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What Is a Smart Contract?

In 1994, Nick Szabo (a cryptographer), came up with the idea of being able to record contracts in the form of computer code. This contract would be activated automatically when certain conditions are met. This idea could potentially remove the need for trusted third-party companies (such as banks). Why, though? The answer is simple — because you no longer need a trusted third party when you make a transaction. Instead, the contracts (or transactions) are self-executed on a trusted network that is completely controlled by computers.

Cool idea, right? Szabo worked on this idea for many years and even wrote a book called “Smart Contracts: Building Blocks for Digital Free Markets“. The problem was that back in 1994, blockchain technology didn’t exist.

In 2009, Bitcoin introduced the first use of blockchain technology. In 2015, Ethereum was founded by an intelligent young man named Vitalik Buterin, and it introduced the first working smart contracts.

A smart contract is an agreement between two people in the form of computer code. They run on the blockchain, so they are stored on a public database and cannot be changed. The transactions that happen in a smart contract are processed by the blockchain, which means they can be sent automatically without a third party. This means there is no one to rely on! The transactions only happen when the conditions in the agreement are met — there is no third party, so there are no issues with trust.

How Does a Smart Contract Work?

Yes, just how do smart contracts work, then? To find the answer, let’s start by looking at how a smart contract can be used:

Let’s imagine that John wants to buy Mike’s house. This agreement is formed on the Ethereum blockchain using a smart contract. This smart contract contains an agreement between John and Mike. In the simplest terms, the agreement will look like this: “WHEN John pays Mike 300 Ethereum, THEN John will receive ownership of the house”.

Once this smart contract agreement has been put into place, it cannot be changed — meaning John can feel safe to pay Mike 300 Ethereum for the house.

Without the use of a smart contract in this scenario, Mike and John would have to pay lots of fees to third-party companies. Including the bank, a lawyer and a house broker.

It’s great, right? No more commissions and no more delays to wait for a lawyer and broker to process the agreement! This is just one of many examples of how a smart contract can be used. Smart contracts are automatically executed once the conditions of the agreement are met. This means there is no need for a third party, like a bank, a broker, or a government.

How Is This Possible?

As mentioned before, we have the blockchain to thank. Because of blockchain technology, we are able to decentralize smart contracts so that they are fair and trustless. By decentralizing, I mean that they are not controlled by one central party (like a bank, broker, or government, etc.). The blockchain is a shared database run by many computers (called ‘nodes’) belonging to many different people. Because of this, not one single person or company has control of it. It means it’s near impossible to hack it — the hacker would need to hack more than half of the nodes if they wanted to attack the blockchain or the smart contracts that run on it. Therefore, smart contracts can run safely and automatically without anyone being able to change them!

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