Bitcoin tends to grab a lot of headlines, but the truth is the most significant innovation since BTC is Ethereum. Ethereum is the engine that is fueling countless innovations in all things crypto.
Bitcoin’s founder Satoshi invented blockchain technology as a ledger for Bitcoin to facilitate transparent transactions directly between parties without the need for an intermediary. While the original concept of blockchain was very innovative in and of itself, Vitalik Buterin and other early Bitcoin programmers quickly took it one step further.
Ethereum and Smart Contracts
The original Bitcoin blockchain kept it simple – all users could do was transact with Bitcoin.
Vitalik saw a need for a platform to support digital money and a wide range of decentralized applications. He created the Ethereum blockchain as a flexible and programmable solution. He also coined the term “smart contract” in the context of blockchain and crypto.
Smart contracts are like the killer app for blockchain. They are snippets of code that include predefined rules and conditions. The code runs on the blockchain to automate actions when parties meet specific contract conditions.
Smart contracts could revolutionize transaction efficiency and cut costs in major industries like insurance, finance, healthcare, supply chain, and government.
Analysts valued the smart contracts market size at USD 684.3 million in 2020 and forecast a compound annual growth rate (CAGR) of 82.2% from 2023 to 2030. Today, several major blockchains alongside Ethereum drive growth in the US smart contracts market.
With smart contracts, people can use their metamask wallet (or other wallets) not just for money but for all kinds of agreements and tasks without relying on traditional contracts or intermediaries like agents, lawyers, salespeople, banks, brokers, and more.
Smart contract executions reflect blockchain’s characteristics – they are transparent, efficient, and tamper-proof. The terminology for smart contracts is a little opaque. To clarify confusion, below is how smart contracts work with immutability, automation, and trustlessness.
- Immutability ensures that once you record a smart contract on the blockchain, no one can alter the code and terms after the fact without notifying the network. This precaution, therefore, provides a reliable and unchanging source of truth.
- Automation allows the contract to execute automatically when predefined conditions are met, streamlining processes and reducing the potential for errors. For example, smart contracts could automate crypto mortgage payments.
- Trustlessness arises because parties involved in a smart contract don’t need to trust each other; they only need to trust the underlying blockchain technology.
We can look to creative spaces for simple, timely examples of how individuals can benefit from smart contracts. In traditional art sales, the artist receives a one-time payment for her work. Her agent, gallery, or auction house also takes a cut.
With blockchain, artists can create an NFT for that artwork. That NFT is a digital token that establishes her as the work’s author and, for example, includes a smart contract that stipulates copyright usage and gives her a commission of 10% of any future sales of the work.
When someone resells the artwork in the future, the NFT goes with it. The change of ownership gets recorded on the blockchain, and the smart contract automatically executes the royalty payment to the artist’s crypto wallet without human oversight.
Since the action takes place on the blockchain, it is transparent to all parties, eliminating the need for a trusted intermediary to verify.
Smart Contract Advantages for Cryptocurrency Transactions
Utilizing smart contracts for cryptocurrency transactions offers numerous advantages, such as:
- Enable real-time settlement and verification of transactions: Smart contracts can eliminate delays typically associated with traditional financial systems, such as cross-border transactions that can take days or even weeks to clear.
- Ensure transparency: Smart contracts aren’t locked in one party’s proprietary database. All transactions and their outcomes are recorded on the blockchain and remain accessible to all parties involved.
- Reduce costs and minimize the risk of human error: Unlike conventional processes that rely on intermediaries, smart contracts’ reliance on decentralized blockchain networks automates and streamlines transactions. It also significantly reduces the chance of error.
- Enhance security by utilizing cryptographic techniques: In theory, smart contracts operate within a tamper-proof and transparent blockchain environment. In reality, hacks happen. However, cryptographic techniques increase the odds that data is secure, and the decentralized consensus mechanism reduces the risk of fraud and manipulation.
- Guard against tampering and fraud: Blockchains have multiple validators that keep exact copies of the ledger and maintain its integrity. Because of this, it’s almost impossible to secretly change a smart contract or otherwise commit fraud around a transaction recorded on the chain.
How Smart Contracts Work
Writing smart contracts involves several steps to create a streamlined, automated, and trustworthy process for executing complex agreements without intermediaries.
- Define the contract: Initially, the contract client and a developer or a group of developers define the terms, conditions, and actions the agreement will carry out. Vendors also offer contract templates for commonplace contracts.
- Write, test, and deploy: Developers use programming languages like Solidity to write Ethereum-based contracts. Once the author writes and tests the code, they deploy it onto the blockchain network.
- Execute: When users interacting with the contract meet specific conditions which trigger the contract’s execution. These conditions are programmed into the contract, ranging from time-based triggers to specific data inputs.
Every step of smart contract execution is recorded on the blockchain, making it accessible to all participants on the network. Once executed, the contract’s code and data are locked in, providing an unalterable transaction record. This transparency ensures that parties can independently verify and audit the contract’s execution, promoting stakeholder trust.
Smart Contracts, Decentralized Exchanges (DEX), and Centralized Exchanges (CEX)
Crypto exchanges’ reliance on smart contracts partly depend on how centralized their structure is. Centralized Exchanges (CEX) are similar to a conventional stock exchange, where a separate entity handles trades and controls the assets’ safekeeping. Users entrust their funds to the exchange’s central wallet. CEX uses smart contracts, but not to the same degree as DEX.
Decentralized exchanges (DEX) (decentralized exchanges) are peer-to-peer marketplaces where investors trade cryptocurrencies without an intermediary to facilitate the transfer and custody of funds. Investors are required to use smart contracts to interact.
This chart gives a snapshot of the differences between CEX and DEX.
A DEX is an excellent example of financial innovation that would not be possible without smart contracts. Popular DEXs include Covo, Uniswap, Curve Finance, and Pancake Swap.
By utilizing smart contracts, decentralized exchanges empower users with greater control over their assets, enable faster settlement times, and promote a more inclusive and censorship-resistant financial infrastructure.
Smart contracts manage order matching, trade execution, and fund custody in a transparent, automated manner. This management not only enhances security and reduces counterparty risk but also contributes to the overall resilience of the exchange ecosystem.
Well, that’s the theory, at least. The DEX space is new and highly complex. As with crypto in general, it has some growing pains. Smart contracts don’t guarantee all security. In late July, hackers exploited a bug in Curve Finance’s legacy code and stole $62 M.
Even so, as the popularity of DEXs spreads, smart contracts will remain a critical component in shaping the future of decentralized trading.
As crypto continues to gain mainstream traction, we will see more innovation and growth for smart contracts, as well. Do you trade currencies on a DEX? If so, ZenLedger can help you organize everything for tax season.
The platform aggregates transactions across wallets and exchanges, computes your overall capital gain or loss, and generates the tax forms you must file yearly. You can even find ways to reduce your tax bill through tax loss harvesting and other techniques.
This material has been prepared for informational purposes only and is not intended to provide tax, legal, or financial advice. You should consult your tax, legal, and accounting advisors before engaging in any transaction.