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Smart Contracts

Smart Contracts: What They Are & How They Work

Learn all about smart contracts, how they work, and some essential tips to consider when using them.

Many everyday tasks involve trusting an intermediary, from buying a cup of coffee with a credit card to sharing a photo on social media. Unfortunately, intermediaries introduce the potential for human error, leading to everything from data breaches to unconscious biases. Fortunately, decentralization can help solve these problems.

Smart contracts are at the heart of decentralization. Rather than trusting an intermediary to execute an agreement, they enable two parties to codify the agreement and automatically execute it when certain conditions are met. The result is zero potential for human error (as long as the contract is well-built) and no room for unconscious bias.

Let’s look at smart contracts, how they work, and some essential tips to consider when using them.

Smart contracts eliminate the need for an intermediary by codifying agreements and executing them when conditions are met.

What Are Smart Contracts?

Computer scientist and cryptographer Nick Szabo coined the term “smart contract” in 1993. He described smart contracts as digital promises with specific protocols for each party to perform on the promises. While he was the first to coin the term, he noted that vending machines were in fact the oldest example of a smart contract implementation.

In 2013, Ethereum merged the idea of smart contracts with blockchain technology. With a Turing-complete language called Solidity, developers could build just about any smart contract they could imagine. In addition, they can easily store ETH in the contract and execute code that performs actions with those funds or updates the contract’s state.

It’s critical to note that smart contracts are immutable by design, meaning you cannot change or delete them. So, if you need to make an update (e.g., a security fix), you must deploy an entirely new contract. Furthermore, when deploying or executing smart contracts, you must pay gas fees to compensate the network for computing power and storage capacity.

Smart contracts can be used for many things:

  • Financial Agreements – Smart contracts can manage the terms of a financial agreement. For example, the entire decentralized finance (DeFi) ecosystem relies on smart contracts to govern the terms of lending agreements and trading activity.
  • In-Game Economies – Smart contracts govern the creation of NFT-based in-game items, proving ownership and codifying scarcity. Smart contracts can even generate random items, creating one-of-a-kind experiences for players.
  • Recordkeeping – Smart contracts can ensure accurate recordkeeping without the need for intermediaries. For instance, real estate transactions can be recorded on a blockchain without costly and time-consuming title transfers or broker fees.
  • Governance – Smart contracts can encode entire corporate governance structures, creating decentralized autonomous organizations (DAOs) that don’t require employment contracts or other formalities to operate.

Of course, these use cases just scratch the surface of what’s possible. For example, the healthcare industry could leverage smart contracts and blockchain technology to enable secure, trustless, and transparent data sharing between patients, providers, and insurance companies. Or, governments could use them to eliminate high overhead costs or manage voting processes.

Pros & Cons of Smart Contracts

Smart contracts are becoming increasingly common to power everything from decentralized exchanges to online memberships. But of course, there has been growing pains along the way. For instance, poorly written smart contracts have been exploited, resulting in millions of dollars worth of stolen assets. As a result, you should carefully consider the pros and cons of using smart contracts:

Pros

  • Security – The blockchain and smart contracts on it are immutable, meaning it’s impossible to alter transactions once blocks are confirmed.
  • Speed – Smart contracts are fully automated, meaning you don’t have to wait for an intermediary to process a transaction.
  • Accurate – Smart contracts ensure 100% accuracy with every transaction since there’s no intermediary capable of making human errors.
  • Transparent – Many blockchains are fully transparent, meaning that everyone can view the record of transactions and verify any part of it.

Cons

  • Legality – Most smart contracts are likely legally enforceable, but there is little case law on the matter, which could create problems in some industries.
  • Flexibility – Smart contracts execute every agreement based on a defined process, leaving little room for flexibility when it’s necessary.
  • Vulnerabilities – Transactions with poorly written smart contracts can be hacked or exploited, leading to unrecoverable stolen funds.
  • Bottlenecks – Smart contracts involve gas fees, storage capacity and computational power, which can sometimes introduce bottlenecks.

How Smart Contracts Work

Smart contracts are written in a domain-specific language (DSL). For example, most Ethereum contracts are written in Solidity—a high-level object-oriented language inspired by JavaScript, Python, and C++. Next, Virtual Machines (VMs) convert smart contracts into bytecode. And finally, the bytecode is stored on the blockchain at a specific address.

Smart Contracts
A diagram showing how the Ethereum EVM works under the hood. Source: Ethereum

The most popular smart contract platforms include:

  • Ethereum – Ethereum is the second most popular cryptocurrency globally after Bitcoin and the original developer of crypto smart contracts.
  • Cardano – Cardano is a proof-of-stake blockchain founded on peer-reviewed research and evidence-based methods. It supports smart contracts written in Plutus or IELE.
  • Polkadot – Polkadot is a multi-chain that uses Moonbeam, a fully Ethereum-compatible environment that runs on a para-chain and offers governance, staking, and more.
  • EOS – EOS is an open-source blockchain with smart contracts written in C++. A defining feature is the ability to upgrade after deployment without disrupting the network.
  • TRON – TRON aims to power the decentralized web, and its smart contracts use Solidity, like Ethereum, making it compatible with many existing smart contracts.

Most people interact with smart contracts using decentralized applications (Dapps). For instance, every Ethereum node exposes an RPC-JSON interface over HTTPS or Web Sockets that Dapps can use to connect and submit transactions. Developers interact with these interfaces using libraries, like Web3.js or Ether.js.

Some popular Dapps include:

  • OpenSea – OpenSea is an online marketplace that allows users to purchase, sell, and trade non-fungible tokens (NFTs).
  • Uniswap – Uniswap is a cryptocurrency exchange that provides liquidity to tokens on the Ethereum network using smart contracts.
  • MakerDAO – MakerDAO is an Ethereum smart contract that incentivizes a network to maintain DAI—a peg to the U.S. dollar.

In addition to Dapps, smart contracts are integral to Web3—the decentralized internet. For example, smart contracts help store domain names on services like UnstoppableDomains and power the hosting networks of IPFS.

The Bottom Line

Smart contracts are the cornerstone of decentralization. By codifying an agreement and executing it when conditions are met, they eliminate the need for costly and dangerous intermediaries. Easy-to-use DSLs and a growing number of Dapp libraries make smart contracts accessible to a wide range of developers and businesses.

If you leverage smart contracts, ZenLedger can help organize your taxes and ensure you stay on the right side of the law. Get started for free!

Justin Kuepper

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