If you’ve just recently started exploring the exciting world of blockchain technology and cryptocurrency, you’ve probably run into the term “smart contract” several times by now. You might have some sort of idea about what it means, or you even heard about this guy named Ethereum that has some of the best smart contracts in town. However, if you’re really serious about dipping your toes in the crypto pool, you should learn a lot more than that.
In this article, we’ll provide you with the ultimate introduction to smart contracts and show you everything you need to know about this innovative technology.
What Is a Smart Contract?
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Smart contracts are programs that exist on a specific blockchain and are activated when the predetermined conditions are met. Just like with “real” contracts, they are used for forming the terms of an agreement. However, unlike traditional contracts, the terms in a smart contract are carried out in the form of a code written on a blockchain. Because smart contracts have the ability to automate agreement execution, parties that use them can immediately be informed of the outcome of an agreement. Plus, they don’t need to waste time with any intermediaries. Some companies even use smart contracts for workflow automation because they can initiate the next step in a process once the criteria are satisfied. Lastly, smart contracts are frequently used by developers that want to make the most out of blockchain security in the apps that they’re building.
In short, smart contracts provide cutting-edge peer-to-peer functionality and can be used for logistics, gaming, loans, and much more. They eliminate the need for a third-party intermediary, central authority, legal entity, or any other external mechanism to verify the credibility of a transaction or agreement.
The Story behind Smart Contracts
The first person to introduce smart contracts was an American computer scientist and lawyer named Nick Szabo in 1994. Szabo is also known for creating “Bit Gold” in 1998, the first virtual currency that came one decade before Bitcoin. Interestingly, many crypto enthusiasts believe that Nick Szabo is actually Satoshi Nakamoto, also known as the anonymous creator of Bitcoin. However, Szabo has denied all of these claims. Szabo coined the term “smart contract,” and he defined it as a computerized transaction protocol that can carry out the terms of a specific contract. His primary goal was to advance the accessibility and functionality of digital transaction systems.
In his paper on smart contracts, Szabo suggested using the contracts for derivatives, bonds, and similar synthetic assets. "These new securities are formed by combining securities (such as bonds) and derivatives (options and futures) in a wide variety of ways. Very complex term structures for payments can now be built into standardized contracts and traded with low transaction costs, due to computerized analysis of these complex term structures."
He also provided a great analogy and compared smart contract technology to vending machines. Let’s say that there’s a machine that sells cookies for a nickel. Now, if you put a quarter into the vending machine and pick a cookie, the machine is engineered to give you the cookie and 20 cents in return. Or, if the cookie you chose isn’t available, it will tell you to pick something else or return the quarter. That’s exactly how smart contracts work. Instead of using a human intermediary, a vending machine automatically executes once you’ve fulfilled your end of the deal (given enough money). Smart contracts do the same and can automate pretty much any type of exchange.
How Do Smart Contracts Work?
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Smart contracts work by following the specific statements embedded in the blockchain code – if/when/then. When the predetermined terms have been fulfilled, the digital network executes the action, which can be anything from registering a vehicle to conducting a crypto trade. Once the transaction is completed, the blockchain network is automatically updated, and the transaction can’t be reversed. There isn’t any set limit on how many stipulations can be added, just as long as all the parties agree on them. When determining the terms, the participants need to determine how their data and the transactions will be represented, and establish the if/when/then statements we mentioned earlier. They also have to establish potential exceptions and define how possible disputes will be resolved. After they agree on the terms, they might hire a developer to program the smart contract. However, most organizations tend to incorporate templates, digital interfaces, and similar tools for the smart contract framework.
We’ve already covered Szabo’s vending machine analogy to explain how smart contracts work, but let’s also take a look at an actual example of a simple smart contract.
Let’s say that Dexter wants to buy Joey’s car. They created an agreement on the Ethereum blockchain through a smart contract that contains all the terms they predefined.This is how the agreement would look like (in a nutshell) – “WHEN Dexter pays Joey 50 ETH, THEN Dexter will get ownership of the car.” After the terms have been implemented into the smart contract, it’s legally binding, and there’s no way for either party to change them. That means that Dexter can transfer money to Joey on a specified date using a specific address, and the ownership change will execute automatically without additional interference.
In this basic example, both Dexter and Joey benefit from the smart contract since they eliminate the need to pay any extra fees for hiring a third-party intermediary (e.g. lawyer).
Benefits of Smart Contracts
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Now that we’ve covered what smart contracts are and how they’re used, let’s move on to the precise benefits.
Transparency
Smart contracts contain detailed terms and conditions that all parties involved in the transaction agree upon. This means that there’s little to no chance of any issues or disputes occurring in the later stages of the transaction. The participants are the ones establishing transparency. Plus, with no third party involved, participants don’t have to worry about the details being modified for anyone’s personal benefit.
Speed and Efficiency
With traditional contracts, third parties typically have to deal with a bunch of paperwork which means that it can take days (if not weeks) for a contract to be fulfilled. Smart contracts offer the complete opposite – they execute a contract as soon as certain criteria are met. Because they’re pieces of code that flow through the internet, the execution can literally take seconds. There’s no documentation and unnecessary steps along the way that can lead to a delay.
Security
Because they operate on blockchain networks, smart contracts are fully decentralized and ensure maximum fairness. There’s no central party (bank, lawyer, government, broker, etc.) controlling them. Instead, the blockchain database is run by countless computers (aka nodes) that belong to countless different people. This means that hacking the blockchain on which the smart contract is built is practically impossible. For instance, a hacker would have to hack into more than 50% of the nodes to even begin launching an attack on the smart contract. Plus, the transaction records are fully encrypted and linked to previous records on a distributed ledger.
Savings
Using smart contracts can lead to hefty savings. Since there’s no need to include any middlemen or intermediaries, you won’t have to spend any extra money on hiring them to execute the contract. And, with no paperwork, time delays, and manual interruptions, you won’t have to worry about any unexpected fees either.
Limitations of Smart Contracts
While the benefits of incorporating smart contracts are pretty much undeniable, there are a few limitations that you should be aware of. Let’s go through them.
Lack of Flexibility
In some scenarios, logic-based contract execution isn’t exactly optimal. There can be lots of subjective elements included in contracts, including the “good faith” concept that leaves room for flexibility. Contracts based on good faith can be very helpful when two parties are striving for a relational contract, not just a transactional one. Smart contracts fall short in this situation.
No Room for Changes
Changing even the slightest detail in a smart contract is practically impossible. While this is good for security reasons, it can be quite annoying to deal with an issue in case any errors in the code occur. Not only is it time-consuming to correct the errors, but it can also be expensive.
Human Error
As with any blockchain transaction, human error can cause problems with smart contracts in a number of ways. First, the contract’s code could be written incorrectly, meaning that nothing happens when the parties perform their part in the transaction. Things could also go wrong if the cryptocurrency address receiver has incorrect or incompatible information. Money could be transferred to the wrong address and be permanently irrecoverable. Incompatible currency could also be sent. For example, if we look at Dexter and Joey’s basic smart contract, the contract terms state that Dexter has to pay 50 ETH, but it doesn’t specify the token standard. Dexter might hold his ETH on Binance Smart Chain as the token standard BEP20, and Joey’s wallet might only support the token standard ERC20. Although the smart contract code specifies ETH as payment, it won’t account for wallet incompatibility. Although both contracting parties fulfilled their obligations correctly according to the legally binding smart contract code, by transferring incompatible token standards, the funds could be lost forever.
Smart Contract Use Cases
With smart contracts constantly evolving, there are hundreds of new businesses and industries each year turning to them for help in simplifying contractual agreements. Here are some of the most popular smart contract applications nowadays.
Healthcare
Even though smart contract usage hasn’t yet been widely adopted by the healthcare community, its benefits are becoming harder to ignore. Firstly, companies can use blockchain technology for secure data storage of patient records. Only those who have the private key to the blockchain can access the records, resulting in much more privacy when dealing with these documents. Furthermore, experts in the industry can benefit from the private and secure nature of smart contracts when conducting research and studies. Patient hospital receipts can also be stored on a blockchain network and automatically distributed to insurance providers. Other notable tasks that can leverage smart contracts include drug administration, supply and resource management, and regulatory compliance.
Supply Chain Management
From a historical perspective, supply chains are generally harmed by paper-based systems where the documentation has to go through a variety of channels until it’s approved. Not only does this process take a lot of time, but it also maximizes the risks of fraudulent behavior. Blockchain technology eliminates these issues by offering supply chain participants a safe and accessible digital version of the process. Inventory management, payments and transactions, and job automation are just some of the processes that smart contracts can streamline.
Traditional Financial Services
Smart contracts are slowly revolutionizing the entire finance industry and its traditional services.
Here are some of the most notable examples:
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Insurance claims – Checking insurance claim legitimacy can often be extremely overwhelming. The insurance company needs to assess manual contract terms and validate the claim, which can take a long time. Smart contracts make filing claims a lot easier and provide automatic validation through decentralized ledgers.
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Lower transaction costs – Smart contract transactions are self-regulatory and self-executed. This greatly minimizes the need for manual intervention and lowers the cost of record-keeping.
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Transparent auditing – Because smart contracts use incorruptible blockchain codes, they increase audit transparency and minimize the risk of infiltration.
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Simplified KYC verification – KYC is one of the most important financial services. Banks and similar institutions always verify the identity of their customers before giving out a loan or offering another service. By using smart contracts, they simplify the process by verifying their credit scores via blockchain records.
Voting System
Smart contracts can help with creating a safe voting environment. Votes cast on smart contracts can’t be tampered with since they’re ledger-protected. What’s more, using smart contracts can have an influence on overall voter turnout, which has been incredibly low in the past few decades due to the ineffective system currently in place.
Most Popular Smart Contract Platforms
Although some organizations prefer to create smart contracts from scratch, it’s much easier to take advantage of existing blockchain networks that already support them. Let’s go through some of the most popular platforms.
Ethereum
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Launched in 2015, Ethereum is the world’s first and most popular smart contract platform. Vitalik Buterin (Ethereum Founder) first offered to introduce app development capabilities to Bitcoin, but after they rejected him, he decided to create his own platform. Because of Ethereum’s stellar reputation and variety of smart contract opportunities, it has the largest developer community in the industry (200,000+). The biggest advantages of Ethereum’s smart contract platform are superior security, standardization, and responsiveness. With clear development guidelines and a unique coding language (Solidity), creating DApps on the Ethereum network is much easier compared to other platforms.
Polkadot
Image Source: Currency.com
Polkadot was developed by Gavin Wood, the co-founder of Ethereum and creator of Solidity. Polkadot isn’t a typical blockchain network, instead, it works as a blockchain ecosystem that incorporates a variety of interlinked platforms. The main part of Polkadot’s system is Relay Chain – a component that overlooks the network’s parachains and parathreads, and manages their interoperability. Parachains are also one of the primary reasons why so many developers are drawn to Polkadot; it allows them to build their own blockchains with custom governance tokens. Also, parachains are used as fragments that contribute to the blockchain’s cutting-edge scalability and incredibly fast transactions. Lastly, Polkadot provides bridge chains that connect parachains to other blockchains (e.g. Ethereum).
Solana
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Solana was developed in 2017 by some of the finest software engineers in the world that worked in leading tech companies like Intel and Dropbox. It belongs to the newer generation of smart contract platforms, and it was created with the goal of solving the scalability issues that platforms like Ethereum are experiencing. Currently, Solana has the highest throughput in the industry, with a record-high 65,000 TPS (transactions per second). This is possible due to its unique combination of PoH (proof-of-history) and PoS (proof-of-stake) consensus models. In a nutshell, transactions aren’t combined in blocks, instead, each transaction is stored in its own block and serves as an input for the next one. Furthermore, Solana incorporates top-notch technology such as Sealevel that allows smart contracts to be processed at the same time without congestion. For DApps that need instant outputs, there’s currently no faster platform on the market than Solana.
Additionally, Solana is home to one of the most promising P2E crypto games currently on the market – Wizardia. Wizardia is a play-to-earn RPG crypto ecosystem that uses Metaverse and NFT technology. It also leverages Solana’s robust smart contracts to provide players with an immersive gaming experience. Within the ecosystem, players battle with wizards that come in form of NFTs with unique artwork and abilities. At the time of writing, Wizardia is in its sixth sale round of Arena Genesis NFTs, and there are only 643 tokens left.
Conclusion
With an ability to eliminate middlemen, offer instant transactions, and help avoid manual errors in dealing with paper-based documentation, smart contracts are the future of business and finance. Even though it’s still unlikely that smart contracts will completely replace traditional contracts, it’s safe to say that they’re not just a fad that will disappear in a few years' time.
FAQs
How Do You Explain a Smart Contract?
In simplest terms, a smart contract is a self-executing and self-verified contract that exists on a blockchain and is activated when predetermined conditions are met. It removes the need for third-party intermediaries and streamlines the transaction for multiple parties. Smart contracts also allow developers to create decentralized apps and tokens and are the backbone of DAOs.
What Are Smart Contracts with Example?
Smart contracts work by following the if/when/then statements embedded in the blockchain code. So, let’s say that Dexter wants to buy Joey’s car and they define the agreement on a smart contract. That would look something like this: “WHEN Dexter transfers 50 ETH to Joey, THEN he will receive the ownership of the car”.
Who Introduced Smart Contracts?
Smart contracts were first introduced in 1994 by an American lawyer and computer scientist named Nick Szabo.
Filip Stojanovic
Filip is a full-time content writer, part-time copywriter, and small-time tennis player. His dream is to win a Grand Slam title, but writing killer content isn't too shabby either!
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