What Are Smart Contracts and How Do They Work?

TL;DR

• Smart contracts are self-executing digital agreements on blockchains, such as Ethereum, that automate and enforce contract terms without intermediaries.

• Smart contracts offer transparency, security, decentralization, and efficiency.

• They have the potential to revolutionize industries and streamline traditional processes and transactions by eliminating the need for middlemen.

What Is a Smart Contract?

A smart contract is a digital agreement written in code, stored on a blockchain, and executed automatically without intermediaries. Powered by blockchain technology, smart contracts benefit from the blockchain’s security and transparency, providing users with a way to enforce agreements and streamline various processes.

Smart contracts are particularly useful for two parties to transact directly with each other, without needing to engage a third party to ensure the contract is honored by the buyer and seller. Let’s say you’re in the market for a piece of digital art. Traditionally, this transaction will require an art gallery to act as the intermediary. 

Instead of relying on this middleman, a smart contract uses computer code to automatically execute and enforce the terms of the agreement. You can think of it as a virtual "if-then" statement. For example, if the buyer sends the agreed-upon amount of money, the smart contract transfers ownership of the digital artwork from the seller to the buyer.

As smart contracts are based on blockchain technology, they are decentralized and can't be changed or tampered with once it's deployed. This mechanism makes them secure and trustworthy, as other users on the blockchain can verify the transactions and ensure that the contract is executed as intended.

What Are Smart Contracts Used For?

The use cases of smart contracts go beyond buying and selling things. They can increase blockchain's potential for mainstream adoption by enabling the creation of new use cases that are not possible with traditional systems. Current use cases include:

Financial transactions

Smart contracts can be used for secure and automated financial transactions, such as transferring digital currencies, making payments, or executing more complex financial agreements such as futures in a direct peer-to-peer manner.

Decentralized applications

Smart contracts serve as the backbone of many decentralized applications (DApps). These DApps encompass a wide array of functionalities, including decentralized finance (DeFi) platforms facilitating lending, borrowing, and trading, as well as gaming platforms that leverage non-fungible tokens (NFTs) for in-game items and virtual collectibles.

Smart contract NFT platforms enable the creation, ownership, and trading of unique digital assets as tokenized items, leveraging the programmability and security of smart contracts on blockchain networks.

Insurance

Smart contracts can simplify insurance processes by automating claims processing, verifying eligibility, and facilitating payouts based on predefined conditions. This can reduce paperwork, improve efficiency, and enhance transparency in the insurance industry.

Supply chain management

Smart contracts can track and verify the movement of goods throughout the supply chain, ensuring transparency, traceability, and reducing fraud. They can automate supply chain management processes such as order fulfillment, payment settlement, and quality control.

Intellectual property

Smart contracts can be used to manage the ownership and distribution of intellectual property, such as music, art, or written content. This is often done using NFTs. Smart contracts allow creators to define licensing terms, automate royalty payments, and ensure fair distribution of digital assets. 

Voting systems

Smart contracts can facilitate secure and transparent voting systems by ensuring the integrity of votes, preventing fraud, and enabling instant tabulation of results. This can help increase trust and transparency in democratic processes.

How Do Smart Contracts Work?

The smooth operation of smart contracts relies on a combination of blockchain technology, code execution, and decentralized consensus. Here's a simplified explanation of the complex inner workings of smart contracts:

1. Creation and deployment

A smart contract developer creates a smart contract using a programming language that’s compatible with the blockchain platform (such as Solidity for Ethereum). The contract is then deployed onto a blockchain network, becoming a part of the blockchain's decentralized ecosystem. Ethereum smart contracts are popular, but developers can also use other blockchains with smart contract functionalities, such as Solana and Cardano.

2. Code and conditions

The smart contract contains code that defines the terms, rules, and conditions of a specific agreement or transaction. These terms can be as simple as a single payment or as complex as a multi-step process with many participants and data point requirements.

3. Contract invocation

Once deployed, anyone with access to the blockchain can invoke the smart contract by interacting with it. Invoking a smart contract typically involves calling specific functions within the contract and providing the necessary inputs.

This could mean that regular users access a user interface or application that provides a friendly interface to interact with smart contracts, such as a decentralized application (DApp) used with a crypto wallet. The user can then select the desired action they want to perform (e.g. buying a crypto token), specify the amount, and send a request to finalize the trade.

4. Validation and execution

When a smart contract is invoked, the blockchain network validates the transaction and ensures that the conditions specified in the contract are met. This validation is performed by multiple nodes on the network through a consensus mechanism, such as Proof of Work (PoW) or Proof of Stake (PoS).

5. Immutable record

Once the conditions are validated, and the consensus is reached, the smart contract's code is automatically executed and the transaction is recorded as an immutable entry on the blockchain. Depending on the blockchain, this entry may include all the relevant details of the transaction, making it transparent and auditable.

6. Finality

The execution of a smart contract is final and cannot be reversed, as it's stored on a decentralized and tamper-resistant blockchain. This ensures the transaction's integrity and security, preventing fraud or unauthorized changes.

What Are the Disadvantages of Smart Contracts?

While smart contracts have numerous advantages, there are also a few drawbacks. Here are some of the disadvantages associated with smart contracts:

1. Dependency on external data

Smart contracts typically rely on external data sources, known as oracles, to retrieve information from the outside world. While smart contracts themselves are tamper-proof, these oracles can introduce potential vulnerabilities or inaccuracies because they are susceptible to manipulation and tampering.

2. Code vulnerabilities

Smart contract code, like any software, may contain vulnerabilities or bugs that can be exploited by malicious actors. Errors in code implementation or design can lead to security vulnerabilities that could result in financial loss or other negative consequences. Smart contracts need to undergo rigorous testing before being deployed to avoid exposing users to these dangers.

3. Scalability

Scalability and performance issues may arise if blockchain networks grow in size and usage. The limitations of blockchain networks can impact the speed and efficiency of smart contract execution, particularly in high-demand scenarios.

4. Immutability

Once a smart contract is deployed and executed on a blockchain, it becomes immutable, meaning it cannot be modified or reversed. While this is usually seen as a benefit of smart contracts, it can also be problematic if there are errors or bugs in the code, or if the contract needs to be updated due to changing circumstances.

How Are Smart Contract Problems Solved?

The cryptocurrency community is acutely aware of the drawbacks and challenges associated with smart contracts and is actively working to address them. For example, many crypto platforms have bug bounty programs with large rewards to encourage white hat hackers, developers, and researchers to identify and report vulnerabilities in smart contract code and disclose them responsibly.

There are also smart contract audit firms that offer services to conduct thorough security audits to identify and remediate vulnerabilities in smart contracts. Their goal is to follow best practices to ensure secure coding standards, including testing, code reviews, and formal smart contract verification techniques.

Furthermore, there’s a common goal among developers to create tools, frameworks, and standards to improve smart contract development practices. One way to do this is through standardization efforts aimed at establishing common interfaces, protocols, and formats for smart contracts. This can improve interoperability and ensure compatibility between different blockchain platforms, making it easier to integrate smart contracts with other protocols, enabling seamless interactions.

Does Bitcoin Have Smart Contracts?

Bitcoin's scripting language allows for the creation of simple smart contracts, but its capabilities are more limited than programmable smart contract blockchains like Ethereum. Bitcoin’s programming language, Script, allows users to set rules and conditions for spending their BTC, but it's not designed for more complex smart contract functionalities. In addition, Bitcoin can support smart contracts on protocols built on top of the Bitcoin network, such as the Lightning Network.

You may be wondering how Bitcoin NFTs and Ordinals use smart contracts. They don’t use smart contracts; instead, the files are inscribed directly onto individual satoshis, which are then included in blocks on the Bitcoin blockchain.

Closing Thoughts

Smart contracts are self-executing digital agreements that enforce the terms of a contract without the need for intermediaries. They leverage blockchain technology to provide transparency, security, and efficiency. Smart contracts have the potential to revolutionize traditional business processes, enabling secure and automated transactions, reducing costs, and providing new functionalities.

Smart contracts also present a few challenges, but the crypto community and individual protocols are actively working to address these drawbacks through continuous testing, security measures, and ongoing development efforts. As smart contract technology evolves, we can expect to see further innovation and adoption, shaping the future of decentralized and trustless transactions.

Disclaimer and Risk Warning: This content is presented to you on an “as is” basis for general information and educational purposes only, without representation or warranty of any kind. It should not be construed as financial, legal or other professional advice, nor is it intended to recommend the purchase of any specific product or service. You should seek your own advice from appropriate professional advisors. Where the article is contributed by a third party contributor, please note that those views expressed belong to the third party contributor, and do not necessarily reflect those of Hibt Academy.