What Exactly is a Smart Contract?
First introduced in the Ethereum blockchain, smart contracts are a fundamental building block of Web3 and a vital part of the blockchain’s advanced capabilities. They form the foundation for decentralized applications and automated business transactions by creating a level playing field of trust, authority, and authenticity that is already proving to be a paradigm shift in many industries today.
Here, we take a look at what smart contracts are, how they work, and the opportunities they unlock for your business. We're going to analyze how they can be used to automate everything from internal business logic to programmable assets, transactions, and tokens. Most importantly, we're going to look at their benefits and limitations, how they're already being used today, and how they're going to evolve in the next few years.
A smart contract is code hosted and executed on a blockchain network designed to execute a transaction when a set of predetermined conditions are met. Most often, it acts as an automated intermediary that will release funds, create tickets, or ship goods when all parties have met their obligations. In this use case, they answer the questions raised by eliminating third-party intermediaries from transactions and provide an accurate, fast, and tamper-proof way to exchange goods and funds.
More broadly, smart contracts can be used to run any piece of code according to any external conditions at all. For example, they are becoming increasingly important in fields such as health care and logistics to maintain accurate records and updates with no possibility for tampering and fraud at their source.
Smart contracts are a game-changing innovation in fields such as finance, health, and logistics because they have no central administrator or single attack vector for malicious parties to interfere with. There can be as many stipulations or requests baked into a smart contract as needed to meet everyone's demands before releasing funds, issuing tickets, or conducting a transaction. Whenever these conditions are met, a smart contract updates the blockchain with the finalized transaction, making the resulting ledger tamper-proof by design.
When applied to multi-party digital agreements, smart contracts reduce the risks for all parties, increase efficiency, and provide a level of transparency that changes how we work with business transactions.
Creating Smart Contracts
As we've defined here, smart contracts are just pieces of code that happen to run on the blockchain. Like any other kind of code, there are about as many languages, conventions, and tools as there are developers available to write smart contracts. Etherium's Solidity is still the most popular by far, launching with the blockchain in 2015. However, there are many others worth mentioning for any new use cases you might have for your smart contracts.
These include:
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Vyper. Another language for building Ethereum smart contracts. Vyper is designed to be more secure and easier to maintain than Solidity. In contrast, it has a smaller community and fewer resources to lean on.
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Rust. Well-known and highly appreciated as a general-purpose language, Rust has exceptional resources and tooling for working in the blockchain space.
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C/C++. The popularity and use of these languages within blockchain applications show blockchain as an evolution of tried and tested technologies rather than an intimidating shift to computing as we know it.
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Go (GoLang). Known for being simple, efficient, and in a league of its own when working with concurrency — Go is an excellent choice for building new kinds of applications using blockchain technologies.
Any developer can create their smart contracts to deploy to a public blockchain using any language or tool they choose. Some of the most lucrative examples might include a personal yield aggregator that transfers funds to the highest-earning application to maximize returns. As with the rest of the blockchain, there's no authority or gatekeeper barring entry from the resource.
A simple smart contract to manage product sales in Solidity might look something like this:
pragma solidity 0.8.7;
contract SimpleSale {
// Declare state variables
address public owner;
mapping (address => uint) public inventoryBalance;
// When 'SimpleSale' contract is deployed:
// 1. set the deploying address as the owner of the contract
// 2. set the deployed smart contract's inventoryBalance to 100
constructor() {
owner = msg.sender;
inventoryBalance[address(this)] = 100;
}
// Allow the owner to increase the smart contract's inventory
function refillInventory(uint amount) public {
require(msg.sender == owner, "Only the owner can refill.");
inventoryBalance[address(this)] += amount;
}
// Allow anyone to purchase producrs
function purchase(uint amount) public payable {
require(msg.value >= amount * 1 ether, "You must pay at least 1 ETH per product");
require(inventoryBalance[address(this)] >= amount, "Not enough inventory in stock");
inventoryBalance[address(this)] -= amount;
inventoryBalance[msg.sender] += amount;
}
}
As a trivial example, this smart contract demonstrates how the technology can be used to automate transactions and replace intermediaries in almost any industry.
Many smart contracts involve multiple independent parties that have a very limited relationship and even less trust. The smart contract they use to interact will define exactly how, when, and where each party can interact with the transaction and what the results will be for any given input. This creates a multi-party digital agreement that executes automatically when everyone involved in the transaction has met the right conditions.
Smart Contracts in Action
Some key uses of smart contracts involve automating business processes and transactions between several entities. This means they can automate payments, process flow, and dispute resolutions to create highly efficient processes that minimize time, risk, and costs to every business. For example, a smart contract that governs global supply and trade might have just a couple of simple terms such as:
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Condition 1: If the product arrives on time, execute payment from retailer to supplier in the full amount.
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Condition 2: If the product arrives late, then execute partial payment from the retailer to the supplier for 95% of the full amount.
Of course, this is a simplified trivial example but there are any number of supplier and customer relationships that can benefit from this technology without relying on intermediate payment processors.
Another type of smart contract utilizes decentralized applications that provide interaction across the board without explicitly setting up permissions. Public distributed apps are typically open-source code that can be widely scrutinized to avoid any security concerns. One example of this type of application is a lending/borrowing market that works on the following terms:
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Term 1: If a user deposits collateral into a specific smart contract, they will be issued a loan for some value of their posted collateral.
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Term 2: If the user’s collateralization ratio (collateral/outstanding loan value) drops below 200%, then the user’s collateral is automatically liquidated and transferred to the lender.
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Term 3: Lenders can deposit funds into a specific contract that other users can borrow from at predefined collateralization ratios, while the lender receives a claim to a portion of the interest rate payments.
Using these automated methods creates a fair and transparent method of lending that doesn't rely on a third party or central authority with a monopoly on terms and conditions. What this means in practice is that well-designed smart contracts can eliminate counterparty risk, and make it impossible for either party to renege on the terms of a deal, or fail to fulfill their contractual obligations.
However, smart contracts are open instead to another kind of risk. Smart contract risk introduces the possibility that the code defining the contract has an inherent flaw or exploit that leads to undesirable outcomes. To guard against this, smart contracts have to be carefully looked over and well-understood by all parties before proceeding with the agreed-upon transaction.
Benefits and Limitations to Smart Contracts
Smart contracts offer a safer and more verifiable way of creating, maintaining, and upholding agreements in both B2B and B2C spaces. They offer data security and guarantees that can't be made any other way — creating something of a paradigm shift to come. However, the blockchain landscape is still relatively new for many, and smart contracts have yet to be proven at the kind of scale we're used to associating with high degrees of trust and authority.
In short, we've still to get to know them fully to understand the risks and advantages they bring to a project. So let's take a look at what they can deliver into the project today and what we should currently guard against before we begin using them.
Benefits of Smart Contracts
- Speed, efficiency, and accuracy. When the conditions of a smart contract are met it is executed immediately without question. By shifting to an automated digital way of working there's no processing time (or fees), time spent checking, fixing, and re-issuing after errors, and nothing is ever lost or broken through manual processing.
- Trust and Transparency. Without the need to bring a third party into the transaction and an encrypted public record is shared — there's no question over whether documents have been altered or truncated at any stage in the process.
- Security. Blockchain records are public, shared, and immutable, meaning they can't be changed after the fact and have no single point of weakness. Each record in the chain is connected and verified by the last, making it impossible to change past transactions for malicious gain.
- Cost-Effective. Smart contracts don't need intermediaries to execute so there are no fees or costs for handling or verification. As a result, smart contracts are the cheapest and fastest way to handle transactions.
Limitations of Smart Contracts
- Immutability. The strongest security feature of a smart contract is also one of its biggest limitations. By being immutable, any bugs or problems in the code can't be changed at any time after the contract has been issued. Any changes in external conditions or demands of the business can only ever be reflected in a new smart contract.
- Complexity. It's crucial that all parties involved in a smart contract understand its conditions and know how to scrutinize it. Bugs, whether introduced innocently or maliciously, can have severe consequences when executed. Every party on the contract needs to know how the code works and what it's going to do when executed.
- Oracle Dependency. Most smart contracts rely on external data for their preconditions. However, this data isn't accessible directly on the blockchain. Smart contracts have to rely on external services (oracles) to retrieve information outside the blockchain — introducing an element of third-party trust, reliability, and verification into some smart contracts.
Five Key Applications for Smart Contracts
In truth, we're only just scratching the surface of what smart contracts can provide for organizations in the future. The creativity, innovation, and capabilities of developers can always be depended on to push the boundaries ever further to build ever more capable solutions to everyday business challenges. Five of the most innovative ways smart contracts are being used in organizations right now include:
1. Decentralised Finance (DeFi)
Smart contracts enable decentralized lending, borrowing, and trading without the need for intermediaries within the transaction. There are already a host of DeFi platforms like Compound and aave set up to allow decentralized transactions using smart contracts today.
2. Insurance
One of the largest and most profitable industries that smart contracts could revolutionize overnight is insurance. Smart contracts can automatically asses external conditions using known sources and trigger automated payouts or resolve accounts according to the terms of the agreement. The efficiency and guarantees smart contracts can provide for insurance products may well prove to overhaul the industry.
3. Supply Chain Management
In contrast, smart contracts can make some of the biggest impacts in logistics. By enabling transparency and accurate accounting in supply chains, smart contracts can provide a level of oversight and tracking otherwise unheard of. Many logistics companies are already using them to track goods from production to distribution with a proven record of cutting down loss and fraud in real-world use.
4. Accurate Admin
One of the largely unsung applications of smart contracts is their ability to securely store and manage data over the long term. Unlike traditional methods of increasing data security, smart contracts make data more accessible, easier to access, and more secure at the same time. In fields such as health tech, this has the power to be truly revolutionary by allowing patients both better access and security over highly confidential data.
5. Identity Management
Smart contracts are ideal digital custodians to ensure the integrity of confidential information. This is critically important in maintaining and proving your identity, particularly on the web. Smart contract features such as selective disclosure, blockchain verification, and its in-built privacy by design are a paradigm shift in how we manage our online and in-person identities that will shift control of our identities from third-party organizations back to the individual.
Learning Smart Contracts
As one of the cornerstones of Web 3, smart contracts are set to revolutionize the way you conduct transactions and agreements in every context. The first step to reaching these capabilities is understanding exactly what they are, how to use them, and the way they work in business today. There's little doubt that they will continue to evolve and change over time as blockchain, web3, and future technologies become increasingly relevant within modern business.
Understanding these technologies on the ground floor is a great first step towards innovating with them sooner, faster, and more effectively than the competition.