What is a smart contract?
A smart contract is a virtual agreement between two parties, where the conditions of the agreement are directly encoded into the smart contract's self-executing coded logic.
The smart contract and its underlying code exist throughout a decentralized network called a blockchain, which is a digital distributed ledger that facilitates cryptocurrency and smart contract transactions. These transactions are traceable and irreversible, thanks to the embedded code.
Blockchain technology, along with the smart contract, regulates its execution without the need for any intermediaries. Smart contracts enable trustworthy transactions between anonymous participants and are a core element of DeFi (decentralized finance).
How do smart contracts work?
A smart contract’s functioning depends on the two contracting parties, as they must agree on the smart contract's terms. Following the completion of contractual terms, which are converted into programming code, the terms are "digitized" and fixed into the smart contract. Essentially, the code is a set of conditional statements that facilitate several outcomes for a future smart contract transaction.
After the code is generated, it’s automatically stored in the blockchain and duplicated among its nodes. Every system must run the code on the blockchain to come into effect. The necessary transaction is carried out if all blockchain-based nodes meet and validate the contractual terms.
Parties can create smart contracts to replace regulatory requirements and retail operations, among other things. Furthermore, smart contracts might eventually eliminate the need for some issues to be litigated in court, sparing parties money and time.
The underlying programming is crucial to this security. Ethereum (ETH) smart contracts, for example, are written in the Turing-complete Solidity programming language. This means that smart contract rules and restrictions are embedded into the blockchain's code, and no scammer can change them. Ideally, these restrictions would reduce fraud or disguised contract changes since users can only implement smart contracts if both parties agree and sign, after which the contract is in place indefinitely.
Individuals can use a smart contract to execute a specific business procedure between two or more companies. These parties agree on the smart contract's conditions, such as payments, working processes, and conflict resolution.
Other smart contracts allow users to connect with dApps (decentralized applications) without authorization from a supervising entity or third-party intermediary. Public dApps are generally open-source, allowing anyone to access and examine how they work before deciding whether to use them.
Why are smart contracts convenient?
Smart contracts are a staple in the crypto world, thanks to their convenience. Here’s a list of other benefits of smart contracts:
- Security: Crypto transactions are encrypted on the blockchain, making them extremely difficult to hack. Also, since each transaction on the network is linked to the preceding and subsequent entries, cybercriminals would have to modify the entire transaction chain to modify or hack a single transaction. This is a near-impossible task on blockchains that contain billions—or even trillions—of transactions.
- Efficiency: Smart contracts enable users and contracting parties to automate transactions and contract conditions. As a result, neither party requires human data for input or the intervention of a third party like the government or a lawyer. Instead, each party needs to meet their commitments per the agreement, and the smart contract automatically triggers itself according to its code, leaving no margin for error.
- Accuracy: The agreement is instantly implemented when the smart contract's conditions are met. Smart contracts are digitized and automated, so there's no documentation to handle and no time lost, rectifying inaccuracies that frequently occur when filling out forms manually.
- Transparency: A smart contract’s conditions can't be manipulated for personal gain as there isn't any third-party intervention. Both participating parties examine and agree to all conditions on the contract, and the contract itself activates when those predetermined conditions are met.
- Reliability: Smart contracts are digital documents that are impossible to lose possession of, like a physical folder with documents. Blockchains are online and active 24/7, so smart contracts are always available and accessible and are backed up by the network's cryptography. Users can rest assured that smart contracts will activate per their conditions.
Smart contract use cases
Smart contracts aren’t just digital agreements between two users for crypto transactions. They have other useful applications in the crypto ecosystem and the real world. Much of the functionality that exists wouldn’t be possible without smart contracts.
DeFi
Smart contracts are at the very crux of DeFi. Smart contracts facilitate the removal of a supervisory intermediate like a lawyer or a bank. This is a fundamental characteristic of smart contracts and a common element in decentralized technologies.
DeFi allows peer-to-peer transactions to replace third-party intermediaries. These transactions enable two willing parties to connect directly with the confidence of security and transparency. This allows users to gain share of value usually earned by centralized institutions such as banks.
Digital identity
Information is the new currency in the digital age. Large corporations use data and information for advertising products and services. Companies profit by identifying users' interests without being aware of how their data is obtained. With DeFi and smart contracts, the power is now back in the public's hands.
With the advent of crypto and blockchain technology, people's identities look set to be tokenized on decentralized platforms, free from interference. On social media, users can decide which information they want to keep private. Instead of obtaining all user data, smart contracts can pick specific information to hand over to another party.
For example, if you want to sign up for a sponsorship or a brand endorsement, you can share a portion of selected data and agree with a smart contact. Additionally, no third party can take a part of the profit or surreptitiously store and sell data.
Gaming and NFTs
Smart contracts are used in games to provide tamper-proof implementations of in-game activities.
Let's take a look at an example to understand this better.
PoolTogether is a blockchain-based game in which players stake their resources in a shared pool, which is subsequently channeled into a market where it generates interest.
The game concludes after a predetermined period, and a winner is chosen randomly to receive the collected interest. The benefit awarded to others is that they can withdraw their original deposited amount, which results in nobody incurring a loss.
Role-playing games can leverage randomization to provide unexpected loot drops, ensuring all players have a fair chance of obtaining rare digital items. Similarly, limited-edition NFTs (non-fungible tokens) can use techniques to ensure equal distribution among users.
Real estate
Because selling properties is lengthy and complicated, owners often employ a broker to handle the complex aspects of a deal, such as documentation and securing a buyer. While this may be great for the seller, remember that agents charge a considerable percentage of the sale price.
Smart contracts can replace real estate agents, expediting the house-transfer procedure while maintaining the same level of security as an intermediary.
Insurance
Smart contracts can potentially benefit insurance coverage. Signing up for insurance enters the customer into a smart contract with an insurance company. The smart contract can include all the necessary policy criteria, which the customer can read, agree to, and sign.
That agreement will remain in effect until the relevant party requests insurance cover. The funds will then be issued when the customer uploads the necessary paperwork, proving their need for insurance. This contract eliminates the need to communicate with insurance providers and saves time.
Are there any downsides?
Smart contracts have plenty of benefits that have led to their popularity and increased use. However, there are some limitations to them.
To begin with, smart contracts can’t retrieve data from the outside world, so they can’t integrate blockchain oracles, which are services that link off-chain data to the real world outside. This external information encompasses numerous sources and delivers an "oracle" of decentralized knowledge.
Additionally, modifying smart contracts is challenging due to their immutability because their conditions are essentially set in stone. Once the terms are in place, they’re more or less set for life. Furthermore, once the terms are agreed upon, they’ll always execute automatically, regardless of whether the parties’ sentiments are changing thoughts.
Wrapping up
Smart contracts and DeFi are gaining popularity in the crypto world, opening up new opportunities for blockchain technology and new cryptocurrencies.
One of the most exciting new currencies is Worldcoin, an innovative project that respects your privacy and values user anonymity.
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