The Importance of Smart Contracts: An In-depth Analysis

Beginner’s Guide / 14.03.2020

Turing completeness is the ability of any system to stimulate other Turing complete machines. Simply put, a stimulation, when configured with specific instructions, could function on its own without outside/external interference. Qixcoin was the first cryptocurrency to feature in its source code a Turing complete mechanism. The mechanism allowed for the continuous embedding of verification, that could function without third-party arbitration.

It didn’t take long for this innovation to pick up. Vitalik Buterin described a derivative of this mechanism that was referred to as Smart Contracts. It was an update to the 1996 terminology coined by crypto-visionary Nick Szabo.

“A set of promises agreed to in a meeting of the minds [which] is the traditional way to formalize a relationship.” – Nick Szabo 

What is a Smart Contract?

A Smart Contract is a computerized mechanism, containing clever code, that can be used to execute virtual obligations by establishing trust, validity, security, and automation. Smart contracts and their integration with distributed ledgers are currently the central forms of attraction within the Blockchain space. Smart contracts facilitate the automation of obligations that would traditionally require third-party arbitration to execute.

The Removal of Arbitration

To give an idea about the importance given to Smart Contract implementation, let me put forward an example.

In the traditional capital market scenario, to procure Shares of a particular organization, an individual has to travel through multiple layers until the delivery is received. First comes the sub-broker through which the individual has registered. The sub-broker then communicates the same to the broker above him, who then has to it pass to the clearinghouse. And finally, it goes to the organization that has issued the shares. It would take a minimum of 2 days and covering the costs of 3-5 intermediaries to lay hands on the share certificate.

We can visualize the same process on a Turing complete blockchain such as the Ethereum. As soon as the individual enters the number of shares required on the company’s forum, a smart contract will be executed. It will deliver the share to the individual instantly and would also update the organization’s ledger. As the organization has embedded a smart contract, it doesn’t have to manually provide authorization each time a request is made. The costs traditionally bourn by an individual has dissolved, and delivery becomes instant.

Smart Contracts don’t necessarily have to involve the facilitation of value transfer alone. Any information or digital data can be linked to a smart contract, which would allow instant transfer without any intermediary or third party continuously mediating the transfer.

Security of Smart Contracts with Blockchain

Technically, a smart contract can be designed and executed on a ‘blockchain-less’ platform for real-time use. No mandatory layer was specified in Nick Szabo’s first paper on the subject. But, in reality, that would diminish the added capabilities that the integration of a blockchain and smart contract would bring. Smart contracts and blockchains together form a virtual bond that discourages any malicious threats. A smart contract that is written and executed without a blockchain layer would lack certain important characteristics that hinder the legitimacy of the contract. Without the use of a blockchain layer, the trust factor is removed, as one party cannot readily trust another party without pre-established rules for trust.

Blockchains are known to be immutable, trust-less, consensus-driven and accountable. A traditional digital contract lacks all the mentioned features, that make it susceptible to outside interference. Smart contracts, that are integrated with the blockchain or any other similar Distributed Ledger Technology (DLT), can achieve consensus immediately.

Real-life use cases

  • Augur Prediction Platform

Augur is an Ethereum based dApp (decentralized/distributed application) that functions as a prediction platform based on the “wisdom of the crowd” principle. It solves all the traditional problems concerning prediction markets, such as censorship, mediation, arbitrator, etc. Any individual seeking an answer can formulate a question that involves the network users betting on the outcome, in the hopes that as more and more people bet on the outcome, the likelihood of being right increases. Augur uses the Smart contracts feature of the Ethereum blockchain to payout the rewards as soon as the contract expires.

  • ICO/IEO/STO platforms

An Initial Coin Offering (ICO), Initial Exchange Offering (IEO) or Security Token Offering (STO) are the IPO equivalent of the traditional financial system. ICOs/IEOs/STOs are in many ways, an update to the IPO system. They bring in a tremendous amount of automation and efficiency, that in turn elevates the process of Capital Accumulation. The ERC-20 feature of the Ethereum blockchain is currently the most used form of obtaining crypto-capital. It facilitates the instant cross transfer of digital assets. Ever since the ICO market kicked off, billions of dollars have been raised by companies. ICO projects usually are looking for growth opportunities, but also filled with scammers looking to make fast money as well. It is still a growing field, but also a prospective one. Today, ICOs are very little used by projects owners as they prefer IEOs and STOs fundrasing mechanisms.

  • Escrow Management

To establish trust with unknown parties over long distances we use banks, brokers, arbitrators, etc. They carry out the fulfillment of the obligation and transfer of value. With third-parties, huge intermediation costs have to be covered. This increases the end burden on the final consumer. Escrow management can be easily carried out on a simple Smart Contract. A simple code can be run on a supported blockchain that would fulfill the necessities of the user. Escrow management can also be customized concerning time, date of delivery, number of participants and so on.

Featured image courtesy of Shutterstock.

Sudarshan M is a long time crypto-enthusiast. Pulled in by bitcoin early on, it did not take long for Sudarshan to divert all of his academic attention from business studies to blockchain by doing his Masters and eventually pursuing his PhD in the subject.