A smart contract is a digital contract that is automatically executed when predetermined conditions are met on a blockchain network.
A smart contract facilitates trustless transactions between individuals who may choose to remain anonymous, eliminating the need for an intermediary like a bank.
Smart contracts make transactions traceable, transparent, and irreversible.
Smart contracts are core elements of decentralized finance (DeFi). They replace intermediaries in financial transactions, where transactions are executed once conditions are met. Smart contracts took decentralization to the next level since users can automatically perform the approved contracts with total transparency.
This article delves into smart contracts, their history, how they work, their advantages and disadvantages, and their use cases.
What are Smart Contracts?
Smart contracts are self-executing computer programs that live on a blockchain. They are made up of codes stipulating predetermined terms and conditions that, when met, activate specific outcomes. By operating on a distributed ledger, like a blockchain, smart contracts enable parties to reach an agreement accurately on schedule, while ensuring immutability.
Smart contracts are vital infrastructure for automation since a central authority does not regulate them; hence making them more resistant to a single point of failure. When deployed in multi-party agreements, smart contracts minimize counterparty risk, boost efficiency, reduce expenses, and introduce extra transparency into processes.
Generally, smart contracts are used to automate the implementation of agreements for parties to achieve near-instant finality without the involvement of a third party. They automate workflows and activate the next possible action when the coded instructions are met.
Features of Smart Contracts
These are the main features of smart contracts:
Smart contracts minimize human intervention significantly since they are self-enforceable. Their logic-driven codes unlock value/access when the predetermined conditions are fulfilled.
Smart contracts can validate themselves when users follow the coded conditions. In the case of a breach, they can penalize the offender according to the rules. For instance, a smart contract can cancel a pending loan if the borrower fails to lock up their collateral within the predetermined timeline.
One party cannot alter the agreed-upon terms of a contract, minimizing corruption and partisan advantage to one party. The only way of editing a smart contract is by adding an extra block to the current network with the mutual consent of all users.
History of Smart Contracts
Nick Szabo, an American computer expert, legal scholar, and cryptographer, was the first to introduce smart contracts in 1994. In his seminal essays, he offered a general definition of a smart contract as follows: “a computerized transaction protocol that executes the terms of a contract,” with broad objectives to “satisfy common contractual conditions, minimize exceptions both malicious and accidental, and minimize the need for trusted intermediaries.”
Though a practical analogy of smart contracts is demonstrated in systems such as vending machines (i.e., a code triggers an anticipated snack once the condition of inserting money is met), blockchains established the basis for digital, immutable, and permissionless smart contracts. The launch of the Bitcoin network in 2009 presented possibly the first protocol smart contract – creating a set of conditions that must be met to move BTC across wallets. The requirements include a BTC sender confirming the transfer with the correct private key and holding adequate assets to fund the transaction.
The Bitcoin network then advanced to support another smart contract type in 2012 – a multisig transaction. This transaction requests a certain number of users (public keys) to sign a transaction with their private keys to validate it. The technique solidifies the security of user assets by preventing a single point of failure, like a hacked or lost private key.
Developers started actively experimenting in the subsequent years and introduced new operation codes or opcodes. Nevertheless, the next major smart contract milestone came with the publication of the Ethereum whitepaper in 2013. Ethereum developers deployed a new blockchain for programmable smart contracts two years later. Instead of acting exclusively as one smart contract use case or providing limited opcodes, the new chain presented a “world computer,” the Ethereum Virtual Machine, which could simultaneously operate multiple sovereign smart contracts.
How Does a Crypto Smart Contract Work?
A smart contract functions by following basic “if, when, then” statements encoded into a blockchain. A decentralized network of computers performs the transaction requests when predetermined terms have been fulfilled and confirmed. The requests could be sending assets to designated wallets, minting an NFT, sending alerts, or distributing an event ticket. Validators then include the transaction in the blockchain when the action is finalized. This means the action cannot be reversed or corrupted.
A smart contract can contain as many provisions as possible to assure participants that the activity will be finalized appropriately. To create the terms, the users must clarify how transactions and related information are denoted on the network, consent to the “if, when, then” commands that regulate the transactions, probe all likely omissions, and devise a mechanism for resolving disagreements.
Anyone can build a smart contract and run it on a blockchain to perform various roles, such as an individual yield aggregator that automatically moves assets to the best-yielding decentralized application (dApp). But blockchain-as-a-service (BaaS) companies also offer templates, website interfaces, and other essential tools to simplify smart contract creation.
Smart contracts often involve several independent participants who may be anonymous and only sometimes trust each other. The contract specifies precisely how participants interact, who can interact with the contract, at what time, and what inputs produce what outputs. The product is a multi-faceted digital agreement that involves the current probabilistic state to a new deterministic state.
Advantages of Smart Contracts
Smart contracts can automate the contract lifecycle and digitize operations. Below are some of the primary benefits of smart contracts:
The terms and conditions of a smart contract is accessible to all parties, and as smart contracts are based on the blockchain, they ensure the immutability of data while providing all parties access to the records in the event of any confusion or disagreement.
Autonomy and Savings
Smart contracts do not require a centralized authority or third party to validate them; hence, they remove the risk of corruption and human errors prevalent in custodians. Furthermore, the elimination of third parties from the equation also reduces costs and streamlines the process.
Smart contracts embrace automation through computer protocols, removing the need for intermediaries and saving many hours of manual work needed to draft a contract manually.
Since smart contracts eliminate manual input from the equation and automate processes, they minimize the occurrence of human errors in documents.
Limitations of Smart Contracts
Though there are numerous reasons to use smart contracts, there are a few concerns you should be aware of, such as:
Once a smart contract is executed, there is no way to undo the transaction. While changes can be made to the code, it will only apply to future transactions. This is why smart contract auditing is important, as the auditor will check for security vulnerability and other potential issues instead of “testing in prod.”
Smart contracts are inflexible as they are objective and will execute once conditions are met. Traditional contracts may include phrases such as “good faith” or “reasonable” to establish room for flexibility. Such terminology is necessary when showing a relational agreement instead of a transactional one.
While smart contracts offer transparency by having all information recorded on the blockchain, this also means that anyone can access this information, and most users would prefer to keep their transaction details private. For example, after interacting with a smart contract, your wallet address can be traced and your entire transaction history exposed.
Smart Contracts and Decentralized Applications
A dApp is an open-source software application that runs on a blockchain or peer-to-peer (P2P) network. While dApps resemble regular apps, they work differently as they operate on decentralized protocols without the involvement of any centralized entities. They bridge the gap between web2 and web3.
A smart contract is an on-chain component of a dApp. We mentioned that smart contracts are self-enforcing computer programs that automatically execute transactions when the agreed-upon terms are fulfilled.
dApps leverage smart contracts as their backend – authorizing transfers and links to the blockchain. Smart contracts are key to decentralized applications, as they run on the logic coded in every contract without any central entity.
Smart contracts are integral elements of DeFi as they form the core building blocks of dApps. They have the potential to improve the transparency, speed, and accuracy of transactions without needing to rely on a third party. However, while their immutability ensures transparency, that also means that there is no "undo" button once the transaction is executed. If you are using smart contracts for transactions, consider using a crypto exchange platform or a secondary wallet to avoid doxxing your crypto balance and transaction history.
Josiah is a tech evangelist passionate about helping the world understand Blockchain, Crypto, NFT, DeFi, Tokenization, Fintech, and Web3 concepts. His hobbies are listening to music and playing football. Follow the author on Twitter @TechWriting001