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Understand Smart Contracts, DApps, and Tokens – Simply Explained

written by FuturisticLawyer
December 18, 2020

In previous posts (see Understanding Blockchain 1, 2, 3, and 4) I attempted to explain how blockchain technically works by using the Bitcoin Network as a point of departure.

As we discovered, the major innovative aspect of blockchains is their ability to track monetary transactions in a decentralized computer network without any involvement from human intermediaries. However, the application of blockchain technology is not restricted to only enable the existence of cryptocurrencies. With the help of smart contracts, any value that can be translated into coding can be recorded and managed on a blockchain, whether it be intellectual property rights, voting rights, development aid, supply chains, deeds of conveyance, or medical records. In this post we will understand how.

The aim of this post is not to go into a technical explanation of how smart contracts or the Ethereum network operates, but rather to provide a general understanding of these concepts that will serve as a ground of reference for future article.

Smart Contracts

The term “smart contract” was first coined by the acknowledged computer scientist and legal scholar Nick Szabo. In his article “Understand Smart Contracts” from 1994 he defines it in the following way[1]:

“A smart contract is a computerized transaction protocol that executes the terms of a contract. The general objectives of smart contract design are to satisfy common contractual conditions (such as payment terms, liens, confidentiality, and even enforcement), minimize exceptions both malicious and accidental, and minimize the need for trusted intermediaries. Related economic goals include lowering fraud loss, arbitration and enforcement costs, and other transaction costs.”

The basic idea of smart contracts is thus to embed contractual clauses directly into a blockchain where they are automatically and irrevocably executed. [2]  Smart contracts are self-executing pieces of computer code that generate transactions when certain, specified conditions encoded in them are met.

Szabo compares smart contracts with the vending machine.[3] The simple function of a vending machine is to automatically deliver a snack chosen by the customer when a sufficient amount of coins is inserted (or the customer’s card or smartphone is swiped at the machine). In a similar manner, payments can be executed automatically through the blockchain when goods are shipped. As soon as the seller can present a bill of lading or proof of delivery. Or policy terms of life insurance could be encoded directly into a smart contract, and release the payment to the named beneficiary against the input of a death certificate.[4] Or a smart contract could allow a user to access a copyrighted work in exchange for a certain amount of cryptocurrency.[5]

Smart contract’s self-enforcing and automatic nature can lower transaction costs, and make intermediaries redundant in a large volume of dumb transactions.[6] However, smart contracts are less applicable to more sophisticated transactions that cannot easily be modeled after simple “if-a-then-b” rules. There is currently no consensus across legal systems and jurisdictions as to how smart contracts fit into the traditional concepts of contract law, and it is unclear how dispute resolution would take place.[7]

Ethereum and DApps

While Nick Szabo proposed the concept of smart contracts in the mid-90s, the Ethereum network brought smart contracts to life when the platform launched in 2015. Ethereum’s coin value “Ether” is referred to as an Altcoin – a collective designation for all cryptocurrencies that are not Bitcoin. However, the Ethereum platform offers much more than a home for its native currency.  Ethereum is a global, open-source platform that runs on smart contracts or so-called decentralized applications (DApps).[8]

DApps are similar to Apps as we know them from Apple Store or Google Play. The important elements of Apps are the frontend coding (the user interface) and the backend coding (the server, application, and database that run “behind the scenes”). The communication between these elements occurs in the form of coding messages via HTTP protocol.[9] DApps also consist of frontend and backend coding.  But the backend is a blockchain network.

As we already know, a blockchain is a secure and decentralized system. Data on a well-designed blockchain is practically impossible to tamper with. Not only does it offer protection from outside intruders, but also there is no central authority on the inside to manage the data of the blockchain. Popular web applications such as Facebook, Twitter, and Instagram operate on centralized servers, which principally makes them susceptible to hacking or data leaks (just think of the Cambridge Analytica scandal).[10]

Additionally, centralized platforms are able to control and assert ownership over user-generated content, which can disrupt the free flow of information. When blockchains used for DApps, there no gatekeepers to decide whether the included data allowed on the platform or not, and no one can change the data, delete it, or manipulate it in any way.

Ethereum and Tokens

The Ethereum network adopts the basic blockchain technology invented by Satoshi Nakamoto in the Bitcoin white paper but adds an additional layer of complexity to it. The base coin of Ethereum, Ether, is used in the same way as citcoins. Ether is a cryptocurrency that can be transferred between Ethereum users as a method of payment, and it also used as rewards for  miners  to incentivize their work. On top of what could be considered the base network are Ethereum’s “tokens”.

A general definition of tokens from www.dictionary.com   “is something serving to represent or indicate some fact, event, feeling, etc.; sign”. Real-life examples of tokens could be chips in a poker game, coupons, or a bracelet that allows you to try the rides in an amusement park. Tokens in the Ethereum network could resemble valuta, shares, intellectual property rights, voting rights,  or any other assets that can be translated into computer coding (virtually anything) and comply with the rules and network standards. Any software developer can create tokens on the network from nothing and sell them. Essentially, tokens represent values “on top” of the Ethereum network.   Smart contracts used to facilitate the transaction of tokens and record balances of tokens in an account.[11]

Utility tokens and security tokens

Tokens can be distinguished into two categories: Utility tokens and security tokens. 

Utility tokens are used to raise capital for DApp-projects through something called an initial coin offering (ICO). An ICO is the blockchain-equivalent of crowd-funding. Once a DApp project can run on the blockchain, the developers issue a limited number of tokens that anyone with faith or interest in the project can purchase. In some cases, the investor’s motivation to buy tokens are to use them as a store of value and to resell them at a higher price to other investors within the network. Ethereum’s development was originally funded in the same manner, by offering Ether for Bitcoin.[12] In other cases, the tokens trigger certain functions in the smart contract(s) of the DApp.[13] This means that the tokens are used as rights within the project for example for product usage or product access to certain features, or to a richer user experience.[14]

When investors buy security tokens, they are offered a stake of ownership in the DApp project. Security tokens serve the same purpose as traditional security, which means attaching a paper or digital legal agreement to a physical object or to a company or project.[15] Examples are shares in a company or investments in government bonds to pay interest. Security tokens similarly allow the investors to share profits, receive interest payments or dividends.

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[1] Retrieved at https://www.fon.hum.uva.nl/rob/Courses/InformationInSpeech/CDROM/Literature/LOTwinterschool2006/szabo.best.vwh.net/smart.contracts.html .

[2] Nick Szabo (1996) – Smart Contracts: Building Blocks for Digital Markets Copyright retrieved at: https://www.fon.hum.uva.nl/rob/Courses/InformationInSpeech/CDROM/Literature/LOTwinterschool2006/szabo.best.vwh.net/smart_contracts_2.html

[3] Ibid.

[4] https://medium.com/coreledger/what-are-smart-contracts-a-breakdown-for-beginners-92ac68ebdbeb (08-12-2020).

[5] Balazs Bodo, Daniel Gervais, and Joao Pedro Quintais (2018), Blockchain and smart contracts: the missing link in copyright licensing?, pg. 316.

[6] Ibid.

[7] Ibid.

[8] https://ethereum.org/en/

[9] https://www.netsolutions.com/insights/why-blockchain-based-dapps-are-the-future-of-decentralization/ (16-12-2020).

[10] Ibid.

[11] https://cointelegraph.com/explained/erc-20-tokens-explained (17-12-2020).

[12] William Metcalfe (2020) Ethereum, Smart Contracts, DApps, pg. 82 -> from the book “Blockchain and Crypto Currency”.

[13] Monika di Angelo (2020), Tokens, Types, and Standards: Identification and Utilization in Ethereum, pg. 1.

[14] https://blockgeeks.com/guides/utility-tokens-vs-security-tokens/ (18-12-2020).

[15] Metcalfe (2020), pg. 83.

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