Bitcoin may have implemented the blockchain, but Ethereum introduced the crypto world to smart contracts. The truth is, crypto as we know it today could never be made possible without smart contracts, but if you’re still wondering what they are, think of it this way.
Imagine you’ve just lent some money to a friend, but you know deep down that they probably won’t return it. As a result, you decide to put a spell on them that ensures the money will be returned on a specific day and at a specific time, no matter what.
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Smart contracts can be seen as the ‘spell’ that ensures someone holds up their side of the bargain. Considering how many ‘agreements’ are involved in the world of crypto, they play a crucial role in the ecosystem.
Table of Contents
What Is a Smart Contract?
A smart contract is a digital agreement between two parties stored on a blockchain.
As the name implies, these ‘contracts’ work largely similarly to traditional contracts used in everyday life. The difference is that smart contracts are a form of code rather than a piece of paper.
Many crypto enthusiasts see smart contracts as broadening the concept of decentralization, that is, managing funds without relying on a bank or third party. Because smart contracts are executed immediately without needing to be signed off, they negate the need for an intermediary to step in, making them both fast and efficient.
Where Did Smart Contracts Come From?
Computer scientist and programmer Nick Szabo conjured up the concept of the smart contract in 1994. Throughout the 1990s, Szabo primarily focused on Bit Gold, one of the earliest attempts at a decentralized virtual currency.
Though Bit Gold struggled to gain mainstream appeal, it did prompt Szabo to start wondering what other aspects of life, aside from currency, could enter the digital realm. Eventually, he landed on smart contracts—mutual agreements that could be executed on a computer.
Importantly, when discussing the concept in his The Idea of Smart Contracts paper, Szabo also mentioned that these contracts could be used in tandem with “synthetic assets”, predicting their use within crypto years before they were even introduced.
The lack of blockchain technology at the time restricted smart contracts from seeing the light of day, and Bitcoin (BTC) also hesitated to incorporate them in 2008. Finally, in 2015, Ethereum (ETH) entered the scene to become the world’s first cryptocurrency network supporting smart contract functionality.
Ethereum has been widely recognised as the central hub of smart contracts, primarily because its unique Solidity programming language streamlines the development process. It might not be the only blockchain that can run smart contracts, but none have amassed a community as big as Ethereum.
Since its inception in 2015, over 4,000 Dapps have arrived on the Ethereum blockchain, and it’s unlikely that any other network will be able to achieve this staggering feat anytime soon.
How do Smart Contracts Work?
Smart contracts use “If/When… then…” statements within their code to register its conditions, such as the parties involved and the actions that are obliged to be performed.
Once both parties have met the agreement’s conditions, the contract will immediately execute the actions it was designed to perform. This level of automation makes smart contracts much faster in practice than their real-life counterparts.
Here’s a clear layout of how it works step-by-step:
- Development: The contract is developed in smart contract code and inserted into the blockchain platform.
- Setting out Conditions: The predefined conditions and terms of a contract are set out for both parties to acknowledge.
- Action: Once the conditions have been met, the contract immediately executes the specified actions.
- Record: The transaction will then be recorded on the blockchain’s distributed ledger for full transparency and immutability.
The easiest way to think about smart contracts in practice is through an example set out by Nick Szabo. When you approach a vending machine, you must insert the correct amount of money and press the button for the item you want. Then, in accordance with the request, the machine picks up and drops the item. This can be seen as a smart contract acting out in real-time.
Smart Contract Use Cases
If we bring this back to crypto, developers have found ways to use smart contracts for many purposes that benefit investors. As we will see, smart contracts can be used to create complex services and platforms and perform very basic activities.
Dapps
When related to finance, Dapps, or DeFi apps, are applications built upon a blockchain that are automated using smart contracts. These are the most popular ways smart contracts are used in relation to crypto.
You can think of this almost as a hierarchy: apps are created through smart contracts, which are stored and executed on the blockchain. Dapps can be anything from blockchain games to financial applications to social media platforms. What defines them all is that they are decentralized, which is made possible by the smart contract.
So, whereas regular apps that we use every day are centralized and hosted by a big tech company, in the case of Dapps, this authority figure is replaced by a smart contract, negating the need for a third party.
Decentralized Exchange (DEX)
Decentralized exchanges (DEX) are a popular Dapp that can only exist and possess many benefits, thanks to the smart contract. No team running things from the background means cheaper fees compared to centralized exchanges, and no point of failure makes them difficult to hack and expose.
Remember, even the most basic transaction will need a smart contract to be agreed upon by both parties when a third party isn’t involved. Since DEXs are all about users buying and selling tokens, smart contracts are important in allowing this to occur.
Token Minting
Minting or creating a token will require a smart contract so that the developer can set out the rules and properties of the new digital asset. Over the years, many token developers have used precedent standards, such as ERC-20, which essentially set out a prewritten smart contract to make minting faster and easier.
NFT Creation
That’s right. Even NFTs (Non-fungible tokens) are built using a smart contract that defines the trading properties and requirements and keeps a log of the owner’s identity.
While smart contracts will hold an NFT’s key information, they also need to customize and set out the royalty methods of an NFT. Essentially, NFTs wouldn’t even exist without smart contracts, let alone being open to trade.
Smart Contract Use Cases Outside of Crypto
So far, we’ve been discussing smart contracts primarily within the cryptocurrency ecosystem, but they have also been used to great effect off-chain. Here are just a few key departments where smart contracts have been utilized and their specific use cases.
- Healthcare: Smart contracts can be used by healthcare providers to access patient information at a moment’s notice, reducing manual intervention and paperwork.
- Retail: Smart contracts make it so that the supplier can be paid automatically based on the predetermined conditions, minimizing delays in the supply chain and ensuring a smooth transaction.
- Global Trade: By using smart contracts, international traders can eliminate the need for a manual auditing process.
- Voting Systems: Provides an alternative method of safe and secure voting for those who might not be comfortable, or able to visit the ballot box.
- Real Estate: A smart contract can automatically register several real estate agreements, such as buying and selling, compliance checks, fractional ownership, etc. These can usually take longer when brokers or lawyers are involved, making the whole process quick and easy.
It does need to be mentioned that since smart contracts negate the need for solicitors or lawyers in many areas, there is still great uncertainty on how they will fare in the long term. However, incorporating them into major fields could be hugely beneficial, as has been the case with the areas listed above.
Benefits of Smart Contracts
Although smart contracts can be easy to forget about, considering that they work behind the scenes, they still provide several key benefits that many of us aren’t even aware of.
- Speed: Smart contracts execute contracts as soon as the conditions are met and are, therefore, self-executing, so no time is spent signing off paperwork or reconciling errors.
- Security: Smart contracts are blockchain-based, which makes them very difficult for hackers to expose because they lack a central authority to fail and use additional cybersecurity measures.
- Transparency: The requirements and results of a smart contract are shared between both parties, ensuring a trustless agreement. This deters people from being bad actors since they must agree on terms and conditions.
- Cheap: No intermediaries mean no delays or fees that need to be spent on a third party’s assistance. This is why DEXs, powered by smart contracts, tend to be cheaper than CEXs.
- Decentralization: By replacing third-party involvement, smart contracts facilitate the ethos of decentralization, which is largely what defines cryptocurrency.
- Interoperability: Smart contracts allow blockchains to communicate with one another. This level of interoperability can open up new possibilities for Dapps and collaborations in the future.
Drawbacks of Smart Contracts
Clearly, there are many reasons why smart contracts have been embraced by much of the crypto community, but that isn’t to suggest they don’t have a few drawbacks to keep in mind.
- Loopholes: As with real life contracts, loopholes in the contract can be exposed by bad actors who aren’t looking for a fair agreement.
- Immutable: As with crypto transactions, smart contracts cannot be changed if there are mistakes. While this is good for security purposes, it is almost impossible to fix an agreement once it’s been established.
- Oracle Reliance: If a smart contract is trying to get extra real-world info, it will require oracles. Oracles, however, aren’t known to be very secure since they can be tampered with by bad actors, so relying on them too much isn’t wise.
- Regulatory Issues: The legal status of smart contracts has yet to be determined as different jurisdictions deploy various regulations, stunting their widespread adoption.
On the Flipside
- Despite the benefits they can offer, some blockchains have been slow to adopt smart contracts fully.
- For example, Cardano only introduced them in 2021, and Bitcoin only supports contracts with basic functionalities.
Why This Matters
Buying and selling crypto on a blockchain is all well and good, but smart contracts can enable investors to uncover unique ways to interact with their assets. Therefore, they can support a person’s investment journey within the crypto ecosystem.
FAQs
Yes, NFTs (Non-Fungible Tokens) are based on smart contracts, which themselves are based on a blockchain network.
Artificial intelligence-powered smart contracts can introduce new capabilities, such as automated decision-making and predictive analysis. However, AI integration has not yet become a mainstay of smart contract development.
A DAO, short for decentralized autonomous organization, is an organizational structure that doesn’t contain a governing body. Therefore, it is decentralized. DAOs rely on smart contracts to function, primarily to tally votes between community members and execute actions accordingly.