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Blockchain Smart Contracts And How They Are Used, Explained

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  • Posted on 06th Aug, 2022 00:14 AM

Smart contracts are blockchain programs that are different from computer programs. Here's how they work, and why they are important for Web3 apps.

Anyone who has spent time in cryptocurrency, blockchain, and Web3 eventually sees the term "smart contract", but many people don't know what it means. Confusingly, smart contracts have nothing to do with legal contracts, despite being inspired by them, and are fundamentally different from web apps and computer programs. Despite being the most powerful technology to emerge from blockchain, most people have never heard of them.

Smart contracts were first conceptualized by Nick Szabo in 1995 (who may or may not be Satoshi Nakamoto, the anonymous creator of Bitcoin), who had the idea of "transaction protocols" that automatically execute the terms of a contract between two parties over the internet. This would have been very useful, as smart contracts could reduce or eliminate the risk of counterparties refusing to uphold their end of a contract, avoiding costly court battles. Unfortunately, there exists no way to do this without relying on a third party to host the contract, who could potentially alter or halt the code, thus rendering the idea pointless. Also, unlike cryptocurrency, digital currency is not programmable, and bank-to-bank money transfers are inefficient and reversible. These limitations are why smart contracts didn't exist before the Ethereum blockchain went live 20 years later in 2015.


Related: U.S. Digital Currency Takes A Step Forward, Here’s What It Could Look Like

Smart contracts are often described like regular contracts, but this is misleading and limiting. They are actually tiny programs running on a second-generation blockchain (i.e. Ethereum), where crypto wallets and other smart contracts can interact with them. Almost all cryptocurrency and NFTs are standardized smart contracts that track token balances, allowing other smart contracts to act like middlemen or vending machines, eliminating counterparty risk during trades, transactions, and distributions. Token contracts are essential to Web3, cryptocurrency, and blockchain-based metaverses, as they create transferrable digital property. Smart contracts can create utilities, like "airdrop" contracts that transfer tokens to many accounts simultaneously, or "multi-sig" contracts that require multiple signatures to confirm an action. Smart contracts are used extensively in Decentralized Finance ("DeFi"), a blockchain sector that replaces common financial applications with smart contracts, and in November 2021, DeFi contracts held nearly $100B of value (according to DeFi Pulse). Smart contract capabilities are extensive, with many more in development.

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Smart Contracts Are Very Powerful, For Better Or For Worse

Smart contracts have many features. Websites and web apps can call smart contract functions, providing an easy interface for them. "Public" functions are open for anyone to use, while sensitive functions can be restricted to authorized users/contracts. Nobody can alter or halt a smart contract's functions, and crypto/NFT transfers are irreversible and take only a few seconds. They are also reliable, and will continue running during high-volume bottlenecks that otherwise crash cryptocurrency exchanges. Smart contracts are autonomous "residents" of their blockchain's ecosystem, requiring no maintenance or expense once they are deployed, and they cannot be destroyed or modified (with some exceptions).

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Smart contracts do have problems, as smart contract "bugs" account for billions in lost/stolen crypto over the past seven years. Because they can't be modified, fixing a smart contract works like a manufacturer's recall, where a new/upgraded contract is deployed and users must manually move their tokens over. Consequently, smart contracts are developed like hardware instead of software, and professional security audit and inspection services are often hired to find vulnerabilities before launch. Smart contracts are limited to their native blockchain's ecosystem, and require the use of "bridges" to move assets to other blockchains, making blockchain bridges big targets for hackers. Finally, smart contracts are "blind" to the real world, and must be fed data through special services, which can cause serious problems if the data is wrong (even momentarily).

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Smart contracts are the most powerful technology within blockchain, giving rise to cryptocurrencies, NFTs, DeFi, Web3 apps, blockchain games, decentralized metaverses, and far more. They are the engines that drive blockchain's adoption forward, being given little credit until things go wrong. While their potential is massive, developers are not yet familiar with their quirks, as complex designs introduce more (expensive) problems, and years of trial and error are needed before blockchain smart contracts will be ready for mass-adoption.

Next: DAOs And Why They Are An Important Part Of The Blockchain

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Source: DeFi Pulse

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