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What Are Smart Contracts & How Do They Work?

March 17, 2022
7
min

Smart contracts are software programs that manage transactions and agreements on blockchains, which are decentralized computer networks on the internet accessible to anyone with a laptop and a web connection.

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Of all the innovations linked to blockchain technology, smart contracts may be the least understood, and one of the most significant. These computer programs are designed to do much more than digital money like Bitcoin; they are meant to foster the creation of a system that automates business dealings that have long relied on intermediaries like banks and brokers.

First popularized on the Ethereum blockchain, smart contracts have enabled scores of new platforms to make loans, swap cryptocurrencies, and perform other financial activities. Now smart contracts are being used to create organizations that exist in decentralized fashion on the internet. They are also being applied in traditional industries such as healthcare and supply chain management. If blockchain technology is going to reorder the financial world, as its champions hope, then smart contracts will be a big reason why. They just might be crypto’s killer app.

What are smart contracts on blockchain?

As their name suggests, smart contracts are software programs that manage transactions and agreements on blockchains, which are decentralized computer networks on the internet accessible to anyone with a laptop and a web connection. 

The concept of smart contracts actually predates the advent of crypto and DeFi by more than a decade. In 1994, Nick Szabo, an American computer scientist and cryptographer, developed the idea of an automated agreement as a way to foster transactions between strangers on the internet. He likened smart contracts to digital vending machines that deliver snacks and drinks to buyers with no human intervention.  

How do smart contracts work?

In traditional transactions, buyers and sellers bring in brokers, financiers, lawyers and others to review and finalize deals as simple as a home loan or as complicated as a corporate bond offering. These are painstaking, time-consuming processes that generate lots of fees for intermediaries and the many people who work at them. And it doesn’t end after the deal is done. Professional services are often required to execute and manage a contract for the duration of its term. Lenders, for example, will oversee the administrative chores of mortgage payments, and applications for home equity loans, over the life of a mortgage. 

With smart contracts, sellers and buyers can replace those intermediaries with computer code. By programming a transaction at the outset to handle various functions—payments, interest rates, penalties, even delinquency notices and liquidations—the smart contract code puts business deals on autopilot. The best part is there are usually no fees to pay on the contracts (though there may be charges for using a blockchain). Because smart contracts operate on blockchains instead of centralized corporate hubs, transactions are visible in real time to all the vested parties. And thanks to the immutability of blockchains, the contract can’t be altered or erased. 

Smart contracts automate the execution of agreements by following basic “if, when, then” models. That means when something happens during the term of a contract, the program will automatically prompt action. For example, if a homebuyer is using a smart contract to manage a mortgage and makes a monthly payment, then the program will reduce the principal owed by the correct amount and levy the appropriate interest rate. Or, if the borrower misses a payment or two, then the smart contract will send a delinquency letter. The contract can even be programmed to activate contingencies in the event the mortgage is paid early or the homeowner seeks a home equity loan, or, for that matter, if the debt goes into default.

What are smart contracts used for?

Ethereum, the most valuable cryptocurrency after Bitcoin, made smart contracts a fixture in the digital assets market by utilizing them like accounts for users on its network. The accounts were denominated in Ether, the token at the heart of the Ethereum blockchain, and users could send ETH to other recipients to make investments, exchange them for other cryptocurrencies, or buy goods and services ranging from art to hotel stays.

A raft of other platforms now employ smart contracts for a range of crypto financial activities. These projects tend to be grouped in an industry called decentralized finance, or DeFi, which offers users an alternative to traditional banking and investing services. A platform called Aave, for example, uses smart contracts to let customers deposit digital tokens in an account and earn interest or yield on the assets. Swarm Markets, a Berlin-based cryptocurrency exchange, uses smart contracts to facilitate trading. 

Non-fungible tokens, or NFTs, also depend on smart contracts. These increasingly popular programs use blockchain technology to create unique versions of digital images that can be auctioned, traded, and exchanged online. NFT marketplaces tap smart contracts to handle the transfer of certified images to buyers and verify ownership. 

Smart contracts are also driving the growth of decentralized autonomous organizations, or DAOs. These groups function like cooperatives with members voting on their governance, mission, and other activities. They are emerging as a new type of corporate structure, and smart contracts make them possible. DAOs use them like an automated constitution or charter—the contracts memorialize and execute an organization’s rules, duties to their members, and other actions.  

Not to be left behind, traditional industries have also embraced this new form of software because their data are so reliable and transparent. Logistics companies have found the smart contract a useful tool for tracking and managing the transportation of goods. By permitting the participants in a global supply chain to access the same record in real time, smart contracts can address the confusion and miscommunication that often bedevils shipping concerns. Corporations such as Home Depot and GlaxoSmithKline use smart contracts, and Microsoft and IBM are developing them for clients. 

What are the potential advantages of smart contracts?

Smart contracts have a wide range of possible uses and offer improvement on existing systems. The plusses include:

  • Accuracy: As blockchain-based programs that dwell on a decentralized network of computers, smart contracts cannot be altered or manipulated by users so their data are reliable. 
  • Speed: Smart contracts are digital, automated programs that execute the terms of an agreement instantly and with no need to consult intermediaries.
  • Efficiency: By eliminating the need for intermediaries, smart contracts can be approved by their respective parties without red tape or fees. 
  • Transparency: Smart contracts can be accessed in real time by any vested party anywhere in the world with an internet connection. 
  • Security: It’s extremely difficult to hack smart contracts because they are based on blockchains such as Ethereum that have proven resilient.

There are some disadvantages too, including:

  • Bugs: Like all software, a smart contract is vulnerable to programming errors, glitches and other technological mishaps.
  • Costs: Executing smart contract transactions can be pricey due to what are known as “gas fees,” which are like tolls for using the Ethereum blockchain. 
  • Immutability: The permanence of smart contracts makes them secure but this also makes them hard to amend should the parties want to alter a deal. 
  • Enforcement: With scant regulatory authority over smart contracts parties may not have legal recourse in disputes.
  • Privacy: While the transparency of blockchain technology improves efficiency, business is often dependent on preserving client confidentiality.

The bottom line

Even as Bitcoin dominates the headlines, smart contracts are being steadily adopted by cryptocurrency ventures and traditional industries alike. By eliminating the need to use pricey intermediaries, smart contracts deliver efficiency and speed in an increasingly fast-moving global economy. Thanks to blockchain networks, the smart contract can also provide reliable data and transparency. 

While the lack of regulatory scrutiny is a worry, smart contracts have the potential to be more than just a useful software tool. They are an intrinsic component in NFTs, which have been embraced by gaming companies, professional sports leagues, media conglomerates, and celebrities. Smart contracts are also a cornerstone of DAOs, a new breed of enterprise that is attracting hundreds of millions of dollars in investments from influential venture capital firms. Contracts are an indispensible staple in the real world. The same appears to hold true in the crypto world, too.

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