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What are Smart Contracts? A Beginner's Guide

By Matthew Zeitlin · August 06, 2021 · 4 minute read

We’re here to help! First and foremost, SoFi Learn strives to be a beneficial resource to you as you navigate your financial journey. Read more We develop content that covers a variety of financial topics. Sometimes, that content may include information about products, features, or services that SoFi does not provide. We aim to break down complicated concepts, loop you in on the latest trends, and keep you up-to-date on the stuff you can use to help get your money right. Read less

What are Smart Contracts? A Beginner's Guide

While the best known use of the blockchain is to store and transmit digital currencies, the blockchain also has many other uses. Among those uses are smart contracts, which makes use of the blockchain technology to automatically execute all or part of the agreements between two parties.

Some users are already using them to do business in the real estate and insurance industries, and they’re a big part of the decentralized finance industry.

Recommended: 9 Blockchain Uses and Applications in 2021

What Is a Smart Contract?

A smart contract is a digitally facilitated agreement between two parties that’s written in code into the blockchain technology. The code automatically executes the terms of the contract when agreed upon conditions occur. There is no third-party required to enforce the terms of the agreement.

How Do Smart Contracts Work?

Rather than having people and institutions back up a contract’s provisions, the blockchain automatically enforces it — “every node in the network holds a copy of the transaction and smart-contract history of the network. Every time a user performs some action, all of the nodes on the network need to come to agreement that this change took place,” according to Coindesk. This feature of smart contracts leverages the security of blockchain technology.

A Short History of Smart Contracts

The idea behind smart contracts predates the blockchain technology that made them possible. Cryptography and digital currency pioneer Nick Szabo, first used the term in the 1990s to describe “a set of promises, specified in digital form, including protocols within which the parties perform on these promises.”

What makes smart contracts “smart,” according to Szabo is that the contract is specified in a computer program or in code, that the contract is executed digitally, and that the exchange of goods that happens due to fulfillment or non-fulfillment happens in the same code or program in which the contract itself was written.

What helped make self-executing, smart contracts a reality was the development of the cryptocurrency Ethereum blockchain, which enables Ethereum.

Smart Contract Examples

While smart contracts are still a relatively new technology, several use cases for them have already emerged.

Decentralized Finance

Perhaps the most obvious arena for smart contracts is, well, money. After all, cryptocurrency is used as just that, a currency, and finance often consists of contracts between two parties surrounding the exchange of money over time.

Think of a typical loan payment, it’s a contract under which one party provides another with a certain amount of money and the other party agrees to transfer money back to the first party at certain dates and in certain amounts, if the borrower does not pay the lender, the lending party can commence legal action against the borrower.

Decentralized finance” seeks to use smart contracts to create financial products like loans that do not rely on third parties. Decentralized finance or “DeFi,” is one of the hottest areas of blockchain technology.

There are several examples of smart contracts in decentralized finance. One of the most prominent are “stablecoins” — cryptocurrency tokens with a fixed value. One stablecoins, Dai, is pegged at a one-to-one value with the dollar. Dai uses smart contracts for the creation of new tokens and governance of the entire token ecosystem.

Recommended: What Is a Stablecoin? A Closer Look

In practice, that means that if a user wants to issue new Dai tokens, they need to stake ethereum as a collateral. If the value of that underlying collateral falls below a certain threshold, the smart contract automatically sells the collateral in order to make up the difference.

Real Estate

One of the most enticing areas to use blockchain is in real estate. When purchasing a home, for example, you set up a contract with a bank and money transfers with the previous owners in exchange for what are essentially a set of legal rights to a property. This process is time-intensive, requires various agents and lawyers on both sides, as well as several complex transfers of money both at one time and over years. This is an area where smart contract developers have been hungry to get into.

While it’s unlikely that you’ll move into the house of your dreams by executing a smart contract, blockchain developers are looking into real estate by “tokenizing” properties, divvying up real estate into slices that investors can own or trade (including through smart contracts).

Here are a few companies already using smart contracts in real estate:

•  Harbor is using smart contract to tokenize a $100 million real estate fund.

•  DigiShares allows real estate developers to tokenize their projects using smart contracts.

•  Ubiquity uses black-chain based smart contracts to tokenize real estate and help reduce costs during escrow.

•  SmartZip, a real estate software company, has partnered with blockchain firm Chainlink to provide real estate pricing data to smart contracts.

•  Propy is a blockchain startup that facilitates real estate escrow through smart contracts.

Insurance

Insurance is another example of a complicated financial contract that many entrepreneurs and developers are looking to deploy blockchain technology in. Blockchain in insurance can mean a lot of things.

One possible model for it is “parametric insurance,” which pays out automatically under certain conditions that are definable in code in a smart contract. This is still an emerging area, but since the insurance industry relies on millions of contracts, it’s a natural area for blockchain smart contract developers to look into.

Here are a few ways smart contracts are actually being used in the insurance industry:

•  The Institutes RiskStream Collaborative is a consortium of 40 insurance industry members working together to build blockchain applications for industry use

•  IBM uses its blockchain technology to automate insurance underwriting using smart contracts.

•  Etherisc is a decentralized insurance protocol insurers are using for smart contracts and other services.

•  Sprout is an insurer that uses smart contracts to provide crop insurance to farmers.

•  Nexus Mutual serves as a decentralized insurance platform that aims to eliminate the need for third-party insurers.

The Takeaway

Smart contracts are one use for the blockchain, made possible in many cases through the adoption of cryptocurrency. Many investors view cryptocurrency, and the blockchain that makes it possible, as an important part of their investment portfolio.

An easy way to get started investing in crypto is by opening an account on the SoFi Invest® brokerage platform. SoFi Invest offers access to a range of cryptocurrencies including Bitcoin, Litecoin, and Ethereum, with up to a $10 bonus for your first trade.

Photo credit: iStock/fizkes


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