What are smart contracts?
Smart contracts are the terms of an agreement or deal established as automatic code running on the blockchain system. Using smart contracts, users can send and receive money without an intermediary like a bank or a financial institution. It automates and decentralizes all transactions on the blockchain like Ethereum. Because of this, smart contracts are safe, reliable and highly accessible.
Smart contracts are components for developers to build decentralized apps and tokens. Developers mostly utilize them in decentralized finance (DeFi), while other use cases can expand to insurance, supply chain management, voting systems, trading NFTs/ digital assets to physical assets, or game experience testing. It’s hard to reverse or alter smart contracts after adding them to the blockchain.
How they differ with traditional contracts
Imagine you and your friend want to open a lemonade stand. You two make a contract, saving that your mom will hold onto the money you both make to keep it safe and only split it after the selling is done. This is how traditional contract works. Your mom acts as the middlemen or the traditional bank.
But now, you and your friend don’t want to rely on your mom anymore. To instill trust, you decide to build a special program that keeps the money, automatically splits it after the day is done and sends it to you and your friend. This program is shared through a network of computers around the world, where anyone can see your contract, but no one can change it. This is a smart contract.
Other than the differences in written language (human/paper vs programming/ blockchain), traditional relies much on manual execution, while smart contracts are open for automation and immune to modification.
However, traditional contracts are accepted by the legal system and have been in use for thousands of years. Meanwhile, smart contracts aren’t entirely legal agreements, as only a few countries support the legislation use of it. Otherwise, smart contracts are still classified as an automatic transaction by a computer or protocol.
How do smart contracts work?
It all started in 1994 when Nick Szabo, an American computer scientist, first proposed smart contracts. The idea was groundbreaking but yet to be achieved because the necessary technology to create smart contracts did not exist around that time.
It wasn’t until 2008 that Satoshi Nakamoto theorized blockchain technology, enabling the development of smart contracts. Ethereum is the first blockchain platform that effortlessly achieved the practical use of smart contracts, and it is still the most used. Other blockchain platforms with smart contracts ability includes Solana, Polkadot and Hyperledger.
Here’s how smart contracts work. It is based on the simple “if/when…then…” statement written in blockchain code.
When a user needs to execute an action, smart contracts check predetermined conditions and verify them, allowing the computer network to do the task. Most of the usual actions are sending notifications, issuing tickets, or releasing funds to the appropriate parties. When the action is complete, the whole blockchain updates itself. The transaction is unchangeable.
Participants can include as many stipulations as needed in a smart contract to make sure the task is done to their satisfaction. To set the conditions, each party must agree on the “if/when…then… rules, investigate potential exceptions, and design a framework for resolving conflicts.
A developer usually creates smart contracts. However, more companies utilizing blockchain technology are offering templates, web interfaces, and other online tools to make this process easier.
Types of smart contracts
There are two main types of smart contracts.
Self-executing smart contracts
When certain conditions are satisfied, these smart contracts automatically execute themselves. It is mostly used for financial transactions, for example, it transfers funds from one account to another when specific conditions are met, namely, a specified date or task completion.
Ricardian smart contracts
They are more flexible and applicable to a broader range of specified conditions and rules. Thanks to its comprehensible natural language component, non-programmers can understand the contract terms. You can utilize Ricardian contracts for various uses, from legal agreements and supply chain management to real estate transactions.
Based on functions
Also, smart contracts are categorized based on their functions and capabilities. There are 7 other common types, including:
- DAO Contracts for creating and managing decentralized autonomous organizations (DAOs), a type of self-governed organization run on a blockchain network;
- Escrow Contracts for holding funds or assets on escrow, releasing them once conditions (project completion, goods delivery, etc.) are met;
- Identity Contracts for verifying blockchain users’ identity on the network, permitting authorized-only parties to participate in certain transactions;
- Insurance Contracts verify data and automatically trigger payouts to policyholders to automate the insurance-claiming process.
- Payment Contracts automatically expedite the transfer of digital assets and cryptocurrency between parties when conditions are met.
- Prediction Contracts allow users to place bets, predict the outcomes of future events, and automatically distribute payouts based on the accuracy of their predictions.
- Supply Chain Contracts for tracking goods’ movement across a supply chain for better transparency and accountability.
Why do we need smart contracts?
Ever since their introduction, smart contracts have undoubtedly made the transfer of data and value safer and more verifiable. Users should consider several benefits of smart contracts.
- Security: Running on decentralized blockchain networks makes smart contracts less exposed to attack at a single point of failure, bribery, and outcome manipulation.
- Reliability: With a decentralized node network, smart contracts are processed and verified to be solid and anti-counterfeit. The rapid and accurate process guarantees that the contract will be carried out on time according to its terms.
- Equitability: It reduces the ability of a for-profit intermediary to abuse privilege and appropriate values. This is because transactions are executed only after all the terms and conditions are satisfied.
- Efficiency: Smart contracts reduce downtime between agreement processes by automating them. Now, neither party has to wait for manual data entry, obligation fulfillment, or a middleman-backed transaction process.
- Built-in backup: Smart contracts record and store all the essential transactional details indefinitely for future reference. If a data loss ever happens, developers can easily retrieve these properties.
When the pros also become the barriers
It’s undeniable that smart contracts enable users to make agreements without third parties. However, this concept has its downsides.
The disadvantages of smart contracts
- Complex data sync: In some cases, smart contracts only work if they can accurately read real-world information. Currently, blockchain does not provide this function, and several Web3 projects are working on narrowing the gap;
- Disputes between parties: Smart contracts cannot be changed once published on blockchains to prevent tampering. However, if one or both parties want to revise the terms, changing the current smart contracts is nearly impossible. Both parties must create a new smart contract, possibly causing logistical and legal complications;
- Uncertain automatability: While specific tasks like making payments or tracking supply chains are relatively rapid, legal contracts for other purposes take more time to interpret and process. This is due to the subjective language that the contracts were written in. In some cases, a third party must join to ensure these agreements are accurately enforced
Why is implementing smart contracts challenging?
First, the legal status of smart contracts must be the first barrier to a wider adoption of it. The future is unsure, but many experts said the growth of blockchain will eventually boost the acceptance of smart contracts, as well as blockchain-based assets.
Second, being a new concept, of course you will be skeptical about its long-term reliability. Claims to offer better security and transparency, cases of smart contracts being hacked or stolen have been reported.
The truth is smart contracts are much more complex for some businesses to truly benefit from them. For a well-written smart contract (remember once it’s deployed, it can’t be changed), you need to invest time and resources. You need both legal executives and professional blockchain developers, which are in high demand and low supply.
Smart contracts are a necessity if you are building blockchain products. It is a great investment for enterprises to automate process and secure the data, but for mid-sizes to small businesses, smart contracts might take a different path.
The use cases of smart contracts
1. Smart contracts in decentralized Finance and serving the blockchain
In decentralized finance (DeFi), smart contracts are the substructure. They enable the development of programmable, transparent, and decentralized financial services. Smart contracts remove intermediaries, cut costs, and make finance globally accessible to citizens worldwide.
To better understand what smart contracts can do, here are some critical applications within the DeFi field.
- Decentralized Exchanges (DEXs): When implemented in decentralized exchanging platforms or DEXs, smart contracts automatically match buyers and sellers, carry out trades, and set pricing following supply and demand.
- Decentralized Lending and Borrowing: Smart contracts in platforms like Compound and Aave manage loan arrangements, set interest rates, and specify collateral requirements.
- Yield Farming and Liquidity Provision: Users can give liquidity to DEXs through smart contracts and receive incentives in the form of governance or interest tokens. Smart contracts ensure even money distribution and fair compensation for users’ contributions.
- Automated Asset Management: Developers can use smart contracts to build decentralized asset management systems. These systems use preset criteria to automatically rebalance and manage investment portfolios.
From there, smart contracts also power thousands of P2P trading and transaction for cryptocurrencies, NFTs and digital tokens.
2. Smart contracts in other industries
- Real estate: Most real estate transactions are risky and stressful; therefore, smart contracts are utilized to minimize the risks. Instead of relying on a third-party to moderate the transfer process and wait forever, smart contracts can automatically execute the terms after each condition is satisfied by both parties;
- Healthcare: Hospitals use smart contracts to accurately and automatically transfer patient data between doctors and each other. Doctors and hospitals don’t need to manually share and complete patients’ health records;
- Voting system: Smart legal contracts are suggested for voting systems by different governments and groups. They help approach voting entries more efficiently and less dependent on mass paperwork and manual documenting;
- Insurance: With the insurance industry, smart contracts reduce waiting times and fraud, ensure certainty and security. AXA, an insurance company first used smart contracts in 2017 to provide automatic flight delay payments using self-executing code stated in its insurance policies;
- Logistics: Smart contracts can enhance visibility and automation in many areas, namely payment settlements, inventory management, order processing and tracking, regulatory compliance, dispute resolution, and origin verification;
- IP rights for media & entertainment: Smart contracts enable ownership of a specific item on blockchains by giving gamers the ownership of their digital items without a centralized server. Therefore, gamers can trade items and assets across multiple games;
- Retail: Smart contracts are utilized for resolving disputes with vendors. It provides real-time communication and visibility into the supply chain to strengthen relationships with suppliers. This will eventually increase time for critical work and innovation.
A few tips to optimize your use of smart contracts
When using smart contracts, users should keep in mind these tips:
Prioritize simplicity
Develop simple contract logic to implement optimal digital processes, gain value, and unleash advantages. Avoid complex contract logic, as it can be error-ridden and time-consuming. You can use pre-written contracts to reduce the possibility of execution errors.
Update Regularly
Updating contracts regularly helps detect errors and vulnerable spots that need resolution. Frequent safety checks and upgrades also improve user experience and safeguard transactions. Those smart contracts cannot update themselves, so manually updating them is necessary.
Conduct Rigorous Testing
Before deploying smart contracts, users must evaluate them on the test network. This will allow users to find and resolve malfunctions within those contracts before they become serious issues. Once defective smart contracts go live, it’s hard to retrieve and fix them.
Work with professionals on independent audits
The code for smart contracts must be trusted since the contracts will function in a decentralized and trustless environment. Any flaw can be the gateway for attacks and fund misappropriation.
Lock compiler versions for smart contract code
Software developers often make the error of not locking the compiler version in contract codes. Users should expressly declare the compiler versions to ensure smart contracts work consistently across environments and prevent issues regarding release and authentication.
Wrapping up
Smart contracts are a new, promising technology that has the potential to transform digital transactions completely. They allow transparent transactions among parties and prevent counterfeiting with terms and conditions. However, smart contracts have drawbacks that users should be aware of, especially regarding implementation.
