 24, 2019

Frankly speaking, a smart contract is neither “smart” nor a “contract” in the legal sense. [0] It is a piece of code that can automatically execute and enforce to fulfil the responsible obligations of related parties. Serkan Katilmis, Maximilian Forster, Yafang Cheng, Hsiao-En Chen

The definition of a smart contract

The concept of smart contracts was first proposed in 1994 by computer scientist and cryptographer Nick Szabo. [1] At that time, he had advocated that the transaction process could be done automatically by a computer, without the assistance of a third party. But unfortunately, there was no suitable environment as well as a platform to realize his idea during then.

In 2008, since Satoshi Nakamoto has introduced the concept of blockchain in “The Bitcoin Whitepaper” [2], the idea of Nick Szabo has been gradually achieved. In 2013, Vitalik Buterin, the talented Russian-Canadian programmer, has come up with a new generation of blockchain — Ethereum, as a platform for running smart contracts. Suddenly, the concept of blockchain was upgraded from a peer-to-peer (P2P) electronic cash system (Bitcoin) to a decentralized world.

A smart contract is a self-executing application intended to facilitate, verify and enforce the performance of a contract on Ethereum. [3] Smart contracts are automatically executed once the certain conditions of the agreement are met. [4] This means there is no need for a third party, like a bank or a government. The development process of smart contracts requires special attention to security. Once deployed, a smart contract is publicly accessible by anyone on the network with the address of the smart contract and their private signatures. To be noticed, Smart contracts once deployed cannot be verified or patched anymore.

How does a smart contract work?

Basically, a smart contract is a predefined plan, which is a piece of code that runs on the Ethereum blockchain. If certain conditions are met, it executes a specific task. Therefore, it usually follows the “ If…,then….” statement.

The composition of a smart contract can be easily divided into 4 parts, which are the “Subject of Contract”, the “Digital Signature”, “Contract Terms” and the “Decentralized Platform”. [5] After the subject of contract is defined and the content of the agreement is converted into codes, the smart contract is initiated by all parties on the chain with their private keys. Finally, it will be compiled and deployed to the Ethereum blockchain.

Features of smart contracts

Security

A smart contract is stored and encrypted on the Ethereum blockchain nodes, which means all the contained parties will have a copy and it is trustworthy, independent, and unable to modify.

Distributed

A Smart contract is replicated and distributed across all nodes on the Ethereum network. It is significantly different from a centralized server.

Consistency

A smart contract only executes the predefined operations if the requirements are met. Moreover, the results are consistent over the entire network.

Tamper-proof

Once a smart contract is deployed, it cannot be changed.

A closed system

A smart contract can’t access data from the world outside the Ethereum blockchain on its own. The main idea is to prevent non-deterministic behavior once the function is called. The only way to write a smart contract using external data is to use Oracles. [6]

Advantages and disadvantages of smart contracts

Advantages

Secured: When you need a public, trustworthy record, you can do it through a smart contract. As mentioned above, once deployed, a smart contract is shared by members throughout the network, and no one is able to change. Furthermore, it won’t be lost.
Efficiency: The process is automatically verifying and executing, and many intermediaries could be eliminated, which reduces the commission fee and intermediary costs, and thus highly reduce the operating cost of a business.
Customized: There are various types of smart contracts, which can be modified according to customers’ preferences.

Disadvantages

Anthropic factor: The code is written by a human, so there is a possibility of miswriting; once the smart contract is deployed on the Ethereum blockchain, it cannot be patched.
Legality: Smart contracts are currently not under a clear regulatory framework. There are still potential problems and limitations.
High implementation cost: Smart contracts must be carefully coded before they can be executed. Therefore, the software as well as hardware cost of implementing a smart contract, are extremely high.
Inefficiency: It is inadequate for a speedy transaction, or situations where large data needs to be stored.

Use case of smart contracts

Token. The most basic application of smart contracts is to make new encryption tokens! As long as you follow a certain specification (ERC20) and deploy a smart contract to the Ethereum blockchain, anyone can easily create your own crypto token. It’s currently the largest use case for smart contracts, mostly used to raise funds by Initial Coin Offerings (ICO).

Automated financial service. A smart contract can help you exchange money, assets, and properties in a transparent, secure and automated way without the third party such as banks or brokers in between.
Identity. A smart contract can be used as identity management (IdM). For example, uPort is built on top of the Ethereum blockchain, and makes use of the smart contracts feature. It aims to provide a decentralized identity for specific services like emailing and banking. [7]
Decentralized Autonomous Organizations (DAO). A decentralized autonomous organization (DAO) is an organization represented by rules encoded as a self-enforcing computer protocol that is controlled by multiple members rather than a central government. Keeping the network safe and performing other network tasks are rewarded with tokens.[8] DAOs are a generalization of multi-signature wallets. The members vote to trigger a method, such as money transfers in smart contracts. DAOs can reduce repetitive and complicated manual tasks by using smart contracts.
Voting. A smart contract can ensure that a specific account only votes once. It provides a transparency, tamper-proof and secure structure to ensure the integrity of an election system.
New business models. By using a smart contract, there is a huge potential for creating new business models. For example, CASH ON LEDGER provides a service that allows autonomous vehicles to pay and bill Euro automatically by utilizing a smart contract service, which integrates the IoT and payment systems.

The future of smart contracts: hype or reality?

Smart Contracts will play an important part in B2B and B2C in the future. They can provide better protection for consumers’ rights. On the enterprises’ side, both the commission cost and the time of transactions can be reduced among business partners, because there is no need for middlemen, such as banks, brokers, and lawyers.

In spite of potential benefits for businesses as well as various industries, smart contracts still have limitations that need to be handled. Regarding the transaction speed and the capacity of expansion, those problems need to be solved. Otherwise, it is hard to replace the traditional financial system nowadays. For example, VISA and Master handle thousands of transactions per second, in comparison, a smart contract on Ethereum can only manage 15–20 [9] transactions at the same time.

To sum up, although smart contracts seem attractive and have huge potential to redefine various industries over the world, they are not suitable for all industries. Organizations should consider seriously and differentiate between hypes and realities rather than jump on the bandwagon directly.

Remarks

If you like this article, we would be happy if you forward it to your colleagues or share it on social networks. Interested in the Euro on blockchain? More information about CASH ON LEDGER on the Internet or on Linkedin.

Serkan Katilmis is a tech entrepreneur and investor, who has more than 20 years of experience in top-tier management consulting. As CEO of CASH ON LEDGER, he promotes the Euro on blockchain systems such that smart contracts can be used in an industrial setting or in B2B contexts. Prior to that, Serkan was working for leading organizations Goldman Sachs, accenture and PwC as an executive. He holds an MBA from Duke University and completed several executive strategy programs at INSEAD. You can contact him via Linkedin.

Maximilian Forster focuses on business development working for Cash On Ledger GmbH. He is the co-founder of the Blockchain Bayern e.V., member of INATBA and member of the Blockchain WG at Bitkom e.V.; previously, he helped to build up the DLT and blockchain service offering of KPMG and Accenture and worked on the blockchain investment strategy for Picus Capital. He is also in close connection with the blockchain ecosystem: for example, he has contributed to the Goethe University Frankfurt’s “Digital Banking Practical Handbook” and DHL’s “Blockchain in Logistics” publication. You can contact him via Linkedin.

Cheng Ya-Fang has studied Finance and Informatics at the Technical University of Munich (TUM). As a professional auditor in PricewaterhouseCoopers(Pwc) for two years, she had advanced her practical experiences in the field of finance and business by providing audit and tax assurance services to multinational corporations. Further, she is also an active attendee of various blockchain and technology forums. You can contact her via email or Linkedin.

Hsiao-En Chen studied TUM-BWL at the Technical University of Munich. Her fields of interests are mainly blockchain technology, cryptocurrencies, e-commerce. She participated in several projects related to Fin-tech applications, previously worked as an Assistant editor in “MIS Review” and Research Assistant in the Department of Management Information Systems in National Chenchi University, Taiwan. You can contact her via Linkedin.