How do crypto smart contracts work?

Key takeaways:

• A smart contract is a digital contract that is executed automatically when predetermined conditions are met on a blockchain network.

• A smart contract facilitates trustless transactions between individuals who can choose to remain anonymous, eliminating the need for an intermediary such as 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 carried out when conditions are met. Smart contracts took decentralization to the next level since users can automatically execute the approved contracts with total transparency.

This article delves into smart contracts, their history, how they work, their pros and cons, and their use cases.

What are smart contracts?

Smart contracts are self-executing computer programs that live on a blockchain. They consist of codes that establish predetermined terms and conditions that, when met, activate specific outcomes. By operating on a distributed ledger, such as a blockchain, smart contracts enable parties to reach an agreement exactly on schedule, while ensuring immutability.

Smart contracts are important infrastructure for automation since a central authority does not regulate them; thus making them more resilient to a single point of failure. When implemented in multi-party agreements, smart contracts minimize counterparty risk, increase efficiency, reduce expenses and introduce additional transparency into processes.

Typically, smart contracts are used to automate the implementation of agreements for the 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 fulfilled.

Functions of smart contracts

These are the main features of smart contracts:

Self-executing

Smart contracts significantly minimize human intervention since they are self-enforceable. Their logic driven codes unlock value/access when the predetermined conditions are met.

Self-affirming

Smart contracts can validate themselves when users follow the coded conditions. In case of violation, they can punish the offender according to the rules. For example, a smart contract can cancel a pending loan if the borrower fails to unlock the collateral within the predetermined timeline.

Immutable

A party cannot change the agreed terms of a contract, which minimizes corruption and biased favoring of a party. The only way to edit a smart contract is to add an additional block to the current network with the mutual consent of all users.

The 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 gave a general definition of a smart contract as follows: “a computerized transaction protocol that executes the terms of a contract,” with broad goals of “satisfying common contractual terms, minimizing exceptions both malicious and accidental, and minimizing the need for trusted intermediaries.”

Although a practical analogy of smart contracts is demonstrated in systems such as vending machines (ie, a code triggers an expected snack when the condition to deposit 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 in order to move BTC across wallets. The requirements include a BTC sender confirming the transfer with the correct private key and having sufficient assets to fund the transaction.

The Bitcoin network then advanced to support another smart contract type in 2012 – a multisig transaction. This transaction asks a certain number of users (public keys) to sign a transaction with their private keys to validate it. The technique strengthens the security of user assets by preventing a single point of failure, such as a hacked or lost private key.

Developers began actively experimenting in the following years, introducing new operation codes or opcodes. Still, the next big milestone for smart contracts came with the release of the Ethereum white paper in 2013. Ethereum developers implemented a new blockchain for programmable smart contracts two years later. Instead of acting solely as a smart contract use case or providing limited opcodes, the new chain presented a “world computer”, the Ethereum Virtual Machine, which could simultaneously run multiple sovereign smart contracts.

How does a crypto smart contract work?

A smart contract works by following basic “if, when, then” statements encoded into a blockchain. A decentralized network of computers executes the transaction requests when predetermined conditions are met and verified. The requests can be to send assets to designated wallets, create an NFT, send notifications or distribute an event ticket. Validators then include the transaction in the blockchain when the action is complete. This means that the action cannot be reversed or destroyed.

A smart contract can contain as many provisions as possible to assure the participants that the activity will be properly terminated. To create the terms, users must clarify how transactions and related information are entered on the network, agree to “if, when, then” commands governing the transactions, investigate any likely omissions, and devise a mechanism to resolve disputes.

Anyone can build a smart contract and run it on a blockchain to perform various roles, such as an individual return aggregator that automatically moves assets to the best-yielding decentralized application (dApp). But blockchain-as-a-service (BaaS) companies also provide templates, website interfaces, and other essential tools to facilitate smart contract creation.

Smart contracts often involve multiple independent participants who may be anonymous and only sometimes trust each other. The contract specifies exactly how the participants interact, who can interact with the contract, at what time and which inputs produce which outputs. The product is a multifaceted digital agreement that involves the current probabilistic state of a new deterministic state.

Advantages of smart contracts

Smart contracts can automate the contract’s life cycle and digitize operations. Below are some of the key benefits of smart contracts:

Transparency

The terms and conditions of a smart contract are available to all parties, and since smart contracts are based on the blockchain, they ensure the immutability of data while giving all parties access to the records in case of confusion or disagreement.

Autonomy and savings

Smart contracts do not require a centralized authority or third party to validate them; thus they remove the risk of corruption and human error that is prevalent among managers. Furthermore, eliminating third parties from the equation also reduces costs and streamlines the process.

Speed

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.

Accuracy

Since smart contracts eliminate manual input from the equation and automate processes, they minimize the occurrence of human error in documents.

Limitations of smart contracts

While there are many reasons to use smart contracts, there are some concerns you should be aware of, such as:

Immutability

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 vulnerabilities and other potential issues rather than “testing in prod.”

Inflexibility

Smart contracts are inflexible since they are objective and will be executed when the 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 rather than a transactional one.

Confidentiality Challenges

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 prefer to keep their transaction details private. For example, after interacting with a smart contract, your wallet address can be tracked and your entire transaction history exposed.

Smart contracts and decentralized applications

A dApp is open source software that runs on a blockchain or peer-to-peer (P2P) network. While dApps are similar to regular apps, they work differently as they operate on decentralized protocols without the involvement of any centralized entity. They build a bridge between web2 and web3.

A smart contract is a chain component of a dApp. We mentioned that smart contracts are self-enforcing computer programs that automatically execute transactions when the agreed terms are met.

dApps leverage smart contracts as their backend – authorizing transfers and linking to the blockchain. Smart contracts are the key to decentralized applications, as they run on the logic encoded in each contract without any central entity.

Conclusion

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 having to rely on a third party. But while their immutability ensures transparency, it also means there is no “undo” button once the transaction is done. If you use smart contracts for transactions, consider using a crypto exchange platform or a secondary wallet to avoid doxxing your crypto balance and transaction history.

Josiah Makori

Josiah is a tech evangelist who is 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