What are Smart Contracts in Blockchain?

‍

As technology continues to revolutionize the world of finance, new concepts like smart contracts are redefining how we handle and secure transactions. 

In this blog, we provide you with a deep understanding of smart contracts, their working mechanisms, and their intersection with tax considerations.

But first, let’s dive into the basics of this transformative technology. 

What is a Smart contract?

A smart contract is a self-executing contract with the terms of the agreement between parties directly written into lines of code. 

These are essentially digital contracts built on blockchain technology. They contain specific rules and conditions, encoded directly within the contract's code. When these predefined conditions are met, the smart contract self-executes, automating the next actions without requiring any manual intervention or third-party oversight.

‍

‍

If 'Condition A' is met, then 'Outcome B' is automatically triggered. For instance, consider a real estate transaction. A smart contract can be set up where, once a buyer transfers the agreed purchase amount (Condition A), the digital ownership title of the property is automatically sent to the buyer (Condition B). This transaction happens directly between buyer and seller, eliminating the need for intermediaries, making the process more efficient and secure.

What are the Types of Smart Contracts?

There are several types of smart contracts that can be utilized based on the requirements and conditions of a transaction. Here's a closer look:

Smart Legal Contracts

These are legally binding smart contracts that impose contractual obligations on all involved parties. Any breach of these contracts could result in serious legal consequences. 

These types of smart contracts ensure both accountability and compliance, providing a digital and automated twist to traditional legal contracts.

Decentralized Autonomous Organizations (DAO)

At the core of a DAO is its governing smart contract, which dictates the specific rules and guidelines of the organization. These contracts, embedded within the blockchain, operate with pre-established governance mechanisms. 

DAOs can vary in complexity based on the number of stakeholders involved. Being open-source, transparent, and theoretically incorruptible, DAOs replace manual community actions with automated, self-enforcing codes.

Application Logic Contracts (ALC)

These smart contracts are designed to facilitate secure and autonomous operation of devices. ALCs enhance automation, reduce transaction costs, and improve scalability. 

They contain application-specific code that interfaces with other smart contracts on the blockchain. This interconnectivity is particularly useful in the integration of different technologies, such as the Internet of Things (IoT) with blockchain.

How does a smart contract work?

The execution of smart contracts relies on the decentralized and immutable nature of blockchain. They function by employing the deterministic execution of pre-defined rules and penalties around an agreement, as automated by its code.

‍

‍

Each smart contract is stored on the blockchain, and its execution is validated by every node in the network. 

The transaction only gets added to the blockchain after a consensus is reached among the nodes, ensuring fairness and accuracy. This chain of operations eliminates the need for intermediaries, thereby enhancing the efficiency of these agreements.

Once deployed on the blockchain, it cannot be altered or tampered with, ensuring a high level of trust and security. This assurance further aids in reducing fraud and breaches of contract.

What are the benefits of smart contracts?

Smart contracts offer an array of benefits including:

1. Autonomy: They eliminate the need for intermediaries giving parties direct control over the agreement.

2. Trust: The tamper-proof nature of smart contracts fosters trust among parties.

3. Backup: Blockchain stores duplicates of all smart contracts, preventing loss of information.

4. Speed and Efficiency: Automated processes enhance speed and efficiency, saving time and costs associated with manual processing.

5. Transparency: The terms of smart contracts are visible and accessible to all relevant parties, enabling clear communication.

6. Security: Utilizing cryptography for encryption, smart contracts offer top-notch security against fraud and hacks.

Smart Contracts and Tax

As discussed previously, smart contracts play a crucial role in facilitating various transactions on the blockchain. These transactions, such as buying, selling, swapping, or depositing assets, carry their own tax implications. 

To ensure compliance, you must accurately handle the tax calculations associated with smart contract transactions. This is where a crypto tax software like Kryptos can help. 

By assessing the programming logic embedded within the smart contract, Kryptos applies the most suitable auto-categorization when importing these transactions into the application. This process ensures that the tax treatment of each transaction is appropriately accounted for, taking into consideration the specific actions associated with the transactions.

Want to get started? Sign Up on Kryptos now.

FAQs

1. What is a smart contract in simple terms?

A smart contract is a digital agreement where terms and conditions are written in code. When these terms are met, the contract self-executes, meaning it carries out whatever actions it was designed to do. 

2. What is a smart contract and how does it work?

A smart contract is a computerized protocol that facilitates, verifies, or enforces the negotiation or performance of a contract. In essence, it is a computer program that directly controls the transfer of digital currencies or assets between parties under certain conditions.

It works on the "if-then" principle. For example, in a rental agreement, if a tenant (party A) pays the rent (condition), then they receive the digital key to the rented property (outcome). These contracts are stored and replicated on the blockchain and supervised by the network of computers that run the blockchain.

3. What is a smart contract vs blockchain?

Blockchain is the foundational technology that enables the existence of smart contracts. It is a distributed ledger that records transactions across multiple computers so that any involved record cannot be altered retroactively, without the alteration of all subsequent blocks.

Smart contracts are an application that operates on top of a blockchain. They use the blockchain's decentralized ledger to validate and enforce their terms. While all smart contracts require a blockchain to function, a blockchain can exist without smart contracts.

4. What are the types of smart contracts?

There are three types of smart contracts: Smart Legal Contracts, Decentralized Autonomous Organizations (DAO), and Application Logic Contracts (ALC).

5.What are the 3 characteristics of smart contracts?

Smart contracts have the following 3 characteristics:

• Self-Verifying: Smart contracts can automatically verify whether conditions have been met and execute the next steps.
• Tamper-Proof: Once a smart contract is deployed on the blockchain, it cannot be modified or tampered with. 
• Autonomy: Smart contracts are self-executing, meaning they can perform the tasks they were designed for without any intermediaries. 

‍

All content on Kryptos serves general informational purposes only. It's not intended to replace any professional advice from licensed accountants, attorneys, or certified financial and tax professionals. The information is completed to the best of our knowledge and we at Kryptos do not claim either correctness or accuracy of the same. Before taking any tax position / stance, you should always consider seeking independent legal, financial, taxation or other advice from the professionals. Kryptos is not liable for any loss caused from the use of, or by placing reliance on, the information on this website. Kryptos disclaims any responsibility for the accuracy or adequacy of any positions taken by you in your tax returns. Thank you for being part of our community, and we're excited to continue guiding you on your crypto journey!