Learn how smart contracts work and how they help power your favorite blockchain networks and tokens.
When it comes to blockchain technology and cryptocurrencies, you open the door to all kinds of technical feats that traditional physical currencies simply can’t match. One excellent example: smart contracts.
What are smart contracts, and how can they benefit you? This article will define what smart contracts are, how they work, what forms they take, and how they can benefit you.
What Is a Smart Contract?
Think of a smart contract as an agreement between participants that is automated by a software program. In the program’s code, “if/when…then” statements allow parts of the agreement to be executed when certain conditions are met.
Importantly, smart contracts’ automation allows execution without the need for a third party or supervising intermediary. A network of computers running a technology called “blockchain” fulfills the agreement, based on predefined instructions.
Smart contracts can be used by any system that employs blockchain technology — financial transactions, supply chain interactions, government registration and compliance processes, etc. But they play a major role in the world of cryptocurrency, which this article will focus on.
How Does a Smart Contract Work?
Smart contracts were first proposed in 1994 by a computer scientist working on a virtual currency called “Bit Gold,” who compared the way smart contracts work to a simple vending machine.
Vending machines automate a purchase. You can deposit the purchase price, or a sum greater or less than the purchase price. The vending machine can calculate how much change to return to you or how much more to ask for. If the item is out of stock, it can refund the money you’ve inserted.
In a much more sophisticated way, smart contracts do the same thing. They can handle interactions between parties and account for various predefined conditions, such as date, time, price, exchange of digital assets, etc.
Since, like a vending machine, smart contracts only execute parts of an agreement when the right conditions are met, they eliminate the need for trust that a party will hold up its end of a bargain. For the same reason, they produce predictable results.
What do smart contracts have to do with cryptocurrency? To best understand the role they can play, let’s first review what makes cryptocurrencies unique, as well as essential elements of the technology — blockchain — that supports their transactions.
What’s a Cryptocurrency?
Pinning down what a currency is always feels problematic. Is it the paper bill you’re holding? The value it represents? Its ability to be accepted in exchange for just about any product or service? Probably all of the above, because it’s really a system of exchange.
Cryptocurrencies are similar except that, instead of having a physical incarnation, they and the system that supports them exist entirely as software code and digital files. Since they are already fully digitized, they make the perfect partner for smart contracts.
In fact, some types of crypto coins and tokens are smart contracts. And all cryptocurrencies and smart contracts run on a foundational transaction technology called blockchain.
What’s a Blockchain?
Blockchain is a technology that enables digital transactions to be recorded accurately, verifiably, and immutably without any intermediary. It’s a database ledger that is distributed over a network of computers, making it very difficult to bring down or take over.
Its name derives from two of its characteristics.
Each series of transactions gets digitally recorded in a discrete “block” that is added once a transaction has been verified. The verification involves solving a difficult computing-intensive problem for a reward.
This gives an incentive for consensus validation instead of a central oversight board that would have to manage transactions. In the process, information about the transaction, the validation, and previous transactions are embedded in the block to “chain” it to previous blocks.
The chain in blockchain is what makes transactions unalterable. Any party that tried to rewrite something in the block would also alter the mathematical signature or “hash” of the block, causing it to no longer align with the rest of the chain.
Crypto Coins and Tokens: Smart Contracts?
As you navigate the world of cryptocurrency, you’ll see references to coins and tokens. At times they may seem interchangeable, but they are slightly different. Some may be strict currency; others may actually be smart contracts.
Generally speaking, a crypto coin (like Bitcoin) is a unit of currency that operates on its own dedicated blockchain, as a native asset. Within that blockchain, it’s the unit of accepted currency. As such, it’s used for exchange on the blockchain but may also be used to buy goods.
A token, on the other hand, is generally created and issued by a smart contract platform. In some cases, it may be a collectible digital asset, as in NFTs — non-fungible tokens.
Many tokens contain or are based on smart contracts. Some coins, such as stablecoins, may also be powered by a smart contract at their core.
Smart Contracts and Cryptocurrency
All crypto assets rely on smart contracts when they are transferred, exchanged, bought, or sold at some point. Some of these smart contracts run on the blockchain itself.
So now that you understand more about how they work and why they exist, but what are their benefits? And are there any limitations to be aware of?
Benefits of Smart Contracts
Smart contracts have been heralded as revolutionary and notably, as a technology that can propose and enforce all legal interactions! It’s important to remember, though, that a smart contract doesn’t have to be a legal contract.
In fact, most smart contracts aren’t legal agreements. They are just simple agreements that are automatically executed once the right pre-conditions are met. However, not all agreement scenarios can be covered by a smart contract.
So what are they good for?
Speed, Efficiency, Accuracy
Since they are automated, no paper is processed and no delays are encountered because of processing time, reconciliations, or error correction. And there are no documents to file manually.
By definition, the parameters for a smart contract are laid out in advance, and the actions are based on conditions known and agreed to by transacting parties.
As we mentioned previously, since they are automatically executed based on those conditions, no trust is required that a party will follow through.
Encrypted blockchain records are difficult to hack, and chaining blocks to make their numeric identifiers interdependent means that to fraudulently change one block, a bad actor would have to also change all the other chained blocks.
Dispensing with the need for intermediaries eliminates third-party fees. And since time is money, faster, automated execution of agreements eliminates delay-induced costs.
Of course, there are some aspects of smart contracts that may be limiting or of concern.
Disadvantages of Smart Contracts
A benefit — immutability — can become a liability if a participant wants to change the terms of an agreement down the road.
While the overall blockchain may be encrypted and hard to hack, individual smart contracts are, well, software programs. Poorly written software can have vulnerabilities that can be exploited. Smart contracts are no different.
Smart contracts are great when the parameters — even very complex interactions among them — are well defined, and subsequent actions to trigger are clearly outlined. They are not “smart” in the human sense when it comes to dealing with nuance or subjective interpretation.
As with the security aspect that was previously covered, smart contracts can experience the same issues any software product does: Quality can vary.
If the smart contract is running on a public blockchain, the contract may be available for public view, even if the actual identities of transacting parties may be anonymized. Depending on what’s being traded, the parties may not want details to be public.
Smart Contract Applications
As we’ve seen, some digital assets are themselves a form of a smart contract. And smart contracts are part of how a blockchain works.
Some crypto exchanges seek to entirely automate their workings by using smart contracts. Called “peer-to-peer” or decentralized exchanges, all crypto trades on such platforms are governed by these contracts.
And outside of the world of cryptocurrency, smart contracts are being used to automate real estate, supply chain, and international cross-border interactions.
Smart Contracts and You
Smart contracts promise to be an important part of our lives over the coming years. They may, in fact, be facilitating everyday interactions you rely on without you knowing it.
Whether they are enabling your cryptocurrency of choice to function on its blockchain or facilitating a buy or sell order, you’ll depend on smart contracts to run things smoothly behind the scenes.
In a sense, smart contracts are a kind of silent partner in your crypto journey.
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