Have you ever imagined a world where every agreement, process, or payment leaves a digital footprint — a verifiable, storable, and sharable record? A realm where every transaction occurs directly between parties, with no middlemen involved?
All these are now possible because of smart contracts.
Let’s understand these digital agreements as we voyage into the future of contract execution and personal finance.
Prepare for a comprehensive journey as we unravel the intricacies of smart contracts explained!
What Are Smart Contracts?
In blockchain and cryptocurrencies, “smart contracts” are a recurring buzzword. But what exactly are these so-called smart contracts?
At the most basic level, a smart contract is a self-executing contract embedded with the terms of the agreement directly into lines of code. The code and its agreements exist across a decentralized blockchain network.
To give you a simple analogy, consider a vending machine. When you deposit money and select a product, the machine automatically delivers your chosen item.
You don’t need an intermediary (like a shopkeeper) to take your money and hand you the product. The machine itself is enforcing the “contract” between you and it.
History of Smart Contracts
The concept of smart contracts was first proposed by Nick Szabo, a legal scholar and cryptographer, in 1994. However, it wasn’t until the advent of the Ethereum blockchain that smart contracts as we know them today became a reality.
Unlike Bitcoin, which uses its blockchain to track ownership of its digital currency (bitcoin), Ethereum allows developers to build a wide variety of decentralized apps and tokens using its blockchain platform, and it’s here that smart contracts have flourished.
In a nutshell, smart contracts are coded and stored on the blockchain. They automatically execute contractual obligations based on the pre-determined rules and conditions, eliminating the need for a third party.
From personal loans to voting systems to crypto wallets like Coinbase, smart contracts are the backbone that allows many blockchain services to function smoothly and transparently.
How do Smart Contracts Work?
To understand how smart contracts work, let’s first look at how traditional contracts operate. Normally, two parties would agree on terms, often with the help of lawyers, and then both parties sign the contract.
If one party fails to meet the terms, the other party may take them to court to enforce the contract. There are numerous steps, and the process can be lengthy, costly, and requires trust in the system.
The following image explains the working process through which smart contracts function –
Smart contracts simplified this process with the help of blockchain technology.
Here are the key steps involved:
- Agreement Creation: The terms of the contract are agreed upon by all parties involved. These terms are then coded into the smart contract. The smart contract code governs what will happen under different circumstances, almost like a traditional contract dictating the terms and conditions.
- Contract Deployment: Once the smart contract has been written, it is deployed onto the blockchain. This means the contract is live and can interact with other contracts, make decisions, store data, and send others Ether (or other blockchain tokens).
- Execution: When the conditions coded into the contract are met, the contract is automatically executed. This could be the transfer of funds, the issuance of a token, or any other pre-agreed action. The execution is automatic and does not require intervention from the parties involved.
- Validation and Record: Because the contract is on the blockchain, the execution is verified by multiple participants in the network, making it virtually tamper-proof. The record of the contract and its execution is also stored on the blockchain, providing a transparent, unchangeable history.
A vital advantage of this process is that it removes the need for a trusted third party. Instead, the parties involved in the contract trust in the contract’s code and the blockchain’s decentralized nature.
Here’s an example of a smart contract in action:
| Action | Traditional Contract | Smart Contract |
| Creation | Lawyers draft an agreement | Developers code the agreement into a smart contract |
| Signing | Both parties sign contract | Smart contract is deployed on the blockchain |
| Execution | One party fails, other sues | Conditions met, contract automatically executes |
| Validation | Court verifies breach of contract | Blockchain participants verify contract execution |
While smart contracts can handle complex logic, automate processes, and interact with other contracts, they are ultimately only as good as the code they are written with. The contract code must be accurate and secure to ensure the agreement is executed correctly.
That’s where skilled blockchain development comes into play.
The developer needs to understand the programming languages, the nuances of the contract’s intent, and the potential edge cases that could disrupt the agreement.
Types of Smart Contracts in Blockchain
Smart contracts are vital in making things work smoothly in the blockchain world.
Let’s uncover the three main types of smart contracts in simpler terms:
1. Smart Legal Contracts
These smart contracts combine traditional legal agreements with the power of blockchain. But what does that mean? Well, it’s like turning a legal document into computer code.
This way, the terms and conditions become automated and can be enforced without manual intervention. They make sure everything is legal and transparent, thanks to blockchain.
2. Decentralized Autonomous Organizations (DAOs)
Now, this one is a bit like a self-governing club. DAOs use smart contracts to run things without a central boss. Instead, they follow rules written in code.
But how does it work? Members of the DAO participate in decision-making and managing projects in a fair and open way, thanks to these smart contracts.
3. Application Logic Contracts
These are the most common types of smart contracts. Think of them as digital helpers. They do tasks automatically when certain conditions are met.
For example, when you buy something online, these smart contracts ensure the transaction happens smoothly without needing a middleman.
These three smart contracts show how blockchain can make things more efficient and change how we do business. Our blog on the types of smart contracts can help you identify the differences between these major types of smart contracts. Don’t forget to look into it if you want to learn more!
NFT Smart Contracts
A NFT smart contract is the backbone of non-fungible tokens, or NFTs, which are unique digital assets stored on the blockchain.
Here’s a brief explanation of what an NFT smart contract is:
- Defining Ownership: NFT smart contracts determine who owns a specific digital item, like artwork or collectibles.
- Immutable Records: They create a permanent, unchangeable record of ownership.
- Transferring Ownership: These contracts enable the buying, selling, and trading of NFTs securely and transparently.
- Customizable Rules: You can customize the rules within the contract to suit the specific needs of the NFT.
NFT smart contracts provide the rules and structure that make NFTs unique and valuable digital assets. Do not avoid checking our detailed article about NFT Smart Contracts if you have more queries!
Web3 Smart Contracts
Web3 smart contracts are digital agreements run on a decentralized internet called Web3. They work by using computer code to automate the execution of agreements, removing the need for intermediaries like banks and lawyers.
These contracts are stored on a secure blockchain, ensuring transparency and preventing tampering.
The technology behind Web3 smart contracts simplifies and accelerates the agreement process. When specific conditions are met, transactions are automatically executed, reducing the possibility of errors and disputes.
Web3 smart contracts have the potential to reshape various sectors, from finance to supply chain management and voting systems. They improve efficiency, enhance security, and foster trust in our increasingly interconnected world.
Have more interest to learn about these contracts? Our in-depth guide about Web3 Smart Contracts has everything you need to know. Reading out it will solve all your confusion, so don’t miss out!
Benefits of Smart Contracts
Smart contracts can transform various facets of our daily lives, from industries like business and finance to legal affairs and societal structures.
1. Trust
Utilizing blockchain technology, smart contracts create a transparent and immutable record of all transactions. Once a contract is written, it cannot be altered, ensuring all parties can trust the executed outcomes.
This transparency fosters an environment of trust, which is critical in sectors like finance, real estate, and healthcare, where the integrity of transactions is paramount.
2. Autonomy
Smart contracts eliminate the need for intermediaries such as notaries, lawyers, or brokers, thereby providing more control to the parties directly involved.
This autonomous functioning leads to streamlined operations, reduced complexities, and the ability for individuals to engage in transactions without requiring third-party validation.
3. Security
Smart contracts are highly secure, thanks to the cryptographic algorithms that protect the blockchain. This level of security ensures that once a contract is deployed, it is highly resistant to hacks, unauthorized alterations, or fraud.
This enhanced security can be invaluable in an era of rampant data breaches and cyber-attacks.
4. Efficiency and Speed
Automation is at the heart of smart contracts, enabling them to execute clauses when predefined conditions are met, all without human intervention.
This speeds up processes significantly and allows for near-instantaneous execution of complex agreements, particularly in time-sensitive sectors like supply chain management or stock trading.
5. Savings
One of the most significant benefits of smart contracts is the cost-saving aspect. By eliminating the need for intermediaries, smart contracts cut down on fees, commissions, and other charges usually associated with third parties.
This can lead to significant financial savings over the long term, making transactions more cost-effective for everyone involved.
6. Accuracy
Smart contracts are automated, reducing the risks associated with human error. Whether it’s incorrect data entry or the misinterpretation of contract terms, such errors can be costly and time-consuming to rectify.
Automated execution ensures that as long as the contract is correctly written, the actions taken will be accurate and as intended.
7. Global Reach
Smart contracts operate on decentralized blockchain networks, making them accessible from anywhere worldwide. This global reach enables cross-border transactions without needing currency exchange or local intermediaries, democratizing access to various services and markets.
It offers an inclusive financial system that can cater to people worldwide, irrespective of their geographic location.
8. Caveats and Considerations
While smart contracts offer numerous benefits, they are not a universal fix for every situation. Traditional contracts may still be more suitable depending on unique requirements and contexts.
Additionally, smart contracts can introduce their own set of challenges and complexities. Subsequent sections will delve into the practical applications and limitations of smart contracts.
Applications of Smart Contracts in Different Industries and Sectors
Smart contracts have far-reaching applications across various sectors, transforming how we do business and interact in digital environments.
The table below shows the applications of Smart Contracts in different industries.
| Sector | Application of Smart Contracts |
| Financial Services | Automate insurance claims, loan approvals, and create DeFi apps |
| Real Estate | Automate buying or renting processes, reducing the risk of fraud |
| Supply Chain Management | Enhance transparency and traceability |
| Healthcare | Maintain patient data privacy and security |
| Voting Systems | Facilitate transparent and secure elections |
| Entertainment Industry | Ensure fair and immediate distribution of royalties |
The true beauty of smart contracts lies in their versatility. Virtually any industry that relies on contractual agreements (which is most) could potentially be disrupted by this technology.
However, it’s important to note that smart contracts have great potential but not without limitations and challenges.
Want to know about the applications of smart contracts in a more detailed way? Look at our comprehensive guide to recognize the use cases of smart contracts in an extended form.
List of Smart Contract Platforms
Smart contracts are revolutionizing industries, offering efficient and secure solutions. Choosing the right platform is crucial for your specific needs.
Here’s a list of some top smart contract platforms:
- Ethereum: Known for pioneering smart contracts and hosting popular dApps like Uniswap and MakerDAO.
- EOS: Offers scalability and free transactions, attracting diverse dApps.
- Avalanche: With its unique consensus mechanism, it’s fast and eco-friendly.
- Algorand: Prioritizes speed and efficiency with notable projects like Circle’s USDC.
- Hyperledger Fabric: Ideal for enterprises focusing on private, confidential transactions.
- Polkadot: Enhances scalability and interoperability with applications in DeFi and identity verification.
- Tezos: Features on-chain governance and is energy-efficient.
Each platform has unique features, from speed and scalability to privacy and environmental considerations.
Do you want to know about more platforms and then decide which aligns best with your future plans or business goals? If so, then make sure you check out our blog, which includes a list of popular smart contracts!
What Smart Contracts Do Not Promise To Do?
While smart contracts have the potential to revolutionize many industries and processes, it’s also essential to understand what they can’t do, or at least what they can’t do yet.
Let’s highlight some of these limitations:
1. Handle External Information
Smart contracts are unable to manage or interact with data outside their network.
They require an external data source known as an “oracle” to interact with off-chain data, potentially introducing a point of vulnerability.
2. Code All Legal Agreements
Not all legal contracts can be coded, especially those that require subjective assessment or personal judgment.
For example, a contract involving the quality of a piece of art would be difficult to translate into a smart contract because “quality” is subjective and can’t be quantified or measured accurately.
3. Overcome Legal Regulatory Hurdles
Smart contracts operate in a digital, decentralized environment, often beyond the reach of traditional legal systems. This can present challenges in areas where legal enforcement is required or in dispute resolution cases.
The legal status and enforceability of smart contracts remain unclear in many jurisdictions.
4. Guarantee Perfect Security
While blockchain networks are highly secure, smart contracts are only as secure as the code they’re written in.
If there are bugs in the code, they can be exploited, as seen in the infamous DAO hack in Ethereum’s early days.
5. Revise or Amend Easily
Once a smart contract is deployed on the blockchain, it can’t be easily changed or updated.
While useful in ensuring trust and transparency, this immutability can pose problems if a contract needs to be revised or if a mistake was made in the original code.
While these limitations don’t negate smart contracts’ incredible potential, they highlight areas where caution, further research, and development are necessary.
Do Smart Contracts Need Gas?
Yes, smart contracts do need gas.
Gas is like fuel for smart contracts on blockchain platforms such as Ethereum. It’s necessary to make them work. Here’s how it works:
- What is Gas: Gas is a fee for each operation your smart contract performs on the blockchain.
- Preventing Misuse: Gas helps prevent people from overloading the blockchain with too many operations.
- Variable Costs: The amount of gas required depends on the complexity of the contract. Simple tasks cost less gas, but complex ones cost more.
Now that you know smart contracts need gas, do you want to know in-depth what gas fees are or the related facts about it? Then please read our latest blog about gas fees!
Limitations and Challenges of Smart Contracts
While the applications of smart contracts are far-reaching, like any evolving technology, they also come with their fair share of challenges and limitations.
Let’s dive deeper into some of these:
1. Technical Issues
Smart contracts are only as good as the code they’re written. This means that if there are bugs in the code, they can lead to severe consequences.
As smart contracts are immutable once deployed, fixing those bugs is challenging.
2. Legal Issues
The legal status of smart contracts isn’t clearly defined in many jurisdictions. If a dispute arises, it may be unclear how to resolve it legally.
Traditional legal contracts often have clauses that allow for changes in unforeseen circumstances (force majeure, for example). It’s unclear how such changes would be accommodated in a smart contract.
3. Regulatory Hurdles
Regulatory bodies worldwide are still grappling with how to deal with cryptocurrencies and smart contracts. Until a clear regulatory framework is in place, businesses and individuals may hesitate to embrace smart contracts fully.
4. Interoperability
Interoperability is a limitation in the realm of smart contracts. Many are designed to work on specific blockchain platforms; an Ethereum-based contract won’t run on a different blockchain.
This restricts the contract’s utility and reach, as it can’t easily interact with other blockchain ecosystems, limiting cross-platform collaborations.
5. Scalability
As smart contracts grow in complexity, they demand more computational resources for execution. This can create scalability issues, potentially slowing down the entire blockchain network.
Scalability remains a challenge, especially for blockchains that aim to host multiple complex smart contracts simultaneously.
6. Data Privacy
Smart contracts on public blockchains are transparent, meaning all data and transactions are visible to network participants. While transparency is often an asset, it becomes a drawback when data privacy is essential.
This transparency can be a significant challenge in sectors like healthcare or finance, where sensitive information must be kept confidential.
Final Words
Smart contracts are changing how we conceive agreements by providing a secure, transparent, and efficient way to execute contracts.
From finance to supply chain management, they are disrupting various industries. However, as with any emerging technology, understanding the nuances of smart contracts—what they can and cannot promise—is crucial.
While they are not without their limitations and challenges, the potential for their evolution and growth is vast. As the world leans more towards decentralization, the relevance and applicability of smart contracts are likely to grow.
By developing better frameworks, refining the code, and setting clear regulations, the world of smart contracts explained can open new horizons for many sectors.
