Beginner’s Guide: What is Blockchain Smart Contract?

SHORT ANSWER: Smart contracts are digital agreements programmed and stored on blockchains that automatically execute when conditions are met. Smart contracts eliminate the need for centralized intermediaries and are the backbone of decentralized applications (dApps). Smart contracts allow various traditional and novel use cases to occur efficiently, securely and transparently in a trustless environment. 

The advent of smart contracts in the blockchain ecosystem has been one of the most pivotal developments since Bitcoin’s inception in 2009. If you have interacted with any decentralized application (dApp), a smart contract was used to facilitate that experience. Smart contracts have provided an efficient way for agreements between parties to be carried out and enforced in a decentralized way, revolutionizing the traditional system and creating amazing use cases. 

What is Blockchain Smart Contract? 

Smart contracts are programmable logic stored on the blockchain executed automatically when certain conditions are met. The logic is similar to traditional contracts; however, smart contracts are digital and decentralized. Smart contracts enable many functionalities previously unable to be performed without centralized intermediaries. Smart contracts permit transactions and other data exchanges to be carried out without requiring trust between parties. 

History of Smart Contracts 

While many date smart contracts to the Ethereum network’s launch in 2015, they were initially pioneered by computer scientist Nick Szabo. Szabo created smart contracts in 1996 to digitize and decentralize traditional contracts. Szabo defined smart contracts as a “computerized transaction protocol that executes the terms of a contract.” The Ethereum network realized Szabo’s vision at scale as the first smart contract blockchain 19 years later. Since then, smart contract networks and applications have become a pillar in the ecosystem given their wide variety of use cases and effectiveness at executing complex transactions in a trustless environment. 

Why Are Smart Contracts Important? 

The successful integration of smart contracts may have been the biggest innovation in blockchain. Blockchain's ethos is decentralization enabled through distributed networks. Smart contracts provide an efficient mechanism for logic to be automatically executed between parties without a centralized intermediary. Leveraging blockchain, smart contracts allow parties to agree in a trustless environment. The distributed infrastructure of blockchain enables these contracts to be very resistant to being tampered with, making them very secure. Once a smart contract is executed, it cannot be reversed and is viewable on the blockchain. This immutability and transparency make smart contracts extremely effective at executing contracts and value exchanges that traditionally require a centralized party. Smart contracts are one of the key building blocks in moving toward a decentralized internet.

How Do Smart Contracts Work? 

A standard contract in the real world is a legally binding agreement between parties, each agreeing to fulfill certain conditions and obligations in exchange for certain benefits and values.  All parties must agree and complete their respective conditions for a contract to be valid and enacted. A legal third party can enforce compliance if parties fail to fulfill their end of the deal. Smart contracts operate similarly by programming if/then statements. Once these if/then statements are fulfilled, the network validates the conditions are met, releasing the predetermined items to each party. By programming logic, smart contracts are automated and do not require manual enforcement like traditional contracts. Smart contracts are stored on the blockchain, making them secure, immutable and transparent for anyone to see. Smart contracts act like a legal third party or escrow, ensuring parties fulfill their obligations. However, smart contracts are not controlled by a single entity and only execute when all if-then conditions are met, fostering accordance in a trustless environment. 

Types of Smart Contracts 

The three categories of smart contracts have their own use cases. 

• Smart legal contract: These contracts are the blockchain-based counterpart to traditional legal agreements. Legal conditions are coded and automatically executed when met. Smart legal contracts are prevalent in exchanging intellectual property and service provisions. 
• Application logic contract (ALC): Used in decentralized finance (DeFi) applications, ALCs are the backbone of blockchain-based applications. They typically handle user transactions, issue tokens, and ensure participants act according to the protocol. 
• Decentralized autonomous organization (DAO): DAOs are autonomous organizations that decentralized decision-making. For instance, smart contracts are commonly used in DAOs to enforce governance and voting mechanisms. Since DAOs are a distributed-member community, smart contracts can record votes from participants and issue access to specific parties when conditions are met. 

Smart Contract Uses and Applications 

With the ability to execute agreements between parties, smart contracts can be used for many purposes. One common smart contract use case is facilitating transactions between parties. Smart contracts are the backbone of  DeFi applications, which require value exchange between users without trust. Smart contracts enable users to transact with each other, executing when if-then statements are met. For example, a user goes to a decentralized exchange (DEX) like Uniswap looking to exchange ETH for USDC. The user navigates to a liquidity pool where liquidity providers have deposited the respective pair of assets. The user looking to swap exchanges their assets. The smart contract automatically facilitates this transaction, giving the user their new assets, rebalancing the liquidity pool and supplying the provider with rewards. All of this occurs automatically without the user and provider knowing each other. Here are some other smart contract applications.

• Smart contracts can be used for real estate transactions, transferring title rights when payments are made. 
• Smart contracts are used to distribute royalty payments to respective parties swiftly and efficiently automatically. 
• Another popular case of smart contracts is enforcing and transferring intellectual property rights – much faster than traditional methods. 

Pros and Cons of Smart Contracts 

Let's examine some of the advantages and disadvantages of smart contracts.

Benefits of Smart Contracts 

• Immutability: Smart contracts cannot be altered once deployed, ensuring integrity in agreements and parties. 
• Accuracy: Because smart contracts are programmable, conditions are solidified. 
• Efficiency: By using smart contracts, agreements are automated and can be executed swiftly.
• Transparency: Smart contracts are easy to confirm and view on chain, making them transparent and audit-friendly.   
• Cost reduction: Traditional middleman fees are waived by eliminating the need for centralized intermediaries. 
• Wide applications: Smart contracts are versatile and can be used for various traditional and novel applications opening the door for incredible use cases. 

Limitations of Smart Contracts 

• Vulnerabilities: Smart contracts can be coded maliciously with loopholes that are hard to spot until it’s too late. Smart contract auditing has become a key part of mitigating this outcome. 
• Inability to change: If a smart contract is coded with an error, it is impossible to reverse. For this reason, ensuring the proper conditions are coded into the contract is important. 
• Scalability: If a blockchain network becomes congested from high volume, the smart contract executes slower because nodes in the network must agree on all transactions they are before finalized.

The Bottom Line 

Implementing smart contracts has been a game changer in the Web3 ecosystem. Pioneered by Szabo in 1996 and popularized by Ethereum’s launch in 2015, smart contracts provide a host of use cases, now ubiquitous in the ecosystem. From facilitating payments between parties automatically and trustlessly to transferring the rights of physical and digital property, smart contracts have revolutionized how people interact. Blockchain infrastructure plays a key role by storing smart contracts and providing a medium for them to execute, providing transparency, security and immutability. While the list of benefits is extensive, smart contracts have drawbacks. They have played a pivotal role in moving towards a decentralized internet and continue to be innovated and improved daily. Virtually all dApps use smart contracts in some way. With dApps being a key part of blockchain adoption, smart contracts have a promising future.