How Do Smart Contracts Work: Step-By-Step Explanation

Smart contracts are to traditional contracts what smartphones are to rotary phones. But how do smart contracts work?

This article will walk you through each step of the smart contract process, from the initial agreement setup to the final completion and settlement, opening a door to a future where trust is built on code, not on paperwork.

Table of Contents

• Agreement Setup
• Contract Outline
• Contract Deployment
• Trigger Conditions
• Automatic Execution
• Verification and Recording
• Completion and Settlement
• How Do Smart Contracts Work: Key Takeaways

Agreement Setup

The foundation of any smart contract lies in establishing an agreement between the involved parties. Basically, you have to clearly identify the parties and outline the contract’s terms. Everyone needs to agree on what the contract is supposed to achieve — this could include details like service delivery dates, payment terms, quality standards, and more.

For instance, in a real estate transaction, the agreement setup would include identifying the buyer and seller, the property details, the selling price, and any contingencies that need to be met. Clearly defined terms are crucial because a smart contract operates on the principle of “code is law” — once coded, its terms cannot be altered easily.

To agree on the conditions, you should:

• Identify all relevant parties and involve them in discussions to capture all perspectives and requirements.
• Clearly specify what conditions must be met, including pricing, delivery dates, penalties for late delivery, and quality standards.
• Outline the precise conditions under which the contract will automatically execute tasks, such as releasing funds or confirming receipt of goods.
• Figure out how you’ll represent transaction data on the blockchain to ensure consistency.
• Decide on methods for resolving disputes, such as arbitration or code-based logic for automatic decision-making.
• Define any exceptions to rules, like acceptable delays due to unforeseen events.
• Make sure the agreed-upon terms comply with legal and regulatory standards relevant to all parties.

Contract Outline

Once the agreement conditions have been set up, the next crucial step is writing the actual smart contract code. To do this, use specialized programming languages designed for the blockchain platform you’re using. For instance, Ethereum employs Solidity, while Hyperledger uses Chaincode.

Here are the steps you should follow:

• Code the Conditions: Translate the agreed-upon terms into executable code. Ensure you accurately represent the conditions, exceptions, and dispute resolution methods established during the agreement setup.
• Test the Code: Before deploying the contract, it’s vital to test the code in a controlled environment. Platforms like Ethereum provide testnets where you can simulate the execution of your smart contract without financial risk.
• Incorporate Security Measures: Smart contracts are immutable once deployed, so prioritizing security is essential. Employ well-known security practices and conduct thorough audits, perhaps even using third-party services to ensure the code is robust.
• Documentation: Include detailed documentation for the smart contract code. This should explain the purpose, functionality, and specific conditions of the contract, making it easier for future audits and understanding by all stakeholders involved.
• Legal Review: Get a legal expert to review the code and ensure compliance with relevant laws and regulations. Even though smart contracts are automated and self-executing, they still need to adhere to contractual and regulatory frameworks.

Contract Deployment

Deploying is the phase where theoretical planning transitions into practical application. This step makes the smart contract a functioning part of the decentralized network. However, it doesn’t happen overnight and a lot thought goes into it, starting with:

• Choosing a blockchain platform suited to your needs. Popular options include Ethereum, Hyperledger Fabric, and Binance Smart Chain, among others. Each platform offers unique features and trade-offs, usually balancing aspects such as security, scalability, and cost.
• Compiling the code before deployment. This process translates the high-level code (written in languages such as Solidity, Chaincode, etc.) into bytecode that the blockchain can execute.
• Setting up deployment tools and frameworks tailored for blockchain deployment, like Truffle for Ethereum. These tools streamline the deployment process, handling bytecode management and providing a user-friendly interface.
• Funding your wallet to ensure your digital wallet has enough cryptocurrency to pay for the gas fees required to deploy the contract on the blockchain. For instance, deploying a contract on the Ethereum network requires Ether.
• Executing the deployment through deployment scripts or blockchain-specific commands to publish your contract. This will include broadcasting the compiled bytecode to the network, which, in turn, adds the contract to the blockchain.
• Confirming deployment. Once the blockchain network confirms the transaction, the contract will have a unique address. This address is crucial as it is used to interact with the smart contract after deployment.
• Verifying on blockchain explorers like Etherscan for Ethereum to verify and view the deployed contract. These explorers provide transparency, allowing anyone to examine the contract’s bytecode and transaction history.

Trigger Conditions

Once the smart contract is deployed on the blockchain, it stands ready to execute its coded instructions when specific conditions are met. These trigger conditions are the “if-then” statements embedded within the contract, defining the exact scenarios under which the contract will act. Assuming you already outlined what events or actions need to happen to trigger the contract’s execution, you should move on to:

• Specifying the data input sources — this is where the contract gets its data from to validate the trigger conditions. This could include oracles, sensors, or APIs that feed real-time information into the blockchain.
• Establishing the default actions — what the smart contract will do if the trigger conditions are not met within a specified timeframe. This adds a level of robustness to the contract, ensuring it can handle exceptions effectively.
• Implementing mechanisms to continually monitor the relevant conditions. Automating this aspect can help detect changes instantly, reducing delays in contract execution.
• Introducing fail-safe protocols in case the data sources become unreliable or fail. This could include fallback conditions or secondary data sources to ensure the contract operates smoothly.

Automatic Execution

Once the pre-defined trigger conditions are met, the smart contract will automatically execute the agreed-upon terms. This step eliminates the need for intermediaries, reducing costs and increasing the speed of transactions.

During this phase, the pre-programmed actions such as transferring funds, releasing tokens, or executing commands are carried out without human intervention. This is made possible through programmable logic embedded within the contract.

By using automated execution, smart contracts reinforce trust between parties while ensuring that no delays or excuses can hinder the process. They provide an innovative solution to the age-old problem of manual error and dependability, making them increasingly attractive for various applications from finance to supply chain management.

Verification and Recording

Once the smart contract executes, the next step is verification and recording if you’re to ensure everything happened as planned. In a decentralized network, this is done using consensus mechanisms, which are part of blockchain technology. This is how this process usually works:

• Each network node must agree that the contract conditions have been met. This usually involves cryptographic algorithms to check the transactions’ accuracy. On the Ethereum blockchain, miners or validators use Proof of Stake (PoS) or Proof of Work (PoW) methods to reach consensus.
• Once verified, the transaction is added to the blockchain and becomes a permanent part of the ledger. This ensures no one can change the contract terms or outcomes after the fact, creating a tamper-proof environment that builds trust.
• When data is added to a block, it is cryptographically hashed, linking it to the previous block and forming a secure chain of transactions.

As you can tell, this process increases transparency. All parties can check the contract’s fulfillment by examining the blockchain records. This is especially useful in industries like finance or supply chain management, which need strict compliance and audit trails.

Completion and Settlement

This phase outlines how the fulfillment of the contract is acknowledged and how any remaining obligations between the parties are resolved. Here’s a breakdown of how the completion and settlement process works:

• Final Confirmation: Both parties receive a notification confirming that all conditions outlined in the smart contract have been met. This acknowledgement ensures both parties are aware of the contract’s fulfillment status.
• Fund Release: Any funds held in escrow by the smart contract are automatically released to the appropriate parties. For instance, if payment for goods was withheld until delivery confirmation, this payment is now processed and transferred.
• Data Recording: The blockchain updates with the final status of the contract. This record includes all pertinent information such as timestamps, fulfillment evidence, and transaction details, ensuring a transparent and immutable trail.
• Auditability: All parties have the ability to audit the transaction history on the blockchain. This capability provides a verifiable proof of contract execution and fulfillment, critical for compliance and dispute resolution.
• Dispute Resolution: In case any party disputes the fulfillment, the immutable records on the blockchain serve as indisputable proof, significantly simplifying and expediting the resolution process.

How Do Smart Contracts Work: Key Takeaways

Smart contracts offer a new and improved way of  handling agreements by delivering tons of benefits to businesses, such as unparalleled security, automation, and efficiency. As industries continue to integrate this technology, the potential for innovation is immense. And as you’ve learned, the process behind smart contract execution is not extremely complicated.

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