We are all familiar with contracts in the traditional sense, in which two or more parties make a legally enforceable promise with one another, along with definitions, conditions, and other clauses.
Ever since the first recorded use of contracts in the 14th century, they have remained pretty much the same for centuries, until the advent of blockchain, and Ethereum, which was the first protocol that supported a new breed of smart contracts and unlocked a whole world of possibilities.
In this article, we’ll explain what smart contracts are, how they work, as well as current and future applications of the technology in various industries.
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The smart home concept works such that certain actions become triggers for the way technology behaves within your home – such as turning on lights, sounding the alarm, or sending a notification – when a particular condition is met. These conditions could be scheduled time elapsing, a water leak being detected by a sensor, or by someone pressing a doorbell, button, or appliance.
In the same way, a smart contract is a piece of code that can trigger actions automatically, according to the terms of the contract. Smart contracts live on the blockchain as a transaction and are thus irrevocable and immutable once verified and initiated.
Inheriting blockchain principles, smart contracts are transparent, decentralised, trustless, and autonomous, which eliminates the need to rely on intermediaries to arbitrate and enforce the terms of the contract. This means that smart contracts have the potential to increase the speed, reliability and cost-effectiveness (and most importantly, trust) of contractual agreements.
Let's talk about how loans work, and how these attributes of smart contracts can make a huge difference in our current financial system.
Traditionally, the administration of loans require multiple parties, especially when repayment lapses and there is a need to seize, valuate, and then liquidate pledged collaterals. These overheads are priced into the cost of offering loans.
With smart contracts, borrowers can use cryptocurrencies they hold as collateral for loans they wish to take. If repayment is not received within a certain time period, or if the value of collateral falls below the value of the loan, it can automatically be sold in accordance with the terms of the smart contract. Thus, smart contracts can simultaneously lower the risks undertaken by lenders while lowering costs for borrowers.
If you need a refresher on blockchain technology and how it works, you can read this article we previously published.
Ethereum was the first widely-used platform that supported smart contracts. Since then, there has been a slew of other platforms launched with smart contracts in mind, including Solana, Polkadot, Avalanche and others.
As we can imagine, every platform brings with it unique features, use different security protocols, have varying transaction costs and confirmation speed, and the programming languages used.
In order to promote the interoperability of smart contract platforms with Ethereum, working groups have published standards known as Ethereum Request for Comment (ERC). These documents outline technical details of how smart contracts should be written. Two important ERCs you might come across are ERC-20 and ERC-721.
ERC-20 is the primary standard for the Ethereum network. It supports smart contract functionality and defines how fungible tokens can be created and deployed. Fungible tokens holds value and can be used interchangeably with one another, akin to physical coins. Smart contracts can be written to automatically perform transactions with these tokens, such as in our loan repayment example earlier in the article.
A cousin to the ERC-20 is the ERC-721, which is a standard for Non-Fungible Tokens (NFTs) within smart contracts. Examples of such assets could be physical properties (such as deeds to homes) or virtual artwork (such as 3D models or images). Smart contracts on NFTs can be used to allow artists to provide proof of authenticity and guarantee originality of their artwork, as well as automatically receive royalty payments every time the NFT changes hands.
Both the ERC-20 and ERC-721 are clear and well-understood standards that allow applications, wallets, exchanges, and other cryptocurrencies to integrate with ERC-20 tokens on user facing . This increases the scope of what smart contracts on the Ethereum network can do. More on this in future blog posts. Want to hear it first? Subscribe to our newsletter, Financial Freedom, for well-researched content and digestible information in your inbox.
The utility and features that smart contracts bring over traditional legal contracts are abundantly clear. Lower costs, faster transactions, greater security, enhanced trust are just some of the benefits.
Smart contracts are digital, can be self-executing, and do not require the intervention of intermediaries to enforce. Furthermore, smart contracts that tap on APIs can interoperate with a wide range of services and can even deploy other smart contracts of their own.
However, as with any new innovative technology, smart contracts have areas that can benefit from continued improvements.
Firstly, smart contracts are only as reliable as the code they are built on, and data they pull from. A lack of engineering expertise and human errors is a bottleneck that limits even wider adoption of smart contracts today. There are meaningul efforts to address these challenges with cryptocurrency projects such as Chainlink and other oracle solutions who are bridging these bottlenecks by providing accuracy around real world data.
Another significant area worth pointing out that the legal establishment in the respective jurisdictions around the world has not uniformly adapted to the existence and use of smart contracts. This means that the legal status of smart contracts are still unclear, and calls into question their enforceability in a court of law (if the need arises).
These challenges would almost certainly be resolved in time, given the actual and possible benefits of smart contracts to society and the economy.
In fact, smart contracts are already being used in a range of industries around the world by individuals, companies, and national governments. In some cases, smart contracts are used to bring new possibilities to existing processes, and in other cases, they replace existing legal contracts, resulting in cost savings and time saved.
In the insurance space, MetLife is utilising smart contracts on Ethereum to add transparency and efficiency to the claims process. A collaboration between MetLife’s Singapore-based incubator LumenLab, Singapore Press Holdings and NTUC Income, the pilot programme allows the surviving loved ones of a deceased policyholder to easily ascertain policy details and payouts due.
Singapore’s own Monetary Authority of Singapore (MAS) had been working on a multi-year project to explore the use of blockchain, distributed ledger, and smart contracts for the clearing and settlement of payments and securities. Dubbed Project Ubin, the project concluded as a success, and is serving as a foundation for developing the next generation of cross-border payments infrastructure.
Finally, in the world of Decentralised Finance (DeFi), smart contracts make possible features like automatic interest payments on assets like bonds, loans, deposits, or allow for the transfer of financial assets without costly legal fees. This significantly lowers the barriers of entry to more users and increases participation in the financial markets.
Despite the many applications of smart contracts today, we believe we are still in the early days of unleashing the potential of smart contracts and revolutionising how people work, transact, and build wealth.
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Decentralised finance is an emerging field with fluid regulations. Learn more about the risks involved.