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What Are Smart Contracts? A Comprehensive Guide

 

By Nerly Shammah 0ct 25, 2023

 

Smart contracts are self-executing programs that run on blockchains to facilitate various decentralized operations.

 

 

A smart contract is an autonomous program designed to self-execute once predetermined or predefined terms are met. Smart contracts power the famous decentralized finance ecosystem and are a crucial building block for financial operations on blockchains.

 

Smart contracts aid in the removal of intermediaries in financial transactions and the risks thereof. Decentralized exchanges are built on smart contracts to enhance crypto trading experiences and network security. 

 

 

Understanding Smart Contracts

 

What is a smart contract in simple terms? 

 

A smart contract is simply a computer program that can function on predefined rules without the need for intermediaries.

 

The introduction of the Ethereum blockchain caused the concept of "smart contracts" to become a standard for developing decentralized crypto economies. This event saw various bank-like protocols and services being deployed on the Ethereum blockchain, effectively leading to the widespread use of DeFi platforms for their differing investment and savings services.

 

The concept of smart contracts can be confusing sometimes due to the complexity of blockchain technology, the ecosystem through which smart contracts have earned popularity. Notwithstanding, smart contracts are really just simple "if-then" statements written in lines of code to govern a specific network operation like asset trading rules or recurring payment protocols. 

 

How Do Smart Contracts Work?

 

Smart contracts work by executing "if-then" statements in programs deployed on blockchains. If then statements are conditional statements in high-level programming used for the execution of various programs when certain parameters written in the lines of codes are met. 

 

For example, an "if-then" statement may instruct a smart contract to issue a token to a specific blockchain address once said address signs a specific transaction on-chain with its public and private keys. 

 

Such contract statement for autonomous asset flow would look simple, like this:

 

"If address X signs the transaction "proposal D" with a verifiable private key, then issue token B to address X"

 

The purpose of these contracts is simply to automate certain tasks and maintain network sovereignty by eliminating the need for third-party involvement in various operations on the network. 

 

Brief History Of Smart Contracts

 

Smart contracts date back a decade before Bitcoin was introduced. An American computer scientist "Nick Szabo" who's also speculated to be Satoshi Nakamoto birthed the idea of smart contracts.

 

Nick Szabo is popular for his part in the history of cryptocurrencies and virtual assets as he invented a virtual currency called "Bit Gold" in 1998. Nick defined smart contracts as computerized transaction protocols that satisfy common contractual conditions (such as payment terms, liens, confidentiality, and even enforcement), minimize exceptions both malicious and accidental, and minimize the need for trusted intermediaries.

 

Nick foresaw the use of smart contracts in far more than cash transactions due to its design enabling the implementation of a wide variety of electronic bearer securities. 

 

In his paper, Nick Szabo explored the wider application of smart contracts and its implications saying:

 

"

 

The consequences of smart contract design on contract law and economics, and on strategic contract drafting, (and vice versa), have been little explored. As well, I suspect the possibilities for greatly reducing the transaction costs of executing some kinds of contracts, and the opportunities for creating new kinds of businesses and social institutions based on smart contracts, are vast but little explored.

 

"

 

It is important to note that most smart contracts do not contain any legal information nor are they linked to any. Smart contracts are computer protocols functioning autonomously on pre-set "terms" defined in "if/then statements" through lines of codes. 

 

The partner course below offers an in-depth exploration of smart contracts, their application for problem-solving, vulnerabilities and opportunities.

 

 

Many of Nick Szabo's views on the use of smart contracts to build and manage various business or institutional structures have today become a reality from the use of complex terms structures in derivatives trading, to the application in decentralized finance networks and most recently, the tokenization of a wide array of digital and physical assets. 

 

Smart Contracts Use Cases

 

Finance, crypto and digital economies analysts have collectively weighed and made claims of smart contracts being at their most infant stage yet, far from being maximally leveraged for their possessed potential.

 

Notwithstanding, smart contracts have been employed by various organizations, networks and individuals to build various structures that automate operations, creating business-efficient workflow protocols. For example, smart contracts are being used in decentralized lending platforms to autonomously accept collateral deposits, lend out assets and settle loans when certain conditions are met.

 

The application of smart contracts in financial transactions is the single biggest, yet, use of smart contracts and is made popular through the growing adoption of blockchain networks like Ethereum as a business-building environment.

 

Due to their accuracy, speed and efficiency, smart contracts have become a powerhouse for Web3-based applications and digital economies at large.

 

 

Smart Contracts Pros and Cons

 

Smart contracts primarily serve the purpose of removing intermediaries in the execution of various operations, to achieve this, smart contracts are rich in various technological advantages that aid in building the perfect workflow or automation protocol. 

 

Below are the pros of smart contracts:

 

Pros Of Smart Contracts 

 

● Permissionless

 

Once a smart contract has been deployed on a blockchain, it requires no permission to function as every written code outlines various contract parameters for it to autonomously execute. 

 

● Composability

 

Just as blockchains are constantly being advanced to support cross-chain communications, smart contracts are interoperable in nature. This Composability enables various smart contracts to communicate with each other and process various autonomous cross-chain operations. 

 

● Immutability

 

Smart contracts are immutable - that is: cannot be changed - once deployed to a blockchain network. This tamperproof mechanism makes them a viable option for decentralized economies to build numerous business structures. 

 

● Fast and Accurate

 

Smart contracts are designed to efficiently execute various contracts on-chain with utmost accuracy and speed. Provided these smart contracts are audited for security and passed as "lacking threatening vulnerabilities", smart contracts offer businesses scaling ease through automation and security. 

 

Cons Of Smart Contracts 

 

● Cannot retrieve real-world data

 

Due to the focus on security on the blockchain level, smart contracts cannot access real-world events or databases on their own. However, with the aid of "Blockchain Oracles", such information can be passed to smart contracts but this introduces a layer of risk as these Oracles have to be trusted to be accurate and ethical in the data they broadcast to smart contracts. 

 

● Permanent

 

The immutability of smart contracts is indeed a double-edged sword. Once a smart contract is deployed on-chain, it cannot be changed, meaning that in events where contracts contain mistakes or are poorly designed, they cannot be changed. 

 

● Vulnerable to attacks

 

Smart contracts, although actively being developed for utmost security, are still pretty much vulnerable to attacks. Hackers exploit loopholes in smart contracts and drain out liquidity from the attacked network. In 2022, DeFi protocols as victims of hacks accounted for 82.1% of all cryptocurrency stolen by hackers — a total of $3.1 billion — up from 73.3% in 2021 according to Chainalysis.

 

● Limitations In Contract Size

 

Due to blockchain's unending quest to keep its memory use low, smart contracts may face various size limitations. On Ethereum, there's a limit of 24KB or smart contracts will run out of gas. However, a walk around this involves using a scaling method called "The Diamond Pattern".

 

Fast Fact: Nick Szabo likened smart contracts to a vending machine saying:

 

"

 

A canonical real-life example, which we might consider to be the primitive ancestor of smart contracts, is the humble vending machine. The vending machine is a contract with the bearer: anybody with coins can participate in an exchange with the vendor. The lockbox and other security mechanisms protect the stored coins and contents from attackers, sufficiently to allow profitable deployment of vending machines in a wide variety of areas.

 

"

 

Are Smart Contracts Limited To Blockchains?

 

Smart contracts are not limited to blockchains, they can be deployed to a variety of other digital platforms. 

 

However, the concept of "smart contracts" is specifically coined for the blockchain ecosystem as it more often than not translates to a permissionless, decentralized, automated, and trustless protocol with self-execution of agreements or contract functionalities. 

 

Which blockchain supports smart contracts? 

 

A variety of blockchain networks support smart contracts but the most famous is the Ethereum blockchain. 

 

Are Smart Contracts Secure? 

 

Smart contracts are autonomously executing contracts that are cryptographically protected. Smart contracts are secured by various blockchain algorithms and contract designs. However, it is important to actively audit smart contracts for potential vulnerabilities. Get the knowledge of smart contracts security and become an expert auditor and smart contract developer by taking this partner course.