Smart contracts are self-executing, business automation applications that run on a decentralized network such as blockchain.
And because they're able to remove administrative overhead, smart contracts are one of most attractive features associated with blockchain technology. While blockchain acts as a database, confirming that transactions have taken place, smart contracts execute pre-determined conditions; think about a Smart contract as a computer executing on "if/then," or conditional, programming.
Essentially, once certain conditions of a Smart contract are met – goods arrive in a port, two parties agree to an exchange in cryptocurrency – they can automate the transfer of bitcoin, fiat money, or the receipt of a shipment of goods that allows them to continue on their journey. Underneath it all: a blockchain ledger that acts as a database to store the state of the smart contract – whether it's been fulfilled or not.
For example, an insurance company could use smart contracts to automate the release of claim money based on events such as large-scale floods, hurricanes or droughts. Or, once a cargo shipment reaches a port of entry and IoT sensors inside the container confirm the contents have been unopened and remained stored properly throughout the journey, a bill of lading can automatically be issued.
Smart contracts are also the basis for the transference of cryptocurrency and digital tokens (in essence, a digital representation of a physical asset or utility). For example, Ethereum blockchain's ERC-20 and ERC-721 tokens are themselves smart contracts.
But not all smart contracts are tokens, according to Martha Bennett, a principal analyst at Forrester Research. "You can have smart contracts running on Ethereum that trigger an action based on a condition without an ERC-20 or ERC-721 token involved," she said.
Smart contracts can govern the transference of other cryptocurrencies, such as bitcoin. Once payment is verified, bitcoin can change hands from seller to buyer.
Most enterprise blockchain networks don't use tokens, Bennett pointed out. In those that do, the rules in smart contracts govern how tokens get allocated and define the conditions of transfer.
"That still doesn't mean the token is the smart contract - it all depends on how the token has been constructed," Bennett said. "And tokens don't have to be about economic value; a token can simply be something you hold that gives you the right to vote on a decision; casting your token means you've voted, and can't vote on this decision again – no economic value associated."
Smart contracts are neither really "smart" nor contracts in the legal sense. They're no more than business rules translated into software.Â
"People often ask what makes smart contracts different from business rules automation software or stored procedures. The answer is that conceptually, the principle is the same; but smart contracts can support automating processes that stretch across corporate boundaries, involving multiple organizations; existing ways of automating business rules can't do that," Bennett said.
In other words, because smart contract code is running atop an open blockchain ledger, rules can be applied not only within the corporation that coded the smart contract but to other business partners permitted to be on the blockchain.
"In other words, they're code that does what it's been programmed to do. If the business rules...have been defined badly and/or the programmer doesn't do a good job, the result is going to be a mess," Bennett said. "And, even if designed and programmed correctly, a smart contract isn't smart – it just functions as designed."
Translating business rules into code doesn't automatically turn the result into a legally enforceable agreement between the parties involved (which is what a contract actually is).
