What are Smart Contracts and How Do They Work?

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Updated: 6th Oct 2021
Written by Andrew
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October 6, 2021
Written by Andrew

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Technology in the crypto sphere moves fast, and it’s increasingly spreading into other areas of finance and investing.

An example of this fast-paced innovation is the creation of smart contracts, which are key components in the blockchains that support cryptocurrencies.

As businesses and programmers find more applications for them, it’s important to know what they are, how they’re used, plus their strengths and limitations.

What are Smart Contracts?

A smart contract is essentially a piece of code written to automatically fulfill the function of a business contract or agreement between two or more parties.

A traditional contract is a legally binding agreement that Party B will do something in return if Party A does one thing.

The digital equivalent is quite similar. Developed as an idea for one of the first conceptual digital currencies, smart contracts simply translate the rules of business into if/then statements written in and fulfilled by computer code.

How Do Smart Contracts Work?

If a smart contract is well-written, it allows two people to uphold their side of a given bargain without the hassle of a lawyer or middleman.

Once the smart contract – or code – is implemented, when Party A fulfills the agreed-upon conditions, then the code runs and fulfills the other side of the deal.

For instance, two people might agree that if Party A sends a file, Party B will pay them $100.

They can then write a smart contract to sense when Party A sends the file. Then, the code will trigger Party B’s account to transfer the $100 automatically.

This system turns legally binding contracts into an automated action operated by a computer, thereby cutting out third parties such as lawyers or arbiters.

>> More: Best Crypto Exchanges

What are the Advantages of Smart Contracts?

Today, smart contracts typically carry out straightforward functions, but their true potential is just now being released. Let’s take a look at the strengths that make smart contracts shine.

Speed

As an automated system, smart contracts can be as fast as the systems to which they’re connected.

For instance, if the contract concerns delivery payment, the fund transfer is authorized when the delivery arrives.

This means that both parties can ensure the bill is paid the exact moment the job is completed.

In other words, the process only slows down if the work requires validation or if the payment routes through a slower system.

The Lightning Network is the perfect example of smart contracts enabling speed on layer two of the Bitcoin network.

Efficiency

Some contracts may require an inspection to ensure that the terms of the contract are met as promised, which can pose problems if the contract involves material applications.

But if the agreement covers electronic transfers – such as files for digital payments – then the need for third-party checks is moot, saving both time and labor.

Trust and Transparency

A contract negotiation can sometimes feel a bit like a hostage situation where neither party trusts the other but hopes that the other trusts them because they need what they have.

But with a proper smart contract, you don’t have to worry whether the other party will follow through on their agreement. Once certain conditions are met, the smart contract executes in a permissionless fashion based on the initial agreement.

Safe & Secure

Properly decentralized blockchains are difficult to alter because they are secured by encryption.

Network consensus mechanisms like proof-of-work and proof-of-stake financially incentivize nodes to stay honest, contributing to the security of smart contracts built on top of them.

What are the Disadvantages of Smart Contracts?

Crypto is a religion for many, and some zealots in the space might overpromise on a technology’s results and capability.

While smart contracts have their strengths and provide an elegant solution to a particular problem, they’re not without their downsides.

Human Error

Smart contracts work if they’re correctly written. Though the automated system itself is unlikely to commit errors, the code involved is handwritten and therefore vulnerable to human error.

Human error can lead to cryptocurrencies getting lost or stolen, which is what once happened on the Ethereum network and led to its hard fork.

Legal Protections

You’re legally bound to uphold the terms when you enter into a traditional contract. Even if that doesn’t provide complete blanket protection to the participants, knowing that they might have to explain their “breach of contract” in front of a judge can go a long way in encouraging honesty.

However, smart contracts are not legally binding (yet, at least). For instance, let’s say that your smart contract stipulates that you’ll pay 0.0005 BTC for 100 pounds of bananas.

The crate arrives, your automated system recognizes the bananas on top of the pile, and your system scans your bananas in and routes the BTC to the vendor.

But when you open the crate later, you find ten pounds of bananas on top and 90 pounds of sand underneath.

In this situation, your money is on the way to the vendor for a bad product, and you have no signed contract to wave in court and demand your payment returned.

Applicability

This issue leads to our next challenge. While smart contracts are ideal for many online services, applying if/then code to other exchanges – especially where quality checks are essential – puts the onus on verifiers to ensure the conditions are met.

This both negates the proposed advantages of smart contracts and reintroduces risk to transactions.

Cryptocurrencies like Chainlink are solving these problems by applying oracle networks of real-world data to smart contracts.

Smart Contract Use Cases: Examples & Disruption Analyzed

Smart contracts have passed from an obscure blockchain function into mainstream applications. Let’s unpack a few of those.

Real Estate

Smart contracts have the potential to cut out costly middlemen, such as brokers, in real estate.

For instance, a seller could tokenize their deed and hold it in escrow in the blockchain. Then, when the buyer transfers funds, they receive the deed automatically.

Insurance

Smart contracts could make routing funds to the appropriate parties a quick, red-tape-less hassle in an emergency – after the proper paperwork goes through processing, of course.

Supply Chains

With high-quality tracking systems, using smart contracts could allow suppliers to automate the transfer of goods and release payments as soon as goods are received and scanned.

Digital Identities

Social media, along with much of the internet, operates by monetizing identity. Users give information to a company to use their website, which then sells information to interested parties.

But blockchain technologies have the potential to make it impossible to track, and therefore control, who uses that information and how.

Users could even create smart contracts to sell their information, thereby controlling their identity and profiting off the sale themselves.

Legal Contracts

Legal contracts provide the most speculative of uses so far, as the legally binding nature of smart contracts is yet to be determined by legislation.

Currently, you can think of smart contracts as an alternative to legal contracts that also cut out intermediaries.

But with the right legal framework, they can become digitized legal contracts or a means of triggering legally binding agreements.

Cryptographically has historically been more consistent than an individual’s word.

Smart Contracts and Decentralized Applications (dApps)

Essentially, dApps decentralized apps that run on a peer-to-peer DeFi network.

These often share many key features of cryptos, such as being open-sourced networks with public data that secure their networks with cryptography.

DApps are made possible due to the presence of smart contracts, which connect the blockchain to the app.

Because smart contracts provide a dApp’s core operability, they’re not only essential to functionality but can minimize transaction failures and improve control.

How are Smart Contracts Created?

A smart contract is created when two parties make an agreement, codify that agreement, and add the code to a particular blockchain. Smart contracts typically require each individual to deposit a certain amount of crypto that is native to that blockchain.

Are Smart Contracts Safe to Use?

Ultimately, smart contracts are exactly as safe as you make them. If you write a sloppy agreement, hire a bad coder, work with untrustworthy partners, or trade-in goods you can’t easily verify, it’s easier to cheat the system. A computer is only as smart as its inputs.

This also applies to the technical question of a smart contract’s security. While there are many protections built into the blockchain system to make hacking and manipulation difficult, bad code can literally write vulnerabilities into the system – as early Ethereum can attest.

In other words, smart contracts aren’t the magic bullet that business needs, but they can be a useful, secure tool when used wisely.

Bottom Line: What are Smart Contracts?

At the end of the day, a smart contract is a piece of code that reflects and executes an agreement between two parties.

They play an important role in blockchain technology, including the development and operation of dApps, though new applications constantly crop up.

That said, smart contracts aren’t infallible, especially when they’re written with bad code or between shady partners.

But by hiring good coders and planning your arrangements carefully, smart contracts can be powerful tools to automate business deals and cut out costly middlemen.

Andrew
Andrew
Andrew is an editor-writer living and working in Southern California. While he’s previously focused on editing for financial publications, he’s now dabbling in the writing pool as well. Hobbies include listening to podcasts, and learning about all things financial. (Just don't ask him about logarithms.)