DEFINITION of 'Smart Contracts'
Smart contracts are self-executing contracts with the terms of the agreement between buyer and seller being directly written into lines of code. The code and the agreements contained therein exist across a distributed, decentralized blockchain network. Smart contracts permit trusted transactions and agreements to be carried out among disparate, anonymous parties without the need for a central authority, legal system, or external enforcement mechanism. They render transactions traceable, transparent, and irreversible.
Blockchain was the technology originally developed for Bitcoin, but blockchain technology has since evolved far beyond the scope of virtual currency.
BREAKING DOWN 'Smart Contracts'
Smart contracts were first proposed in 1994 by Nick Szabo, an American computer scientist who invented a virtual currency called "Bit Gold" in 1998, fully 10 years before the invention of Bitcoin. In fact, Szabo is often rumoured to be the real Satoshi Nakamoto, the anonymous inventor of Bitcoin, which he has denied.
Szabo defined smart contracts as computerized transaction protocols that execute terms of a contract. He wanted to extend the functionality of electronic transaction methods, such as POS (point of sale), to the digital realm.
In his paper, Szabo also proposed the execution of a contract for synthetic assets, such as derivatives and bonds. “These new securities are formed by combining securities (such as bonds) and derivatives (options and futures) in a wide variety of ways. Very complex term structures for payments can now be built into standardized contracts and traded with low transaction costs, due to computerized analysis of these complex term structures,” he wrote. In simple words, he was referring to the sale and purchase of derivatives with complex terms.
Many of Szabo's predictions in the paper came true in contexts preceding blockchain technology. For example, derivatives trading is mostly conducted through computer networks using complex term structures.