How Do Crypto Smart Contracts Work?

Important points:

• A smart contract is a digital contract that automatically executes when certain conditions are met on the blockchain network.

• Smart contracts facilitate trustless transactions between individuals who can choose to be anonymous, eliminating the need for intermediaries like banks.

• Smart contracts make transactions traceable, transparent, and irreversible.

Smart contracts are a core element of decentralized finance (DeFi). They replace intermediaries in financial transactions through which transactions are executed once conditions are met. Smart contracts have taken decentralization to the next level, as users can automatically execute approved contracts with complete transparency.

In this article, we’ll take a closer look at smart contracts, their history, how they work, their strengths and weaknesses, and their use cases.

What is a smart contract?

A smart contract is a self-executing computer program that lives on the blockchain. They consist of code that prescribes certain conditions that, when met, activate certain outcomes. By operating on a blockchain-like distributed ledger, smart contracts allow parties to reach agreements precisely on time while ensuring immutability.

Smart contracts are an important infrastructure for automation as they are not regulated by a central authority. Therefore, it is more tolerant to single points of failure. When deployed in multiparty contracts, smart contracts minimize counterparty risk, increase efficiency, reduce costs, and increase process transparency.

Generally, smart contracts are used to automate the implementation of contracts for parties to achieve near-instantaneous final decisions without the involvement of third parties. Automate workflows and activate the next possible action when coded instructions are met.

Characteristics of smart contracts

The main features of smart contracts are:

self-executing

Smart contracts are self-enforcing, greatly minimizing human intervention. Logic-driven code unlocks value/access when a given condition is met.

self-verification

A smart contract can validate itself if a user follows coded conditions. In case of violation, the offender can be punished according to the rules. For example, a smart contract can cancel a pending loan if the borrower fails to lock the collateral within a given timeline.

immutable

Terms agreed upon by one party cannot be changed, minimizing corruption and partisan interests of one party. The only way to edit smart contracts is to add extra blocks to the current network with the mutual consent of all users.

History of smart contracts

American computer expert, legal scholar, and cryptographer Nick Szabo first introduced smart contracts in 1994. He has broad objectives of “meeting general terms and conditions, minimizing malicious and accidental exceptions, and minimizing the need for trusted intermediaries.”

A practical analogy for smart contracts has been demonstrated in systems such as vending machines (i.e., when the conditions for inserting money are met, the code triggers the expected snack), but blockchain Established the foundation for digitally immutable, permissionless smart contracts. The launch of the Bitcoin network in 2009 probably presented the first protocol smart contracts. This creates a set of conditions that must be met in order to move her BTC between wallets. Requirements include BTC senders using the correct private key to confirm transfers and holding sufficient assets to fund the transaction.

The Bitcoin network then evolved to support another smart contract type, multisig transactions, in 2012. This transaction requires a certain number of users (public keys) to sign the transaction with their private key in order to validate the transaction. This technology enhances the security of user assets by preventing single points of failure such as hacking or loss of private keys.

After that, developers began actively experimenting and introducing new operation codes or opcodes. Nevertheless, the next major smart contract milestone was the publication of the Ethereum Whitepaper in 2013. An Ethereum developer has rolled out a new blockchain for programmable smart he contracts two years later. Instead of serving exclusively as a single smart contract use case or providing limited opcodes, the new chain uses the Ethereum virtual machine, a “world computer” that can simultaneously operate multiple sovereign smart contracts. presented.

How do crypto smart contracts work?

Smart contracts work according to basic “if, when, then” statements encoded in the blockchain. A distributed network of computers executes transaction requests when certain conditions are met and verified. Requests include sending assets to designated wallets, creating NFTs, sending alerts, distributing event tickets, and more. Once the action is completed, the validator will include the transaction on the blockchain. This means that the action cannot be undone or corrupted.

A smart contract can contain as many provisions as possible to assure participants that the activity will end properly. To create terms, users articulate how transactions and related information are presented on the network, agree to “if, when, then” commands governing transactions, and explore all possible omissions. and devise mechanisms for resolving disagreements.

Anyone can build a smart contract and run it on the blockchain to perform a variety of roles, such as individual yield aggregators that automatically move their assets to the highest yielding decentralized applications (dApps). But blockchain as a service (BaaS) companies also provide templates, website interfaces, and other essential tools to simplify the creation of smart contracts.

Smart contracts often involve multiple anonymous, independent participants, who may trust each other. Contracts specify exactly how participants interact, who can interact with the contract when, and what inputs produce what outputs. This product is a multi-faceted digital contract, from the current probabilistic state to the new deterministic state.

Advantages of smart contracts

Smart contracts can automate the contract lifecycle and digitize operations. Below are some of the main advantages of smart contracts.

Transparency

Smart contract terms and conditions are accessible to all parties. Because smart contracts are based on the blockchain, they guarantee data immutability while keeping records accessible to all parties in the event of confusion or disagreement.

autonomy and savings

Smart contracts do not require centralized authorities or third parties to validate them. Thus eliminating the risks of corruption and human error that are prevalent among administrators. Additionally, removing third parties from the equation reduces costs and streamlines processes.

speed

Smart contracts introduce automation through computer protocols, eliminate the need for intermediaries, and save hours of manual work required to manually draft contracts.

Accuracy

Smart contracts eliminate manual entry from the equation and automate the process, minimizing the chance of human error in documents.

Smart contract limits

While there are many reasons to use smart contracts, there are a few concerns to be aware of:

Immutability

Once the smart contract is executed there is no way to undo the transaction. You can change the code, but it will only apply to future transactions. This is why smart contract audits are important. Because auditors check for security vulnerabilities and other potential issues, not “test in production”.

Inflexibility

Smart contracts are objective, rigid, and executed when conditions are met. Traditional contracts may include phrases such as “good faith” or “reasonable” to establish room for flexibility. Such terms are necessary when referring to relationship agreements rather than transactional agreements.

Confidentiality challenge

Smart contracts provide transparency by recording all information on the blockchain, which means that anyone can access this information and most users prefer to keep transaction details private. increase. For example, after interacting with a smart contract, your wallet address could be tracked and your entire transaction history exposed.

Smart contracts and decentralized applications

A dApp is an open source software application that runs on a blockchain or peer-to-peer (P2P) network. dApps are similar to regular apps, but they behave differently because they operate on decentralized protocols without the involvement of a centralized entity. These bridge the gap between web2 and web3.

A smart contract is an on-chain component of a dApp. We said that smart contracts are self-enforcing computer programs that automatically execute transactions when agreed-upon conditions are met.

dApps leverage smart contracts as backends to authorize transfers and link to the blockchain. Smart contracts are the key to decentralized applications as they all run with the logic coded in the contract without a central entity.

Conclusion

Smart contracts are an integral part of DeFi as they form the core building blocks of dApps. Potentially improve the transparency, speed, and accuracy of transactions without relying on third parties. However, while immutability ensures transparency, it also means that there is no ‘undo’ button once a transaction has taken place. If you are using smart contracts for your transactions, consider using a crypto trading platform or secondary wallet to avoid exposing your crypto balances and transaction history.

Josiah Macori

Josiah is a tech evangelist passionate about helping the world understand the concepts of Blockchain, Cryptography, NFTs, DeFi, Tokenization, Fintech and Web3. His hobbies are listening to music and playing soccer. Follow the author on Twitter @TechWriting001