Smart contracts enable secure, automated transactions through self-executing code on blockchain networks. They simplify agreements and eliminate the need for intermediaries or human intervention. This smart contract explainer will explore how these contracts work, their practical applications, and the unique challenges they face within traditional systems.
KEY TAKEAWAYS
➤ Smart contracts automate and secure digital agreements.
➤ These digital contracts eliminate the need for intermediaries to ensure faster and more reliable transactions.
➤ Several major industries like finance, supply chain, and real estate benefit from smart contracts’ efficiency and cost reduction.
➤ Legal, security, and scalability issues pose challenges for smart contracts, but ongoing improvements are addressing these challenges effectively.
What are smart contracts?
➤ Smart contracts offer a new approach to creating and executing digital agreements. These computer programs are deployed and executed directly on a blockchain network. They contain codes that specify predefined conditions and automatically trigger actions when those conditions are met.
In short, no more lawyers, bureaucrats, and brokers to extract a toll!
Smart contracts run on decentralized blockchain networks rather than centralized servers. This means they enable multiple parties to achieve a shared outcome securely, accurately, and without interference.
The decentralized design of smart contracts also makes them ideal for automation. Because they operate without a central authority, these contracts are usually immune from single points of failure or malicious attacks.
In fact, automation is central to their functionality, as it reduces human error and ensures timely execution without intermediaries.
Smart contracts also reduce counterparty risk, boost efficiency, cut costs, and enhance transparency in multi-party agreements.
How smart contracts work
Smart contracts run on decentralized blockchain platforms like Ethereum. They encode business rules and operate on a blockchain or distributed ledger using a dedicated virtual machine.
➤ Put simply, smart contracts work based on “if/when…then…” logic. When predefined conditions are met and verified by a network of nodes, the contract automatically carries out the specified actions.
As a general rule of thumb, creating a smart contract begins with businesses or other relevant teams collaborating with developers. The developers are provided with an outline of the contract’s intended behavior in response to specific events.
Simple triggers might include actions like authorizing a payment, confirming a shipment, or tracking utility thresholds. More complex scenarios could involve calculating and processing derivatives or releasing an insurance payout upon verified events — for example, natural disasters or an individual’s passing.
Developers then use a smart contract development platform to encode and test the contract, ensuring it behaves as expected.
The completed contract usually undergoes a security audit, often performed by an internal expert or a third-party firm specializing in smart contract security. Once approved, the contract is deployed on the chosen blockchain or distributed ledger.
After deployment, the smart contract connects to an “oracle,” a cryptographically secured data source that supplies real-time event updates and data. The contract executes its programmed actions when it receives verified data from one or more oracles, thus ensuring all specified conditions are met.
Blockchain technology and smart contracts
Blockchain’s decentralized, tamper-resistant network supports smart contracts by storing each transaction across a network of nodes. This decentralization ensures that participants interact without relying on a central authority and provides a secure and reliable environment for smart contracts to operate autonomously.
Distributed ledger technology (DLT) underpins blockchain functionality by allowing smart contracts to record data securely across a network. Each action in a smart contract is recorded on multiple nodes — this ensures a transparent and permanent record.
This structure strengthens data reliability and provides resistance to tampering, adding another layer of security.
The role of oracles
Oracles connect blockchain networks to external data sources, enabling smart contracts to interact with real-world information.
For example, an insurance contract could automatically trigger a payment based on verified weather data provided by an oracle. Without oracles, smart contracts would be limited to data already on the blockchain, restricting their versatility.
Cross-chain smart contracts
Cross-chain interoperability allows smart contracts on different blockchains to communicate and transact with each other, expanding the range of applications.
For instance, a cross-chain contract could facilitate asset exchanges between Ethereum and Polkadot, enabling a broader scope of decentralized finance operations.
What programming languages are best for smart contracts?
Developers use a variety of programming languages to create smart contracts — each tailored to specific blockchain platforms.
Solidity remains the primary language for Ethereum and other EVM-compatible blockchains. It offers a high-level, contract-oriented syntax.
Vyper is another popular choice for writing smart contracts on the Ethereum network. It provides a simpler, more secure alternative with a Python-like syntax.
Similarly, developers tend to favor Rust for non-EVM blockchains like Solana and Polkadot because of its performance and safety features.
Aptos and Sui now use Move, a language originally developed by Facebook (now Meta) for the Diem project, due to its focus on safety and flexibility.
Additionally, WebAssembly (WASM) enables cross-platform compatibility, allowing smart contract development in languages like C, JavaScript, TypeScript, and Rust.
The evolution of smart contracts
The earliest recognizable concept of smart contracts appeared in the 1990s when computer scientist Nick Szabo proposed using digital protocols to automate and enforce agreements. His analogy of a vending machine helped illustrate how smart contracts could automate transactions by following preset conditions.
Szabo envisioned a future where digital systems could manage legal agreements and reduce the need for middlemen/arbitrators. His ideas gained traction as blockchain technology advanced, particularly with Ethereum’s launch in 2015, which brought smart contracts into practical use.
Szabo’s work was the earliest recognizable concept of automating agreements, which ultimately laid the groundwork for blockchain-powered smart contracts.
“[….]we can extend the concept of smart contracts to property. Smart property might be created by embedding smart contracts in physical objects. These embedded protocols would automatically give control of the keys for operating the property to the agent who rightfully owns that property, based on the terms of the contract.”
“For example, a car might be rendered inoperable unless the proper challenge-response protocol is completed with its rightful owner, preventing theft. If a loan was taken out to buy that car, and the owner failed to make payments, the smart contract could automatically invoke a lien, which returns control of the car keys to the bank.”
— Nick Szabo, in his seminal writing
The role of Bitcoin
The Bitcoin blockchain, launched in 2009, introduced one of the earliest forms of a smart contract protocol. It demonstrated how to enforce conditions that users had to meet to execute transactions.
➤ For instance, users must sign transactions with a private key that matches their public address and have sufficient funds to complete the transaction. These conditions created a secure and self-enforcing way to authorize transactions on the network.
In 2012, Bitcoin added another significant type of smart contract: multi-signature transactions. This feature requires a specified number of parties (each with their public and private keys) to sign a transaction before it is approved.
Multi-signature transactions improved security significantly by requiring multiple approvals. They reduced the risks associated with a single private key being lost or compromised.
Over the next few years, Bitcoin and other blockchains began experimenting with additional programmable conditions known as opcodes. However, a major breakthrough in smart contract functionality came with Vitalik Buterin’s 2013 Ethereum whitepaper.
When Ethereum launched in 2015, it expanded far beyond Bitcoin’s limited functionality.
It introduced a versatile blockchain capable of running multiple independent smart contracts simultaneously on a “world computer.” Thus, we had the first modern smart contracts as they are known and used today.
Platforms supporting smart contracts
Ethereum remains the most widely used platform for deploying smart contracts, largely due to its flexible infrastructure and native programming language, Solidity.
Ethereum’s network powers decentralized finance (DeFi), non-fungible tokens (NFTs), and various decentralized applications (DApps). The platform is the leading choice for complex smart contract applications in 2024.
Other blockchain platforms
- EOS: EOS provides a high-performance platform for smart contracts that prioritizes scalability and low transaction costs. It is designed to support large-scale applications with quick transaction speeds.
- Hyperledger Fabric: Developed by the Linux Foundation, Hyperledger is a permissioned blockchain widely adopted for enterprise applications. It allows businesses to deploy private blockchain solutions tailored to internal processes and regulations.
- Cardano: Cardano’s blockchain uses the Plutus programming language for its smart contracts, focusing on formal verification to enhance security. This makes it a suitable choice for applications where reliability is essential, such as financial and medical records management.
Key features of smart contracts
- Automation: Smart contracts automatically execute terms once specific conditions are met, streamlining workflows and minimizing the need for manual intervention. This automation enables immediate action when conditions are fulfilled.
- Security: Blockchain cryptography protects smart contracts from unauthorized access or tampering. The decentralized network verifies each contract execution, providing a defense against fraud and unauthorized changes.
- Transparency: The public ledger records every action taken by a smart contract, allowing all participants to view the contract’s terms and history. This transparency fosters trust among participants by ensuring that each action is verifiable.
- Trustless transactions: Smart contracts enable interactions without relying on trust in third parties. The contract code enforces terms, removing the need for an intermediary and allowing transactions to proceed solely based on predefined conditions.
Smart contract use cases
If something is quantifiable, like in a regular contract, it can be coded into a smart contract and stored on a blockchain.
Most common use cases of smart contracts in 2024 include (but are not limited to):
- Financial services: Smart contracts streamline lending, payments, and asset transfers in decentralized finance (DeFi). For example, a loan contract can release funds to a borrower when predefined conditions are met, with the repayment terms automatically enforced by the contract.
- Supply chain management: Smart contracts enhance transparency and accountability in supply chains by tracking products from origin to delivery. A contract can automatically update the status of goods as they move through each stage, reducing paperwork and improving traceability.
- Real estate: Smart contracts simplify property transactions by automating tasks like title transfers, escrow, and payment processes. This minimizes the need for intermediaries, reducing transaction times and the potential for errors.
- Legal agreements: Smart contracts enable the automation of legal agreements, such as rental contracts that trigger access permissions and payments automatically. This reduces disputes and enforces terms reliably, enhancing efficiency in legal transactions.
- Decentralized Applications (DApps): DApps leverage smart contracts to provide a range of services, including gaming, finance, and social networking, without relying on centralized control. By interacting through smart contracts, users gain a more transparent and self-reliant experience.
Benefits of smart contracts
| Benefits of smart contracts | Description |
| Efficiency and speed | Automates processes to reduce delays and completes transactions (typically) within seconds or minutes. |
| Cost reduction | Cuts transaction costs by removing intermediaries, e.g., no need for escrow in real estate. |
| Eliminating intermediaries | Enables direct execution between parties and reduces reliance on intermediaries. |
| Enhanced security | Cryptographic security on blockchain minimizes tampering, with network validation reducing fraud risks. |
Challenges and limitations
| Challenges and limitations | Description |
| Security vulnerabilities | Coding flaws can lead to exploits, as seen in the 2016 DAO hack; secure practices are essential. |
| Legal and regulatory hurdles | Uncertain legal status can limit use, especially in industries needing established legal frameworks. |
| Scalability issues | High network traffic can slow processing and raise fees. This could adversely affect smart contract efficiency. |
The future of smart contracts
Smart contracts hold significant potential for reshaping various sectors by providing trustless, automated solutions. With advancements in blockchain, oracles, and cross-chain capabilities, smart contracts are positioned to drive innovation while promoting efficient, decentralized interactions across industries.
The future of smart contracts may include more advanced capabilities, such as AI integrations. Developers are also exploring complex use cases, like autonomous organizations governed entirely by smart contracts, which could further decentralize and automate organizational structures. As these technologies mature, smart contracts are likely to become an integral part of mainstream business.
Frequently asked questions
What is a smart contract in blockchain?
How do smart contracts differ from traditional contracts?
What are some real-world applications of smart contracts?
Are smart contracts legally binding?
What risks are associated with using smart contracts?
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