What Are Smart Contracts?
Smart contracts are agreements between two entities, designed to be executed automatically when the conditions of the contract are met. Smart contracts are coded onto a blockchain, meaning that they cannot be altered.
The automation of smart contracts means that there is no need for third-party intermediaries, increasing trust and ensuring that everybody involved in the contract is instantly aware of any outcome.
Some smart contracts are also designed to trigger an onwards reaction once the predetermined conditions have been met.
How Do Smart Contracts Work?
In principle, smart contracts work by following statements written in code on a blockchain. The terms of these contracts are stored in a distributed database, while the blockchain also processes transactions, meaning that payments and other outcomes are completely automated.
But how do smart contracts work?
- Terms and conditions are agreed by both parties
At their core, smart contracts are formalised agreements between two entities. Therefore, before a smart contract can be created, specific terms must be agreed. This includes determining how the contract will work and which conditions must be met in order for it to be executed.
- A smart contract is created
The actual creation of a smart contract is a slightly more complicated matter. Some parties will code it themselves, although they will often rely on a smart contract developer to do it for them.
The agreed terms are implemented using the chosen blockchain’s programming language, specifying the exact nature of the agreement. This is not a dissimilar process to that which is followed during the traditional creation of a legal contract.
- The smart contract is deployed
After its creation, a smart contract is deployed to a blockchain. As is the case with any cryptocurrency transaction, the smart contract is available for everybody to see. Once the transaction is confirmed, the smart contract is considered “live” and cannot then be changed.
- Conditions are met
A smart contract will only be triggered when the conditions mentioned above are met. These conditions will depend entirely on the contract in question, although they could include a date passing or a payment being made.
It is also possible, depending on the nature of the smart contract, that conditions are met when certain parties complete a specific task or action.
- The smart contract is executed
Smart contracts are written in code, which means that they happen automatically once triggered. A range of actions might follow the conditions of the smart contract being met, including the transferral of funds or an asset’s ownership.
- Results are recorded on the blockchain
Once the contract has been executed, it is broadcast to the blockchain, which verifies and records the actions.
Once logged on a blockchain, these actions cannot be reversed or altered, although they can usually be reviewed by anybody.
What Are Smart Contracts Used For?
Within reason, smart contracts can be applied in all of the same areas that a traditional contract can.
Decentralised Applications (dApps)
There is often confusion regarding the differences between smart contracts and decentralised applications. dApps are applications built on a blockchain network, while smart contracts are the power source behind them.
Essentially, smart contracts act as a backend mechanism for the decentralised applications, which effectively act as a user interface.
Healthcare
There are a range of potential uses for smart contracts within the healthcare sector. For example, smart contracts could be used to streamline patient data management, allowing healthcare providers to easily and securely access records.
In countries such as America, where healthcare is not free, the medical billing process could also be automated using smart contracts and blockchain technology. This would reduce errors, prevent fraud and simplify processes.
Finance
Perhaps most obviously, smart contracts can be utilised within the financial industry. Repayments, documentation verification, cross-border transactions, and more can all be simplified and automated using smart contract technology.
Smart contracts have also played a pivotal role in the growth of the decentralised finance (DeFi) industry. Fundamentally, DeFi looks to remove the need for third-parties and governing bodies from financial processes, and this is made possible through the use of smart contracts.
Whether it’s peer-to-peer lending and borrowing, yield farming, rewarding liquidity providers, or something else, smart contracts have positively impacted the DeFi space, and will likely continue to do so.
Supply Chains
Every step of the supply chain process can be recorded and traced using smart contracts. Blockchain technology means that these records are visible to anybody, and that they are immutable, which means that they cannot be altered. From a business perspective, this is crucially important and can reduce instances of theft and loss.
Smart contracts can also be used for inventory management. Using smart contracts to accurately maintain stock records allows businesses to avoid potential supply issues.
Real Estate
Smart contracts can be used to facilitate real estate transactions. As well as speeding up processes, smart contracts can also limit the need for paperwork, while blockchain technology provides a clear history of ownership.
Smart contracts are also useful for rental properties. Tenancy agreements can be created as a smart contract, and rent collection and maintenance requests can also be automated.
Smart Contract Pros and Cons
There are a range of positives and negatives associated with smart contract usage.
Advantages of Smart Contracts
A lot of the benefits of smart contracts will be similar to the benefits of blockchain technology. Records cannot be altered, and smart contracts do not require third-party intermediaries in the same way that traditional contracts do. This can avoid the need for expensive legal fees in many cases.
Smart contracts are also typically more efficient than traditional contracts. By automating processes, and acknowledging that smart contracts come with less opportunity for human error, it is possible to speed up processes and increase the level of trust between the involved parties.
Risks of Using Smart Contracts
Although the permanence of smart contracts could be considered an advantage, it is important to note that they cannot be changed once agreed. This means that if there are mistakes, it is impossible to adjust the terms of the agreement.
Secondly, there is still a reliance on human involvement when it comes to smart contracts. Although they eliminate the need for intermediaries, they do require a developer to implement the necessary code, according to the agreement in question. This means that there will always be room for human error. Loopholes in the smart contract code could lead to malicious actions being taken by one or or more of the parties.
Which Blockchains Are Smart Contract Compatible?
Lots of blockchain networks are smart contract compatible, although not all of them are designed in the same way. Please note, the following is not an endorsement of any particular blockchains.
Ethereum
Ethereum is perhaps the best and most famous example of a smart contract platform. Smart contracts on Ethereum are primarily written in Solidity, a variant of the JavaScript programming language, making them reasonably accessible to developers.
Ethereum uses the Ethereum Virtual Machine (EVM), a computation engine that manages the blockchain and enables smart contract functionality. Since its launch, EVM has become the standard for other smart contract platforms.
Thanks to Ethereum’s wider popularity, developers will often consider the network to be one of the best options for deploying smart contracts, especially those with DeFi capabilities. This is because decentralised applications have higher potential for growth, due to Ethereum’s existing infrastructure and user-base.
However, Ethereum is a relatively expensive platform to use, especially compared to some other smart contract compatible blockchains. With inconsistent gas (or transaction) fees, some developers prefer to build smart contracts elsewhere.
Cardano
Cardano is considered a cheaper option for smart contract development than Ethereum. However, developers have only been able to build smart contracts on Cardano since 2021, following the network’s Plutus upgrade.
The Cardano network differs slightly to most other blockchains, as it was designed using academic theory and research. Although this means that progress has been slower compared to other networks, it does mean that Cardano benefits from increased security and stability compared to blockchains such as Solana, for example.
Cardano also uses a programming language called Haskell. Haskell is lesser-known than some alternatives, such as Solidity, which has caused some developers to lose interest in building on top of the Cardano blockchain. Combined with the fact that there is less value locked into the Cardano ecosystem compared to Ethereum, many have questioned the network’s potential as a smart contract platform.
Avalanche
Avalanche is one of the world’s fastest blockchain networks. It has high throughput, scalability and security, and has experienced significant growth in recent years. The Avalanche network is able to handle thousands of transactions per second with incredibly low fees, making it an ideal platform for smart contract creation.
Avalanche is Ethereum Virtual Machine-compatible, and so developers use Solidity to create smart contracts, much like they would on the Ethereum blockchain.
Polkadot
Polkadot differs from the above networks in that it does not naturally support smart contracts. In fact, it is not possible to create smart contracts on the Polkadot Relay Chain, Polkadot’s primary layer 0 blockchain.
However, Polkadot uses a system of parachains, which are separate blockchains that run – and process transactions – parallel to the main Relay Chain. These parachains have their own use cases and cryptocurrency tokens, and are equipped with smart contract functionality.
There are actually two main smart contract environments on Polkadot: EVM and ink!. The former uses Solidity, while the latter allows developers to create smart contracts using Rust.
History of Smart Contracts
The idea behind smart contracts was initially proposed by Nick Szabo in 1994. Szabo was a computer scientist who invented a virtual currency called Bit Gold in 1998. Some people have suggested that Szabo could be Satoshi Nakamoto, Bitcoin’s anonymous creator, although he has always denied this rumour.
Szabo’s idea of smart contracts involved computerised transactions and the automated execution of a contract. Although many of Szabo’s ideas were theoretical at the time, his research paper contains many suggestions and predictions that have since been realised.
Conclusion
Smart contracts are one of the most important elements within the Web3 space. Although cryptocurrency on its own has the potential to revolutionise the finance industry, smart contracts and decentralised applications mean that blockchain technology is more likely to see greater mainstream adoption.
Although smart contracts are still a relatively new technology, the ability to remove third-parties, ensure accuracy, automate processes and increase the level of trust within an interaction suggests that smart contracts are likely here to stay.
FAQs
Can You Build Smart Contracts on Bitcoin?
Bitcoin was primarily created for use within peer-to-peer payments, although it also offers a secure and decentralised way to store value. This means that Bitcoin was not designed to be smart contract compatible, although it is still possible to build smart contracts on the Bitcoin blockchain.
Bitcoin uses Script, a non-Turing-complete programming language. For a programming language or machine to be “Turing-complete”, it needs to be able to run any program, or solve any problem, that the Turing Machine could. There are limits to how programmable Script can be, which is a positive in many ways, but does make it difficult to utilise the Bitcoin network for smart contracts.
That being said, there are some projects, such as Stacks, that do use Bitcoin for smart contract deployment. Stacks specifically is a separate blockchain, linked to Bitcoin by its consensus mechanism, that allows the project to utilise Bitcoin’s security, while also enabling the creation of smart contracts.
Are Smart Contracts Legally Binding?
Smart contracts can be legally binding, as long as they follow the basic rules of a contractual agreement. This means that terms need to be legally permissible and legally eligible for an electronic signature, and there should be an offer, acceptance of the offer, and consideration attached to the smart contract in question.
Admittedly, it is a little difficult to know whether a smart contract is legally binding, and will likely depend on the jurisdiction in which you are based.
How Risky Are Smart Contracts?
Smart contracts can be risky, although there are elements of risk attached to any form of contract. With smart contracts specifically, the primary risk involves coding errors or bugs, which can leave room for financial loss, depending on the nature of the contract.
