Smart Contracts are currently small computer programs that sit on a blockchain.
They can automatically do “x”, if “y” happens.
“x” could be something like transferring money from one person to another.
“y” could be something like “if the temperature is above a certain level”.
This type of arrangement, could allow two parties to agree that if the temperature is above a certain level, then a set amount of money is automatically transferred from the first party to the second. This could be a form of insurance contract.
Similarly a smart contract could be used, for example, for a kickstarter-like campaign – where the funds are only released to the company if over a certain amount of money is raised in total – and otherwise the money is returned to each backer.
A more common type of smart contract is one where multiple “signatories” are required to release money from one wallet to another. This is a feature available on Bitcoin as well as many other cryptocurrency platforms.
To execute contracts on Ethereum, parties need to pay to use the “Ethereum Virtual Machine” (the payment is called “gas”). Gas is paid in ether (the cryptocurrency for the Ethereum network).
Current problems with smart contracts include: the risks of conceptual mistakes and bugs when writing the smart contract, the difficulty for most people to be able to read and so agree to the contract (written, for example, in Solidity), difficulties in correcting or otherwise modifying contracts once they are created, blockchain-use (gas) costs, and the limited number of events and outcomes that are currently on blockchains or through APIs – and so can be accessed for smart contracts.
Smart contracts have the potential to become widely used as blockchain technology develops, as more assets become tokenised and as people experiment with more use cases. Smart contracts have the potential to reduce the risks and costs of people/companies transacting with each other (at least for a set of transactions) – which in turn could allow many transactions that currently do not happen to happen – and so add to the economy. An analogy is how the internet as a technology was initially difficult and expensive to use, technologies improved, and now many transactions occur each day that could/would not have happened if the internet did not exist.