What is a Smart Contract?

A smart contract is a digital agreement that is signed and stored on a blockchain network.

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Smart contracts are the heart of blockchain technology and a key component of decentralized applications (dApps). They offer the security, reliability, and accessibility of blockchain technology while providing complex peer-to-peer functionality. Let’s examine smart contracts and how they work.

Today, everyone is familiar with applications and app stores. You browse them, download the app you want, and have it instantly. Behind the beautiful UX and UI interfaces of mobile devices, these applications follow a specific set of instructions set by their creator. It could be a game, a fitness app, or a way to purchase goods and services. Well, smart contracts serve a very similar function.


Indroduction

A smart contract is a program that executes and automates the actions required in an agreement or contract. Once transactions are completed, they are traceable and irreversible. Smart contracts are built on the fundamental idea of Bitcoin transactions without intermediaries. Your data is neither stored nor verified by any party because the blockchain handles it for us.

The Ethereum community, led by Vitalik Buterin, believes this is the future of blockchain. If Bitcoin is the gold of the business world, smart contracts are the oil that fuels it. Ethereum is the first and largest smart contract network, setting the standard in the crypto world.

Fun fact: Nick Szabo, an American computer scientist who invented the virtual currency Bit Gold in 1998, defined smart contracts as computerized transaction protocols that execute the terms of a contract.


How Do Smart Contracts Work?

Let’s look at a typical car purchase transaction without a smart contract for a simple idea. For the entire process, you need:

  • A website with a list of cars and information you want to see.
  • A way to communicate with sellers.
  • A payment system that allows you to exchange money when you find your vehicle.
  • Some refund options exist if the car differs from what you paid for.
  • How do you report a car ownership change to the relevant authorities?

As we know from experience, each point requires a certain level of trust between you and the website in question. Additionally, another company or individual usually controls each part of this process. This means there is a risk that a malicious person or organization could quickly interfere with any of these elements, disrupting or nullifying the entire process.

This is where smart contracts come in, which can eliminate the need for trust in multiple parties in the purchasing process.


Smart Contracts: Advantages

Security: They use cryptography to prevent record tampering.

Transparency: Anyone can see what the smart contract is and what it’s used for.

No need for third parties: Smart contracts don’t require a mediator for their verification, as blockchain technology does.

Autonomy: They operate automatically, so there’s no need to wait for human intervention.

Accuracy: Since smart contracts are written in code, they have fewer errors than written or spoken languages.

Smart Contracts: Disadvantages

Immutability: Once deployed, contracts cannot be altered or upgraded, which can lead to catastrophic consequences if the code has issues.

Human factors: They rely on programmers to ensure the code follows the contract terms.

Legal loopholes: There may be loopholes in the code that allow the execution of contracts in bad faith. This was best illustrated by the hacking of the Ethereum DAO in 2016. An unknown attacker exploited a loophole in the DAO’s distribution function to steal ETH worth around $50 million.


“If – Then”

“If this happens, do this” is the main mantra of smart contracts. A mechanism that causes a specific action to occur in response to a particular event through computer code. This mechanism already exists. For example, if you want to pay for something with a credit card, the software used by your bank will employ the “if – then” function in the following way:

  • If the amount in the bank account exceeds the required, it releases the funds.
  • If the amount in the bank account is less than the required amount, the funds are not released.

The difference with smart contracts is that third parties decide on the blockchain instead of the bank. Applying the above example to a smart contract, we get the following:

  • If the amount in the digital wallet is more significant and has not been spent, it releases the funds.
  • The funds are not released if the amount in the digital wallet is less or has already been spent.

The fascinating thing about smart contracts is that anyone can enter into a contract with anyone else. The blockchain records it all; anyone can look at it at any time and verify the transaction.


Who Can Use Smart Contracts

Smart contracts enable developers to create various decentralized applications (DEX) and tokens. They have various applications, from new financial tools to logistical and gaming experiences, and are stored on the blockchain like all other crypto transactions. Once a smart contract application is added to the blockchain, it generally cannot be revoked or changed.

DeFi applications allow cryptocurrency owners to perform complex financial transactions without any “theft” by a bank or other financial institution anywhere in the world. Some of the currently popular DeFi applications include:

Uniswap: A decentralized crypto exchange that allows users to trade certain types of cryptocurrencies through a smart contract without a central authority setting the exchange rates.

Maker DAO: A Decentralized Finance (DeFi) application that allows users to borrow and lend cryptocurrencies without intermediaries.

Axie Infinity: The most played play-to-earn game where players breed and battle monsters.

USDC: This cryptocurrency is pegged to the US dollar by a smart contract. So, one USDC is worth one US dollar. USDC is part of a newer category of digital money called stablecoins.

However, the use of smart contracts is not limited to companies in the crypto scene. A whole range of companies, and even some governments, have begun to use them. Below are a few examples:

Swedish Government: The Swedish government has tested a blockchain-based land registry to prove land ownership, which relies on smart contracts.

ING: The Dutch bank ING co-created Finality, a blockchain-based transaction system that utilizes smart contracts. It is also involved in many other blockchain initiatives.

Ubisoft: Among its numerous blockchain initiatives, Ubisoft has created specially designed smart contracts that allow users to own, transfer, and trade rare NFTs based on the popular Rabbids gaming franchise and has also launched Ubisoft Quartz.


History of Smart Contracts

Like blockchain technology used for most cryptocurrencies, smart contracts were born out of earlier technologies that were not entirely perfected.

The term “smart contract” was first proposed in 1994 in an essay by Nick Szabo, an American computer scientist who invented the virtual currency Bit Gold in 1998, a decade before the introduction of Bitcoin. In fact, there is often speculation that Szabo is the real Satoshi Nakamoto, the anonymous inventor of Bitcoin.

Szabo likened smart contracts to a vending machine. Imagine a vending machine selling cans of Coca-Cola for 25 cents. If you insert a dollar into the machine and select a soda, the machine is programmed to give you the drink and 75 cents in change or (if your choice is sold out) prompt you for an alternative selection or return your dollar. This is an example of a simple smart contract.


Ethereum Is Currently the Leading Platform for Smart Contracts

ETH Smart Contract

While Ethereum is currently the most popular smart contract platform, it can also be deployed on many other blockchains, such as EOS, Neo, Tezos, Tron, Polkadot, Algorand, and more. Anyone can create and deploy a smart contract on a blockchain. Their code is transparent and publicly verifiable. Meaning that any interested party can see precisely the smart contract’s logic when receiving digital assets.

Smart contracts are written in various programming languages, such as Solidity, Web Assembly, and Michelson. In the Ethereum network, the code of each smart contract is stored on the blockchain. So, it allows anyone interested to inspect the contract’s code and current state and verify its operation.

In addition to blockchain and transactional data, each computer in the network (or “node”) stores a copy of all existing smart contracts and their current state. When a smart contract receives funds from users, its code is executed by all nodes in the network to achieve consensus on the outcome and resulting value flow. Also, you must pay a gas fee to perform a smart contract on the Ethereum network. Once deployed on the blockchain, smart contracts generally cannot be changed, even by their creator.


The Largest Smart Contract Platforms

The largest smart contract platforms by market capitalization are:

  1. Ethereum: Ethereum is designed to function as a decentralized “world computer” that can be used as a platform for running dApps.
  2. Binance Smart Chain (BSC): BSC is a blockchain platform developed by the cryptocurrency exchange Binance.
  3. Cardano: Cardano (ADA) is an open-source public blockchain project. It claims to be the first peer-reviewed blockchain in the world, with a network of academics and scientists verifying its protocols before they are released.
  4. Avalanche: Avalanche is an open-source platform for new financial and decentralized applications developed by Ava Labs.

Smart Contract Audit

Although the underlying blockchain technology secures smart contracts, they must also be secure by structure. As mentioned above, some features or errors in their code can be exploited. This has happened many times and remains one of the biggest challenges to widespread adoption. According to the blockchain security company CertiK, $1.3 billion was lost to DeFi hacks alone in 2021. Therefore, assets worth billions of dollars have been stolen from unsecured smart contracts.

To mitigate this risk, many third-party development and security companies, such as MythX and ConsenSys Diligence, now offer smart contract audit services. These services involve carefully inspecting the smart contract code to identify vulnerabilities that can be fixed, usually occurring before the smart contract is deployed.


Conclusion

Smart contracts are code written on the blockchain that implements the terms of an agreement or contract off-chain. They automate actions that would otherwise be performed by parties in the contract, eliminating the need for mutual trust between the two parties. Based on their functionality, we can expect smart contracts to become part of our everyday lives on several levels. Today, most blockchains have smart contract capabilities and active developer communities are creating applications that utilize them. The range of possibilities with smart contracts can vary from straightforward ones based on Bitcoin or Litecoin to more advanced ones supporting decentralized applications like Ethereum and Cardano.


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