What Are Smart Contracts?
In this article, we’ll be looking at smart contracts. In particular, they are:
- Intended to digitally facilitate, verify, or enforce the negotiation or performance of an agreement.
- Capable of performing credible transactions without third parties.
- Self-executing thanks to terms being baked into lines of code.
Background
In our first two educational articles, we took some time to examine the defining characteristics of blockchain and cryptocurrencies. To summarize, this technology largely promotes decentralization and automation. Stated another way, web 3 services seek to remove the need for middlemen, ultimately expediting different processes at a fraction of the cost.
Many blockchain companies seek to allow their products and services to operate without trusting a centralized entity, effectively meaning that a system could continue to function in perpetuity regardless of what happens to the issuing entity.
Introducing Smart Contracts
When it comes to understanding how this is possible, smart contracts play a crucial role in allowing these ideas to take form. First introduced by Nick Szabo, “smart” contracts are more or less sophisticated digital contracts that expand upon the capabilities of legacy paper-based contracts.
“The basic idea of smart contracts is that many kinds of contractual clauses (such as liens, bonding, delineation of property rights, etc.) can be embedded in the hardware and software we deal with.”
Why Is This Useful?
Smart contracts are capable of facilitating a trustless and automated exchange of money, property and anything else of value while eliminating the need for costly and inefficient middlemen.
While there’s a wide range of potential applications (described below), blockchain-based smart contracts largely provide a new framework for digital automation due to the following characteristics:
- Accessible: Smart contracts can be utilized by anyone with the requirements to do so. Many existing smart contracts have little to no requirements meaning they’re very easily accessible to anyone with an internet connection.
- Efficient: Smart contracts are self-executing, meaning there are little to no delays in the underlying actions being performed. Similarly, the lack of human maintenance makes them inherently cheap to deploy and even cheaper to execute.
- Robust: Smart contracts are stored on an immutable ledger, meaning that they will continue to function so long as the underlying protocol continues to exist. While contracts can be updated, many contracts are designed to be deployed once and operate in perpetuity.
- Verifiable: On a public blockchain network, all smart contract code is open-source and easily verifiable. This means that anyone can check that the code does what it’s supposed to, ensuring there aren’t any gimmicks or risks implemented by the issuer.
To summarize, businesses that rely on the verification of different parameters can leverage smart contracts to expedite their services. Examples of smart contract use-cases include (but are definitely not limited to) real-estate agreements, securities trading, loan origination and royalty payments.
How Do They Work?
The basic principles of a smart contract follow an if-this-then-that logic. This ensures that the final outcomes defined by a smart contract don’t execute until every single condition outlined by that contract is satisfied. In the event that all the conditions are met, smart contracts call predefined functions to perform the intended actions.
In practice, this could take the form of asserting that both parties have held up their end of the bargain, or automatically transferring assets from one wallet to another. Commonly, most smart contracts incur a small cost (usually paid in the network’s underlying currency) when executed.
Value Capture
As it stands today, a big reason for Ethereum’s success was its ability to write and execute smart contracts through a native programming language called Solidity. Similarly, Ethereum’s Virtual Machine offered new capabilities for digital logic that was previously unavailable on Bitcoin (or any other blockchain), meaning that new services could be performed without approval from a centralized third party.
The clearest example was the issuance of new Ethereum-based assets which led to the ICO boom in 2017. Ethereum’s programmable token issuance made it possible to use smart contracts to create sub-tokens that stood on top of the underlying protocol. In plain terms, smart contracts allowed people to register new assets, using the functions of their contract to allow tokens to be transferred from one Ethereum wallet to another (given that certain requirements were met). Taking this a step further, smart contracts are what allow decentralized exchanges such as Uniswap or permissionless lending protocols like MakerDAO to operate in an open and permissionless fashion.
Looking Ahead
In the future, smart contracts will gradually evolve thanks to the introduction of blockchain-based oracles, a topic that we’ll cover in our next article. For now, we hope that the concept of smart contracts can help stimulate new business practices that were previously reliant on humans or third parties to function.
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