Simply put, smart contracts are digital contracts that are executed automatically when some predefined conditions are met. They are completely automated once live and can facilitate transactions and agreements in a trustless manner. In other words, various parties can do business without actually having to know or trust each other.
Smart contracts are widely used in the Decentralized Finance (DeFi) space, however, they can be applied in other industries to automate workflow and other agreement processes.
In this article, you will learn about the fundamentals of smart contracts and their pros and cons, and you will get to know some of their applications and use cases.
Smart contracts are executable computer codes on a blockchain system that perform specific tasks if the predefined and necessary conditions are met.
Blockchain technology allows smart contracts to be secure and immutable while helping unknown parties to do business in a decentralized and trustless manner.
Even though multiple blockchain networks support smart contract functionality, the Ethereum blockchain is the main platform for smart contract development.
Smart contracts on the Ethereum blockchain are written in Solidity programming language and will run on the Ethereum Virtual Machine (EVM).
Smart contracts are the foundation of Decentralized Finance (DeFi) protocols that facilitate financial interactions between two parties without the need for intermediaries such as banks or exchanges.
DeFi lending protocols, for example, allow two users to be able to exchange their assets directly and without knowing each other. The underlying smart contract of a DeFi lending protocol will make sure that all conditions are met and that both parties are providing what is required from them.
Smart contracts work in an if…then fashion. If a predefined condition is met, then a specific action will be initiated.
Let’s see this with a simple example:
Alice has a shoe store and Bob wants to buy a pair of shoes from Alice. With current systems, Bob should first choose his shoes, place an order, choose the payment method that suits him best, and wait for his shoes to be delivered.
With a smart contract, things will be much easier and more automated. Let’s say Alice’s online shop is leveraging a smart contract with simple conditions and actions. If the product is delivered successfully, the payment will be initiated.
In this way, Bob can be sure that payment will only go through if he is satisfied with the product while Alice can rest assured that Bob is capable of the payment (in case of a Payment-on-Delivery order).
The contract can also be programmed in a way to punish both parties in case of any misconduct to ensure fair results for everyone involved. If the delivery is delayed, Alice should compensate Bob for the missing time. On the other hand, if Bob was not available for the delivery, Alice should be compensated for the extra time and costs of rearranging the delivery.
As we can see in this example, the conditions in a smart contract need to be defined and drafted in a fair manner to ensure that both parties are benefiting from the contract equally. Once the contract is executed and live, the conditions cannot be changed which ensures the security of the contract in the absence of a central authority.
On the Ethereum blockchain, for instance, the contract goes live as the first transaction is executed and the incurred fees are paid in the form of Ether. This fee keeps random smart contracts from entering the system and congesting the network.
Smart contracts offer multiple benefits that can streamline the workflow and processes in various industries. The current executions, however, have shown some serious flaws that need to be addressed to make the technology ready to be used widely.
Here are some of the advantages that smart contracts bring to the table:
Security: smart contracts are executed on the blockchain. A copy of the contract exists on the blockchain nodes which removes a single point of failure. This also makes smart contracts immutable as they are secured in the history of the blockchain by complex mathematical methods.
Saving Time/Cost: smart contracts are decentralized and can be executed automatically without the need for any intermediaries. This makes the whole process faster while cutting costs associated with the regular middlemen.
Efficiency: as mentioned above, smart contracts are quite faster than conventional methods. Smart contracts are restless and can work all the time. Regardless of time or workload, smart contracts can initiate the process once the required conditions are met.
Transparency: being blockchain-based allows smart contracts to be transparent as well. Everyone can view the history of transactions on an open blockchain system and verify the authenticity of realized conditions and performed actions.
Below are some of the main disadvantages of smart contracts that need to be addressed:
Prone to Error: smart contracts are written by humans and are prone to errors. These errors can lead to catastrophic results if not addressed properly and on time. The DAO hack is a good example of this which led to a $60M loss of users’ funds.
Complex: not tech-savvy users would not be able to develop smart contracts on their own and need to rely on third parties. This complexity may keep many from using smart contracts in their work, holding the technology back from becoming mainstream.
Unreliable Data: many smart contracts rely on outsourced data to be able to assess the condition and see if it’s met. Unreliable data will cause the results of a smart contract to become untrustworthy as well.
Uncertain Regulatory: smart contracts are yet to become legally accepted by authorities. At the moment, smart contracts can be legally binding, however, the laws and regulations are not as clear as should be.
Smart contracts are quite new in practice, however, they can be useful in various fields:
Retail: as mentioned in the example above, smart contracts can bring more transparency and efficiency to the retail industry by ensuring on-time payments upon the successful delivery of the ordered items.
International Trade: smart contracts open the door to sufficient and trustless international trade. Regardless of location and background, two strangers can do business together and trust the secure code to execute the conditions and safeguard their rights.
Supply-chain management: just like the retail space, smart contracts can be used on a greater scale for supply-chain management. Along with transparency and efficiency, smart contracts will provide powerful traceability and the end user will be able to trace the received final item and its journey from the origin to its destination.
Insurance: the combination of the Internet of Things (IoT) and smart contracts can streamline insurance processes. Data from sensors, for instance, can confirm if a predefined condition in the insurance contract is met after which the smart contract can initiate the compensation process.