What is a Smart Contract?

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The term “smart contract” is used often when discussing distributed ledger technology; however, its definition tends to be broad, unclear and often controversial.

The term “smart contract” itself can be misleading, as the notion of “smartness” and the extent to which something is truly a “contract” is questionable in many instances. Smart contracts have become so closely associated with distributed ledger technology and referred to so often, that in many cases the meaning has strayed from its original intent and has been generalized to the point of inaccuracy.

The phrase and concept of a smart contract was originally developed in 1994 by Nick Szabo, a legal scholar, computer scientist and cryptographer. Szabo’s background reveals the original intent and requirements of a true smart contract: a confluence of both legal and computer code. In fact, Szabo’s entire methodology is centered around the improvement of contract law and practice through electronic protocols.

It is critical to distinguish between the technically accurate concept of a “smart contract” and today’s buzzword. There are often situations where a simple piece of code is claimed to be a smart contract when, in reality, it is neither “smart” nor technically a “contract”. A smart contract is not simply any piece of self-executing computer code, but is rather an agreement whose execution is both automated and enforceable.

A smart contract is automated in the sense that the core business terms (the actual “transaction” among parties) is expressed through, and independently executed by, computer code and which no party can block or otherwise tamper with. It is enforceable in the sense that it constitutes legally binding rights and obligations of the involved parties.

Currently, most smart contracts consist of a combination of both computer code – a programmable transaction protocol that defines the business terms of the contract – and legal prose that reflects that the computer code constitutes part of the binding legal agreement between the parties, and is therefore also legally binding.

Smart contracts are critical aspects of distributed ledger technology for financial institutions. They allow parties involved in an agreement to conclude with certainty that they are in consensus at all times as to the existence, nature and evolution of the facts shared among them, which are governed by the program. Additionally, they can be used to satisfy common contractual conditions, lower transaction costs and risk, and eliminate the need for trusted intermediaries.