Smart contracts idea is probably older than you think. Smart contracts were first proposed by Nick Szabo, who coined the term in 1994. You can check his original work:

http://www.fon.hum.uva.nl/rob/Courses/InformationInSpeech/CDROM/Literature/LOTwinterschool2006/szabo.best.vwh.net/smart.contracts.html

What is a contract

First of all, let’s have a look at the dictionary definition of a contract:

“A written or spoken agreement, especially one concerning employment, sales, or tenancy, that is intended to be enforceable by law.”

A contract is an agreement between two parties that mutually agreed to behave or act as the contract states. The contract usually has to have a specific form (date, conditions, names, signatures) and if any party does not agree with the acting or not acting of the other party then the law have to get engaged to solve the issue.

The issue is that in the real world a paper contract cannot enforce the correct or honest behavior of the participants. There must be a third party that solves all possible issues. Thus there are so-called legally binding contracts. “Legally binding” means that the parties must obey the terms written in the contract and perform their contract duties as stated. Failure to do so may result in legal consequences, such as a damages award.

We are able to avoid middle-man when we want to send a transaction. A distributed network can act as a middle-man and ensure that a transaction sent by Alice to Bob will be processed as expected if all conditions are met. Bitcoin does it quite well.

Why smart contracts

What if we could create a digital contract and use it similarly as a transaction between Alice and Bob? What if Alice and Bob could create a digital contract between each other and a distributed network, as a middle-man, ensures correct execution and enforces both to act honestly? This is exactly what a smart contract can do. Let’s have a look at what Nick Szabo wrote about it in his work:

We also see that to implement a full customer-vendor transaction, we need more than just the digital cash protocol; we need a protocol that guarantees that the product will be delivered if payment is made and vice versa. Current commercial systems use a wide variety of techniques to accomplish this, such as certified mail, face to face exchange, reliance on credit history and collection agencies to extend credit, etc. Smart contracts have the potential to greatly reduce the fraud and enforcement costs of many commercial transactions. Digital cash protocols use several of the rich new building blocks coming out of the fields of cryptography and computer science. Most of these components have not yet been widely exploited to facilitate contractual arrangements, but the potential is vast.

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Finally, we can extend the concept of smart contracts to property. Smart property might be created by embedding smart contracts in physical objects. These embedded protocols would automatically give control of the keys for operating the property to the agent who rightfully owns that property, based on the terms of the contract. For example, a car might be rendered inoperable unless the proper challenge-response protocol is completed with its rightful owner, preventing theft. If a loan was taken out to buy that car, and the owner failed to make payments, the smart contract could automatically invoke a lien, which returns control of the car keys to the bank.