What are Smart Contracts and How do they Work?

What are Smart Contracts and How do they Work?

What is a Smart Contract?

A smart contract is a piece of code that lives on the blockchain and controls the transfer of digital assets between parties. They work as a written agreement between multiple parties where the code controls the funds, event, or execution of a certain transaction. Smart contracts are self-executing, meaning they can automatically execute the contract terms without needing third-party intervention.

For example, suppose two parties agree to buy and sell an item for a specific price. In that case, the smart contract can execute the trade once both parties have deposited the agreed-upon amount of cryptocurrency into the contract. 

Smart contract timeline
Smart contract steps for execution

Smart contracts can also automate other processes, such as voting, loan repayments, or asset management.

Smart contracts are often seen as one of the most important decentralized applications of blockchain technology, as they have the potential to significantly reduce transaction costs and increase efficiency by eliminating the need for intermediaries.

How Smart Contracts Work?

Smart contracts are powered by blockchain technology and are the building blocks on of a blockchain network. Blockchain is a distributed ledger system that allows for tamper-proof, transparent and secure record-keeping. Smart contracts use blockchain and sophisticated logic to store and execute the terms of the contract without human intervention.

Smart Contracts work by matching the conditions of the contract with real-world data. When the conditions are met, the contract automatically executes the terms of the contract enforcing agreements between parties involved.

Smart Contracts can be written in various programming languages, a popular one being Solidity. Solidity is a programming language designed for Ethereum Smart Contracts.

Benefits of Smart Contracts

Smart contracts are often compared to traditional contracts. However, there are several key differences and advantages of using Smart Contracts. Smart contracts are:

  • Self-executing: Smart contracts can automatically execute the contract terms without needing third-party intervention.
  • Tamper-proof: Smart contracts are stored on a blockchain, which is a tamper-proof and secure record-keeping system.
  • Transparent: Smart contracts are transparent, meaning all parties can view the contract terms and execution.
  • Secure: Smart contracts are more secure than traditional contracts as they eliminate the need for intermediaries.
  • Cost-effective: Smart contracts can significantly reduce transaction costs by eliminating the need for intermediaries.

Current Issues & Wide Adoption

Before smart contract technology is widely adopted, a few challenges must be addressed.

The technology is still in its early stages, and there are a limited number of developers with experience coding smart contracts. If the demand outweighs the supply, then the scalability of this new technology will be slowed down.

Smart contracts are immutable, and any errors found in the smart contract’s code cannot be fixed. This means it is important to carefully test smart contracts before deploying them on a blockchain. If a contract is not written correctly, it could lead to unintended consequences.

Smart contracts can interact with other smart contracts, which can lead to unforeseen complications.

Despite the challenges, smart contracts have the potential to revolutionize the way businesses operate and open up new opportunities for collaboration and innovation. Smart contracts could one day be used to create a truly decentralized economy.

When are they used?

Smart contracts are used in almost every aspect of Web3, from DAOs to NFTs. They can be used to create new tokens, manage financial transactions, automate workflows, and much more.

The use cases of smart contracts are only limited by the imagination of the developers. Some of the most popular use cases include:

  • Decentralized exchanges
  • Decentralized apps (Dapps)
  • Voting systems
  • Prediction markets
  • Token launches (ICOs & IEOs)
  • Lending platforms
  • Insurance company contracts
  • Real estate transactions
  • Wills & trusts
  • Digital currency & digital tokens
  • Digital Identity

Who termed the name “Smart Contract”

Nick Szabo first proposed smart contracts in 1996. He defined a smart contract as “a set of promises, specified in digital form, including protocols within which the parties perform on these promises.”

In 2014, Ethereum founder Vitalik Buterin proposed a more general use case for smart contracts. For example, he suggested that smart contracts could be used to create ” decentralized autonomous organizations” (DAOs).

Auditing Smart Contracts

As the use of smart contracts increases, so does the need for smart contract auditing services. Smart contract auditing is critical to developing safe and secure smart contracts. Audits help to ensure that smart contracts are error-free and secure before they are deployed on the blockchain.

Several companies offer smart contract auditing services. These companies will review the smart contract code and test it for vulnerabilities. Smart contract auditing is vital for new protocols to gain trust from their users.

Legalities of Smart Contracts

Smart contracts are still in their infancy and the legal landscape is constantly evolving. In some jurisdictions, smart contracts may be considered legally binding, while in others they may not. It’s important to consult with a lawyer in your jurisdiction to understand the specific laws around smart contracts.

The Future of Smart Contracts

Smart contracts are still in their early stages of development, and it will take time before they are widely adopted. However, they have the potential to change the way we interact with each other and do business.

Smart contracts could one day be used to create completely decentralized organizations that are not controlled by any central authority. Only time will tell whether or not smart contracts will live up to their hype.

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James Satoshi
James Satoshi
James is a leader in Web3, NFTs, & DeFi with over 4 years of experience in the industry. You'll spot him covering all topics through-out Coinmash in our guides and analysis sections.