Blockchain-based smart contracts: What they are and how they work

Formal agreements have always relied on intermediaries – lawyers, brokers, or escrow services – to enforce their terms. But thanks to blockchain technology, smart contracts are changing the rules of the game.

​​In this guide, we’ll explain how blockchain-based smart contracts increase efficiency in the traditionally complex world of legal agreements.

What is a smart contract on the blockchain?

A smart contract is a code on a blockchain network that executes predefined terms when triggered by a user or event. These contracts automatically enforce the terms when specific conditions are met, using "if/when...then..." logic. For example, a smart contract releases funds once a service is completed or processes a payment after goods are delivered. By eliminating the need for third-party supervision, smart contracts streamline and accelerate processes, reduce costs, and lower the risk of errors or fraud.

How smart contracts work on the blockchain

Imagine a scenario where a client wants to hire a freelancer to complete a project and agrees to pay 1 ETH upon successful completion by a specified deadline. Here's how this agreement would work using a smart contract on the blockchain:

1. Determining contract conditions: The client and freelancer discuss and agree on specific terms for the project. They set conditions that the freelancer will deliver the completed project by the deadline, and the client will pay 1 ETH upon delivery. These conditions form the basis of the smart contract. 
2. Creating the smart contract: With the terms established, the client and freelancer create a smart contract on the blockchain. The contract’s code specifies that 1 ETH will automatically transfer to the freelancer’s wallet once the client confirms satisfactory completion of the project.
3. Deploying the contract: They publish the smart contract to the blockchain network, using cryptographic encryption to ensure security. The contract becomes publicly accessible and ready for execution. Both parties receive a digital notification that the contract is live.
4. Executing the contract: The freelancer completes the project and submits it for review. Upon the client's approval, the conditions of the smart contract are met. The contract’s code automatically triggers the agreed-upon actions.
5. Validating the contract: The blockchain network validates the transaction, checking that the project submission and client approval are recorded accurately. This step ensures that the smart contract’s conditions are fully met before proceeding with any transfers.
6. Recording the result: The blockchain network logs the transaction on the distributed ledger. The release of 1 ETH to the freelancer is now a permanent and transparent record on the blockchain, confirming the fulfillment of the contract.
7. Settling the contract: After validation, the smart contract processes the settlement. It transfers the 1 ETH from the client’s wallet directly to the freelancer’s wallet, completing the payment without any manual steps required.
8. Notifying the network: Upon completion, all nodes in the blockchain network receive an update about the transaction. The ledger reflects the completed contract, ensuring both the client and freelancer – and the entire network – have the latest record.

Benefits of using smart contracts on the blockchain

Smart contracts are one of the most innovative tools to emerge from blockchain technology, offering a range of benefits from cost savings to increased efficiency. Here are four key advantages:

• Cost savings: Smart contracts eliminate the need for third-party intermediaries by recording transactions directly on the blockchain. This reduces costs, allowing parties to save on legal and transaction fees.
• Transparency: By providing all parties with equal access to the same information, smart contracts enhance transparency and reduce the potential for disputes.
• Enhanced security: Thanks to blockchain technology, smart contracts are secure and tamper-resistant, fostering greater trust and confidence in agreements. 
• Greater efficiency: The automated nature of smart contracts streamlines processes, making them faster by removing the need for intermediaries to validate information or perform manual tasks.

Types of smart contracts 

Smart contracts come in various forms, each designed to automate the enforcement of specific terms and conditions. Understanding all the possible applications for smart contracts can help you determine which is most relevant to your needs:

Smart legal contracts

Smart legal contracts convert legally binding agreements into automated code. These contracts automatically monitor the agreement's conditions and enforce the terms once they are met. For example, a rental agreement could be converted into a smart legal contract that automatically transfers rent payments from the tenant to the landlord's account on the first day of each month, provided the tenant continues to occupy the property.

Decentralized autonomous organizations (DAOs)

DAOs utilize smart contracts to execute on collective governance and decision-making without a central authority. Governed entirely by their codebases, DAOs promote decentralization and trust while reducing the risks of bias or corruption. For instance, a DAO could manage an investment fund where all decisions on asset purchases or sales happen through a voting process by its members. The smart contract would then execute the decision with the majority vote.

Application logic contracts (ALCs)

ALCs manage specific functions within decentralized applications (dApps), ensuring these applications operate autonomously. Developers use ALCs to automate processes and reduce operational costs when building dApps. For example, an ALC in a decentralized finance (DeFi) app could automate interest payments to users who stake their cryptocurrency in a lending pool, eliminating the need for manual intervention.

Supply chain contracts

These smart contracts are used in transactions involving the exchange of goods. They automatically track and verify the movement of goods, eliminating the need for manual monitoring. Once the specified conditions are fulfilled, a supply chain contract can release held funds automatically, making them particularly popular in business environments. For instance, a supply chain contract could automatically release payment to a supplier once a shipment is confirmed as delivered by a logistics provider, ensuring all parties are paid promptly without manual processing.

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Disclaimer: This post is informational only and is not intended as tax advice. For tax advice, please consult a tax professional.