Smart Contracts: The Backbone of Decentralised Applications

• Smart contracts were proposed in 1994 by an American computer scientist called Nick Szabo. He was famous for designing a virtual currency called “Bit Gold” in 1998.
• Smart contracts became recognised after the creation of the Ethereum blockchain in 2015.
• Ethereum is the widely preferred blockchain for smart contract development and the biggest blockchain network regarding TVL (total value locked).

What are Smart Contracts?

Smart contracts are self-executing digital agreements written in code that provide transparency, security, and autonomy in blockchain transactions and assist developers in creating decentralised applications (dApps). Once the defined conditions are met, smart contracts automatically self-execute the agreed-upon conditions, eliminating the need for intermediaries.

To better understand this technology, think of a vending machine. The machine automatically dispenses the chosen item when the correct amount of money is inserted and an option is selected. Smart contracts function similarly: they automate actions when certain inputs are provided. The only differences are that smart contracts can be further programmed, are far more versatile, and can execute complex operations.

Benefits of Blockchain in Smart Contracts

Smart contracts are self-operating agreements coded directly in blockchains. By utilising their underlying technologies, essentially enabled by tokenisation, smart contracts achieve the following:

• Decentralisation: Blockchains function through a network of nodes, eliminating the need for intermediaries.
• Immutability: Once a smart contract is written and deployed on a blockchain, it cannot be altered or tampered with.
• Transparency: Blockchains record all transactions and interactions conducted on the network, enabling users to view and verify smart contracts.
• Integrity: Consensus mechanisms in blockchains ensure combined agreement on the validity of transactions and the execution of smart contracts.

How do Smart Contracts Work?

Smart contracts streamline and automate processes and transactions with the help of blockchain technology after the defined conditions within them are met. But how?

Smart contracts are simply “if, when, then…” statements written in code on a blockchain, executed and validated when predetermined conditions (values, parties, etc.) are fulfilled. The blockchain updates only after the transaction has been successfully approved and completed, after which the transaction cannot be altered. Only the involved parties can view the results.

To begin the process, a user initiates a blockchain transaction (i.e., through a digital wallet), which is sent to the distributed ledger for verification. Post verification, the transaction, which also includes the code defining the type of transaction, is approved and executed after the conditions are successfully fulfilled. At this point, the transaction is added as a block in the blockchain. Moving forwards, any changes in the contract follow the same process to get updated on the blockchain.

1. Agreement Identification: Involved parties identify agreements and desired outcomes.
2. Condition Definition: Conditions to be met are defined.
3. Code Encoding: The contract is encoded into a computer program.
4. Blockchain Integration: The code is encrypted and integrated into the blockchain.
5. Code Execution: The code is executed, and successful outcomes are stored and recorded.
6. Ledger Update: All the nodes in the distributed ledger get updated to reflect the change.

Smart Contract Use Cases

1. Fintech: Smart contracts automate complex documentation, confirmations, and payment processes. Moreover, the rise in DeFi (decentralised finance) can be attributed to smart contracts, which support DeFi protocols that facilitate peer-to-peer lending and token swapping on DEXs (decentralised exchanges).
2. Supply Chain Management: Smart contracts simplify the processing of goods, from production to delivery, and assist in ensuring authenticity and combating counterfeit goods. This paves the way for transparent and fair transactions. Moreover, smart contracts create an immutable record of transactions, promoting trust among stakeholders and a smooth global supply chain.
3. Digital Identity: Using cryptographic methods to encode user permissions, smart contracts secure personal and private data and ensure that only authorised people can access specific information.
4. Real Estate: Smart contracts streamline real estate processes by simplifying property transfers, accelerating transactions, and reducing paperwork.
5. Gaming and NFTs: Smart contracts automate the execution of agreements in NFTs (non-fungible tokens). This ensures that transactions, such as trading, selling, or purchasing in-game assets, are processed transparently and securely without involving third-party interference.

Benefits of Smart Contracts

1. Automation: One of the biggest benefits of smart contracts is automation. They are self-executing contracts that perform actions when conditions are met, reducing lengthy wait times and eliminating the need for human resources and intermediaries.
2. Transparency: Involved parties can view the specifications of smart contracts since they are coded into blockchains.
3. Accuracy: Since smart contracts execute based on code, they nullify human errors caused by manual input or misinterpretation of agreements.
4. Immutability: Unlike traditional contracts and agreements, a smart contract cannot be changed or tampered with once coded.
5. Cost Reduction: Smart contracts eliminate intermediaries, reducing the associative costs of administration and paperwork.
6. Speed: Transactions are sped up due to smart contracts’ automation and elimination of third parties, saving businesses hours of processing and approval times.

Limitations of Smart Contracts

1. Human Factor & Loopholes: Codes are written by humans and are not prone to errors. Moreover, it isn't easy to ensure that the terms of a smart contract are met in good faith.
2. User Complexity: Smart contracts are based on blockchain and underlying technologies that might be too complicated for non-technical users to understand.
3. Permanent: The immutable nature of smart contracts can be a drawback when changes need to be made to the code regarding data or information, or an error correction.
4. Scalability: Validating transactions in a blockchain can sometimes take time. Since smart contracts copy every transaction to every node in a blockchain network, they may face scalability limitations.

Bottom Line

Smart contracts are digital agreements written in code that offer transparency, security, and autonomy. These self-executing codes simplify and automate processes and streamline transactions between parties, eliminating the need for intermediaries.

While there are benefits and challenges, smart contracts are still in their early stages, with constant ongoing developments revolutionising the digital landscape. Moreover, businesses and individuals are gradually recognising the potential of this technology and its role in transforming the global economy.

Frequently Asked Questions (FAQs)

What is a smart contract?

A smart contract is a self-executing digital agreement written in code and deployed on a blockchain. It automatically performs actions when predefined conditions are met, eliminating the need for intermediaries.

How do smart contracts work?

Smart contracts are statements encoded into a blockchain. When the specified conditions are fulfilled, the contract executes automatically, and the transaction is verified and recorded on the blockchain.

What are the benefits of using smart contracts?

Some benefits of smart contracts include automation, transparency, accuracy, immutability, cost reduction, and speed.

Where are smart contracts used?

Smart contracts are widely used in fintech, supply chain management, real estate, gaming, and NFTs.

What are the limitations of smart contracts?

The main limitations of smart contracts are human errors, user complexity, and scalability.