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What are smart contracts?

What are smart contracts?

Smart Contracts

As cryptocurrency becomes more prevalent every day, there is a growing importance for people to become educated and understand what is going on in the space. One of the most important concepts in cryptocurrency, and a driving force behind creating the utility crypto has today, is smart contracts. Smart contract code controls most of what goes on behind the scenes to make decentralized ecosystems work. However, even though smart contracts are vital to how cryptocurrencies work, they remain unknown to many investing and participating in the space.

This article is an introduction to smart contracts and how smart contracts work. Education is vital and an understanding of smart contracts will help everyone do their own research on the smart contracts that will become a bigger part of their life, whether they are invested in cryptocurrency or not.

What is a smart contract?

A smart contract is code, operating on the blockchain, that runs when certain conditions are met. Smart contracts enable two parties to enter into an agreement without a third party intermediary. The contracts automate transactions and secure them using blockchain technologies. There is added security, increased efficiency, and lower costs because transactions are able to happen peer-to-peer.

Security comes from the fact that all parties are able to inspect the smart contract code on the blockchain and understand what the code will do when they interact with it. Transactions cannot be altered after they take place, the transaction will always be reviewable. Since the code will run as written, consider checking if the smart contract has been audited by a trusted third party source.

Increased efficiency happens because smart contracts run automatically without a third party intermediary. There is no waiting for normal business hours, the transaction happens when the conditions are met.

Lower costs are a result of fewer steps in the process. There is no outside party that needs to be compensated for time or effort. The smart contract just runs how it was programmed to run.

The term “smart contract” was first introduced by Nick Szabo, a computer scientist and legal scholar, in 1994. He compared them to vending machines, where you insert money and press a button knowing that a corresponding item would be dispensed. There is no need for a middle man in the transaction because you enter into an agreement with the vending machine knowing what will happen after you follow certain steps. He saw the value in digital smart contracts by being able to automatically execute certain terms of a traditional contract.

Bitcoin introduced rudimentary smart contracts but it wasn’t until the release of the Ethereum blockchain in 2015 that smarts contracts truly took off.

Ethereum smart contracts allowed developers to be more creative and programming languages such as Solidity gave developers the tools to innovate on what was possible. Decentralized applications, or dApps, are programs that run off of one or more smart contracts on the blockchain and benefit from many of the same benefits smart contracts and blockchains provide.

How do Smart Contracts work?

Smart Contracts work by executing code when certain parameters occur. They typically follow if-then conditional logic. If X happens, then the smart contract will make Y happen.

Developers create the smart contract program and deploy it to the blockchain where it becomes immutable. Anyone can see the code which provides transparency regarding what will happen if the smart contract is interacted with.

When the conditions of the smart contract are met, the program is run on the blockchain and the transaction is then secured on the blockchain forever. 

Benefits of Smart Contracts

Benefits of smart contracts include speed of transactions, trustless transactions, and low cost transactions.

Since there is no third party involved, smart contracts on the blockchain are able to settle transactions from seconds to at most hours depending on network congestion, even the high end of hours is significantly shorter than the days required by traditional escrow services.

Most people are familiar with how long it takes for transactions to show up on their bank statement or for refunds to be processed back to their card. Those are all delays associated with the use of a third party intermediary for payments. Smart contracts remove those steps to create a transaction that can be processed much faster.

An issue with peer-to-peer transactions is being able to trust the other party. For example, if you meet up with someone to buy a toaster, the toaster could end up being broken or the check used to pay for it could bounce. There is a level of trust that needs to take place for people to feel safe about any transaction.

Smart contracts provide this security by making the transaction trustless, both parties are given assurance because the smart contract will only run if both parties fulfill their obligations.

Low costs are another benefit of smart contracts. Removing extra steps in the transaction process removes extra costs. Instead of paying for a third party to process paperwork, the smart contract takes care of everything automatically. This means that the transaction can occur with minimal fees.

Applications of Smart Contracts

Supply Chain

Smart contracts can be used to make the supply chain more efficient. Information can be transmitted in real time to keep everyone informed about where items are along the chain. Documents can be automatically generated as shipments are checked in. For example, a bill of lading can be generated when the carrier arrives at a destination. This helps to keep track of shipments and cuts down on steps that can delay the process.

Insurance

Smart contracts are useful for insurance because they can automate payouts. Insurance payouts can potentially take months or longer to process. The information is transparent to everyone involved and administrative costs are reduced. The smart contract ties the insurance policy to certain real world events and can automatically payout if those events take place. Smart contracts use oracles, nodes on the blockchain that allow real world data to be accessible, to verify if events take place.

Decentralized Finance

Decentralized finance (DeFi) is powered by the use of smart contracts. DeFi opens up the potential for any person to be involved in finance without the need for an expensive middleman. The transparent, high speed, and low cost nature of smart contracts make DeFi viable. Smart contracts enable lending, borrowing, and providing liquidity among other uses.

NFTs

Smart contracts are used in NFTs to ensure a fair distribution when minting digital assets. They allow the ownership history of each NFT to be tracked and the legitimacy to be proven on the blockchain. Also, royalty payments to benefit the original artist from subsequent sales are executed based on the original code