All information about the functionality, advantages and security of the blockchain contracts

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When it comes to blockchain applications, you read about them again and again: Smart contracts. But what exactly is behind this term?

Smart contracts are contracts that are made using a transaction stored in the blockchain become. They precisely define the conditions under which they come into force and what effect they have. The blockchain automatically implements the terms of the contract. The implementation of these conditions is therefore independent of a central institution. Compliance with the contractually stipulated conditions is checked by the smart contract itself and does not have to be checked by either of the two contractual partners or even a third party. The contract cannot be changed retrospectively, but can be viewed by everyone due to the transparency of the blockchain.

However, these automatic contracts only run on blockchains specially developed for smart contracts. The best-known platform for creating and using smart contracts is the Ethereum blockchain – the Bitcoin blockchain, on the other hand, only offers a very simple form of smart contracts.

In today’s financial system, a stock exchange or bank must be involved as a third, independent party in almost every financial transaction. They ensure that transactions are processed properly. However, this also results in additional costs and losses in terms of privacy, since the central authority, in its function as a middleman, also has access to the details of the transaction. Replacing the bank as a middleman is one of the reasons cryptocurrencies like Bitcoin became popular. With smart contracts, the removal of a central party is also applicable to other industries and situations, in which contracts are concluded.
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Smart contracts are blockchain-based, automated protocols that enable the creation of peer-to-peer contracts, verify their authenticity and enforce the subject matter of the contract. This fully automated contract handling eliminates many of the disadvantages of classic contracts, such as the costs and the time required for notarial certification when selling real estate. Smart contracts offer users enormous leeway with regard to the design of the subject matter of the contract. In this way, the party drawing up the contract can provide it with any number of conditions that define the content of the contract.

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Using the example of a real estate sale, the advantages of a smart contract can be clearly identified: At the moment, it is a very lengthy process that is determined by bureaucracy. The contract for the sale of a property must be signed by the buyer and seller and certified by a notary. After the contract has been successfully signed, the notary notes the planned change of ownership in the land register by means of a notice of conveyance. As soon as the real estate transfer tax has been transferred by the buyer to the tax office and the payment of the purchase price has been received in the notary’s account, the notary will arrange for the land register to be rewritten and forwards the purchase price to the buyer. The notary usually charges a fee of around two percent of the purchase price for this service.

Such a model could also be constructed much more cheaply on the basis of a blockchain and the use of smart contracts. If the land register were stored on a decentralized blockchain, going to the land registry would be eliminated. The smart sales contract would only have to be provided with the legal conditions that have previously been checked by the notary. By directly linking the contract with the land register blockchain, the ownership structure would already be validated by the blockchain (instead of the notary) when it was triggered. Thus, the contract would initially only be executed if the seller’s signature stored in the sales contract also matches that of the owner stored in the land register. The transaction would then take place, which includes both a transfer of the purchase price and the payment of the property transfer tax to the tax office and automatically instructs the change in the land register.

(Graphic: A. Stein and L. Beul)

This example shows that smart contracts can lead to huge cost savings. Likewise, processes can be accelerated and automated, which among other things leads to the elimination of the priority notice.

Smart contracts would ensure that the correct performance of the contract between different parties is validated by a further, independent and decentralized party who does not pursue the same goals as one or more of the contracting parties. Automation also eliminates human error when handling contracts. Since the smart contract is in the blockchain, it is audit-proof or unchangeable. However, this also means that it can no longer be updated in the event of incorrect programming, so there are no updates, as usual with software. If an error in the program code of the smart contract leads to incorrect issuance or loss of cryptocurrency, the trustworthiness of the contract is no longer guaranteed.

This immutability also protects against malicious manipulation of the contract. So it is not possible for a hacker to change the contract afterwards. A signature on a paper contract, on the other hand, is – relatively speaking – easy to forge.
In addition to unintentional errors, security can also be impaired by deliberately harmful contracts. For example, an attacker can create an alleged sales contract that does not ask for confirmation of the product. This would enable the seller not to have to pay anything in return. In this attack scenario, the attacker pretends that the contract is programmed correctly, although in reality it does not cover the intentions of all contracting parties.

Louis Beul

Louis Beul is currently completing his Abitur and is working as a volunteer ambassador and event manager for the Code + Design eV initiative, which helps young people and children to develop their own apps or software projects.

Aaron Stein

Aaron Stein programmed since he was 14 years old. In 2017 he developed an app for his school to make everyday school life more digital. With 1000 active students, parents and teachers, this is used every day.

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