When people think of decentralized finance (DeFi) and blockchain technology, their minds often go immediately to cryptocurrency. Of course that's an important part of this digital world. But there is another feature — the smart contract — that's even more foundational.
In many ways, smart contracts operate similarly to any other contract. They represent an agreement between two parties. But instead of being written with ink and paper, they're written in computer code, stored on the blockchain and often execute automatically.
In this guide, we dive into what smart contracts are, how they work, their various applications and more.
In This Article
The Short Version
- A smart contract is an agreement between two parties that's written in lines of code on the blockchain.
- A smart contract self-executes. This means that once the two parties agree to the terms, the contract comes to fruition automatically.
- Smart contracts have many applications. These include trading, lending, insurance, and supply chain management.
- Smart contracts have plenty of benefits. These include security and predictability. But they also have some downsides, such as legal uncertainty and inflexibility.
What Are Smart Contracts in Crypto?
A smart contract is a secure and transparent agreement between two parties that's written in lines of computer code. Smart contracts are built using blockchain technology and are designed to execute automatically when certain conditions are met. In other words, each party can be assured the other will follow through on their side of the agreement. And because smart contracts are written in the blockchain, the terms of the agreement can't be changed and all transactions can be tracked.
The concept of smart contracts isn't exactly new. Nick Szabo coined the term in 1994. This computer scientist described smart contracts as computerized transactions that execute the terms of a contract.
In an article from 1996, he wrote, “A smart contract is a set of promises, specified in digital form, including protocols within which the parties perform on these promises.”
He described these protocols as being embedded in both the software and hardware being dealt with — whether it's a vending machine that dispenses treats only after money is registered or powerful computer networks that can make smart contracts self-enforcing.
Of course, back in the mid-'90s, Szabo couldn't have known what the digital landscape would look like or how smart contracts would fit into today's world of decentralized finance and blockchain technology. However, many of the objectives and protocols he introduced do, in fact, exist in smart contracts today.
What Is Decentralized Finance (DeFi)?
Decentralized finance, also known as DeFi, is a subset of the financial industry. It takes place outside of the traditional centralized financial systems. DeFi operates largely by using blockchain technology. It allows for peer-to-peer transactions that bypass the middleman of a traditional bank or other type of financial institution.
DeFi allows consumers to make some of the same transactions they usually conduct through the traditional financial system. These include borrowing and lending, investing, storing their money and earning interest on their savings. The difference is that DeFi removes the party that facilitates these transactions and instead relies on smart contracts to complete them.
How Smart Contracts in Crypto Work
Some people compare smart contracts to vending machines. These are based on a similar principle. You receive a specific output based on the information you select.
You choose the product and insert the payment as stated and required. Then the smart vending machine (or smart contract) verifies you have fulfilled your obligation and completes the transaction.
Smart contracts have a few characteristics that make them different from your typical ink-and-paper contracts. These include:
- Automatic execution: One of the defining characteristics of smart contracts is that they're self-executing. Once the parties have signed the contract, neither has to take any further action to complete the transaction. Instead, the contract executes all on its own.
- Predictable outcomes: Because they execute on their own, there's no room for human failure. Parties don't have to worry about another failing to follow through on their end of the deal or interpreting it differently. The smart contract produces a predictable and certain result.
- Public record: Transactions on the blockchain are public records. They provide transparency and tracking. Think of it like the tracking number you get for your UPS package, which confirms that it's been delivered. Because the contract is public, it also has visible terms that leave no room for confusion.
- Security measures: Despite their transparency, smart contracts also leave room for privacy and security. Your transactions are tied to your cryptographic address rather than your identity, so you can remain anonymous.
What Are Smart Contracts Used For?
Smart contracts have many real-world applications. Some people use them in place of a more conventional contract. Others use them for applications that are entirely unique to the blockchain and DeFi.
Lending and Borrowing
Smart contracts have a natural home in the financial world, specifically between a lender and a borrower. Whether it's two private parties or an individual and a financial institution, a smart contract can be used to facilitate the initial transfer of funds, the repayment of funds, and in the case of a secured loan, the release of the property when the loan is paid off.
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Usually a broker acts as a middle person between a buyer and seller in a transaction. But with a smart contract, the two parties come to an agreement and have it automatically execute without the involvement of a third party. The smart contract ensures the asset is delivered to one party while the payment is delivered to the other.
Smart contracts can also be used in the creation of businesses and other legal entities. There are often legal documents required to incorporate and manage a business, and smart contracts can be used to do exactly those things. The smart contract encodes the company's ownership structure and ensures all parties are held to the initial contract.
Supply Chain Management
Another industry where smart contracts can have a place is supply chain management. Rather than having individuals create and track a supply chain, smart contracts could do that instead. A smart contract tracks inventory more accurately and ensures that the business makes and receives the order exactly when it needs it.
And Much More
The above list is just a small sampling of the different applications smart contracts can have in the real world. Other examples include security, government operations, insurance contracts and escrow accounts. In the coming years, it's likely we'll see smart contracts become even more prevalent.
Smart Contract Platforms
Smart contracts can be facilitated on different platforms for different purposes but perhaps the most common platform is Ethereum. Digital contracts are a critical part of Ethereum's blockchain and are available to anyone on the network.
Ethereum smart contracts execute on the Ethereum virtual machine (EVM). To create a smart contract, you need to know how to code your contract. Luckily, there are services that can help with that. And because a smart contract is a transaction, you must pay any transaction fees (known as gas fees) the Ethereum platform requires.
Currently, Ethereum is the most popular platform for creating and executing smart contracts. Bitcoin blockchain also allows the creation of smart contracts.
Bitcoin smart contracts are created and executed on the Bitcoin blockchain network (BSV). The Bitcoin blockchain ledger stores the agreement with the same security and predictability as on the Ethereum platform.
What Are the Benefits of Smart Contracts in Crypto?
Smart contracts have many benefits, and it's easy to see why they're becoming prevalent in a number of different industries.
First, smart contracts create a level of simplicity. They execute automatically. This means no human action is required. You don't have to deal with the time commitment of collaborating with other individuals or balancing schedules to sign documents or finding safe storage for those documents or even worrying about the accuracy of the smart contract.
Secondly, smart contracts also create a level of trust and security. Because they are self-executing, smart contracts allow both parties to feel more comfortable about the transaction. Not only can neither fail to follow up on their side of the agreement, but there's a clear record of the transaction. And even though everything is transparent, individual parties can still maintain their security and anonymity.
Risks & Challenges of Smart Contracts
Despite their benefits, there are some challenges associated with smart contracts. For one thing, creating a smart contract requires writing computer code, which not everyone is able to do. Even attorneys — those individuals most qualified to write and analyze contracts — have an uphill battle navigating smart contracts if they aren't particularly tech savvy.
Related to that is the issue of how smart contracts work in a legal setting. As long as a smart contract has the legal components of a contract — offer, acceptance and consideration — it can be legally enforceable. But there are very few examples of these contracts being argued in a court of law.
Another potential issue with smart contracts is their inflexibility. Yes, parties may appreciate the self-execution and reliability of smart contracts. But a smart contract cannot be modified. Traditional contracts have legal mechanisms that allow parties to amend certain terms. Not so with a smart contract. Once a smart contract is locked into place, there's no turning back – not even if the two parties mutually agree to a compromise or find an error in the original contract.
Smart contracts don't leave room for subjectivity or human action. This is both an advantage and a risk. In a traditional insurance relationship, for example, if your payment is late, you could speak with your insurance provider and request that they waive the late fee and allow your policy to stay intact. In fact, it wouldn't be at all outside of the ordinary for them to do that. But a smart contract allows no human interaction.
The Bottom Line
Smart contracts combine legal agreements and blockchain technology.
Smart contracts are relatively new. But they already have many uses in the financial world, from borrowing to investing to insurance. And moving forward, it's likely we'll see these contracts become even more prevalent. Of course, there are some risks and challenges to smart contracts, so make sure you fully understand their legal implications before entering into one.
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