Cryptocurrency has become a global phenomenon, and one of the biggest catalysts was the introduction of smart contracts. These self-executing programs have made crypto projects like Ethereum into massive platforms that developers have flocked to for creating state-of-the-art applications.
But what exactly are smart contracts and how do they work?
In this article, we’ll cover the details of what a smart contract is, how it works, how smart contracts are used, and some potential pitfalls to be aware of.
What Is a Smart Contract?
A smart contract is a digital agreement that is automatically executed on a blockchain network once the conditions of the agreement are met. The contract itself is simply a program that runs on the blockchain. It is designed to facilitate transactions and other actions without the need for an intermediary or trusted third party.
How Smart Contracts Work
Smart contracts are designed to execute based on simple if/then programmatic statements: “if X happens, then execute Y action.” Multiple if/then statements can be coded into a contract, and the contract will only execute when certain conditions are met.
For example, if you are trading USD Coin (USDC) for Bitcoin (BTC), then the smart contract can only execute when there is enough USDC in your digital wallet to cover the cost of the transaction and you authorize the purchase.
Once a transaction is processed via a smart contract, the details of that transaction are copied onto the public blockchain and verified by multiple independent “nodes” on that blockchain. These transactions are unchangeable once the smart contract is executed, which is a feature of the secure design of blockchain technology.
A simpler way to showcase the functionality of smart contracts is perhaps best told by their inventor, Nick Szabo. Well before Bitcoin and cryptocurrencies were invented, Szabo proposed the idea of the smart contract in 1994.
In 1997 he likened it to a vending machine transaction. Essentially, the vending machine programming is the contract owner, and it will execute based on different criteria being met.
If you put a $1 bill into a vending machine and select an item that costs $1.25, the vending machine would return a message stating you do not have enough funds. Essentially the conditions of the contract were not met.
If you select an item worth $1, the vending machine would process the transaction and release your item. In this case, the conditions of the contract were satisfied, and the transaction could be processed. All of these processes happen without the need of a human intermediary.
Smart contracts run on their respective blockchains, with Ethereum being the most popular place to deploy decentralized applications (DApps) with smart contract functionality.
When executing a transaction on any blockchain, there are fees associated, known as “gas fees,” which pay the node operators that process and validate the transactions on the blockchain.
Benefits of Smart Contracts
The main benefit of using a smart contract is to perform transactions and other tasks without the need for an intermediary. In the case of decentralized finance (DeFi) applications, this allows financial transactions to take place without needing to route payments through a bank.
Transactions executed by a smart contract are also inherently secure, operating on a blockchain that requires independent verification for a transaction to be approved. All transactions are publicly verifiable, and each independent node on the blockchain keeps a copy of all smart contracts and transactions, helping to avoid any discrepancies.
Smart contracts are also immutable once executed because they are stored on the blockchain, which is a distributed ledger of all transactions. Hackers cannot simply change the terms of a contract because doing so would create conflicting records on the blockchain, and the new contract would be rejected.
Overall, smart contracts make it easy to transact globally, instantly, and securely.
Smart Contract Applications
There are a variety of applications that utilize smart contracts, with the most popular being decentralized financial applications. This secure design and public accountability makes smart contracts ideal for facilitating financial transactions between anonymous parties, including buying & selling of cryptocurrency or NFTs, crypto lending, staking, and other complex financial transactions.
Outside of finance, smart contracts are also used in other blockchain-based applications, including gaming, logistics, and even community governance.
Blockchain-based gaming is very popular, especially with play-to-earn (P2E) gaming growing in popularity. The smart contracts within these blockchain-based games allow users to perform certain tasks or achievements and receive native crypto tokens in return. All of these transactions are governed by smart contracts.
Decentralized autonomous organizations (DAOs) have also become a popular way to govern cryptocurrency projects. These communities themselves are governed by smart contracts that are built to help organize proposal and voting systems within the DAO, allowing an automated way to propose new features or actions for a project, vote for a proposal, and release DAO funds to execute the winning proposal.
There are numerous applications for smart contract functionality, and we have only begun to scratch the surface of their capabilities for real-world implementation.
Smart Contract FAQs
Smart contracts may seem complicated, but they are simply programs that help make transactions fast and easier than ever before. Here are the answers to a few of the most common questions about smart contracts:
What Are Smart Contracts’ Limitations?
Smart contracts are effective tools to help automate financial transactions, but there are a few limitations to consider. First, smart contracts are very difficult to change once they have been deployed onto the blockchain. Since a blockchain is a distributed ledger that carries a record of every transaction and blockchain update, going back and changing a contract would mean forking the current blockchain to an entirely new one. This is massively time-consuming, and a huge headache for users and node operators.
Smart contracts are, like any program, coded by humans who can make mistakes. This makes them vulnerable to code bugs that can have an adverse effect on the functionality of an application. In addition, there may be vulnerabilities coded into a smart contract, making them open to being exploited. And since smart contracts can govern large numbers of financial transactions, this potentially puts investor cryptocurrency at risk.
Overall, smart contracts are great tools, but they do have some shortcomings that can be costly.
Are Smart Contracts Legally Binding?
They can be, if a smart contract follows the legal rules of contractual agreements, including:
- Mutual agreement
- Valid offer and acceptance
- Adequate consideration
According to the Legal Information Institute at Cornell Law University, contractual agreements that follow these rules are considered legally binding.
But smart contracts make things difficult because they are automatically executed and are irreversible once deployed. If the terms of a contract are not legal, or there was not a valid offer and acceptance, for example, a legal case may need to resort to other means of obtaining lost funds.
These are uncharted waters currently, but legal clarity will most likely come over time as more and more smart contracts are deployed.
Can You Change a Smart Contract?
In general, no. Once a smart contract is deployed, it is recorded permanently on the blockchain. Unless the entire blockchain is forked to a new version before the smart contract was deployed, it is immutable.
Smart contracts are groundbreaking technology that offers an alternative to the traditional financial system. With the ability to execute transactions automatically, it removes the need for a trusted third-party intermediary, and avoids some of the unnecessary fees and delays caused by current financial processes. Smart contracts also allow many types of transactions to take place, with rules-based programs acting as the building blocks of decentralized applications.
Smart contracts are not without their downside. Although the permanence of a smart contract is seen as a great security feature, it is also time consuming and cumbersome to alter a smart contract after it has been deployed. And smart contracts are only as good as their human programmers, opening the possibility of security risks and code bugs that may seriously compromise an application or even an entire blockchain.
Smart contracts are the future of finance, but are still in their infancy and need to do a bit of “growing up” before they can be widely adopted across all industries.