Contracts are everywhere—at work, in school, or even in our personal lives. From job agreements to project deals and even marriage, contracts serve as promises between two or more parties, ensuring obligations are fulfilled, or protections are in place if things go wrong.
In a traditional sense, these agreements take a long time to implement, with multiple intermediaries like lawyers or banks involved. So, what if there was a faster, more efficient way of handling deals? Enter smart contracts.
But what are smart contracts? How do smart contracts work? And how are they reshaping industries, especially within the world of crypto?
Read our guide, where we explain smart contracts and their role in the future of blockchain technology.
What Are Smart Contracts?
Smart contracts are programs recorded on a blockchain that execute when specific conditions are fulfilled. They are often used to automate the implementation of a contract so that every party can be sure of the conclusion immediately, without the involvement of a third party or time lost. Additionally, they can automate a workflow such that it only moves forward when certain criteria are met.
The concept of a smart contract first came to light in 1994 through the works of computer scientist and cryptographer Nick Szabo, long before blockchain technology existed to make them a reality. Szabo’s vision was that digital contracts be self-executing and self-enforcing to eradicate the need for intermediaries.
The early works of Szabo laid a proper foundation for what is now a popular component of the blockchain network. Despite the idea only sounding theoretical in the early days, the advent of decentralized blockchain networks made the concept a reality.
The Benefits of Smart Contracts
The technology, which dawned only about 7 years ago, after the launch of the Ethereum blockchain, brings a range of benefits and attributes. Here are a few features associated with smart contracts:
Automation
The first and biggest benefit associated with these contracts is the automation of Financial processes and agreements. Once the pre-set conditions are met, the contract is executed immediately.
Take, for instance, you are renting a property. The contract can autonomously release funds to the landlord once the tenant confirms they’ve moved in. This proper automation reduces human error and speeds up processes, making transactions faster and more efficient.
Transparency
These contracts always live on the blockchain, hence fostering transparency. Every party involved can rightfully view the terms and conditions of the contract, with every action being recorded on the decentralized ledger. This transparency ensures trust, as no single party can alter the contract or its results after deployment.
Security
The contracts are secured using cryptographic encryption and the blockchain’s inherent decentralized nature. Once the contract is written and deployed, it cannot be altered. Because they are stored on decentralized networks, smart contracts are less vulnerable to tampering or fraud than their traditional counterparts.
Trustlessness (No Intermediaries)
Smart contracts eliminate intermediaries, such as banks, brokers, or legal authorities, to facilitate or enforce agreements. Instead, the blockchain network verifies and enforces the execution of the contract. This “trustless” setup eliminates reliance on third parties.
How Do Smart Contracts Work
A smart contract is a unique piece of software built into a blockchain. The terms of the contract are written directly into the code. The contract is stored on-chain to bolster its immutability while fostering transparency.
“If/when then…” phrases are the base of functionality. If/When the predetermined conditions specified in the contract are met, the contract executes automatically. “If this happens, then something else happens.”
In the writing of smart contracts, one thing is clear: third-party involvements or manual enforcements have no space. Suppose you are using your a contract for online transactions once both parties fulfil their obligations, such as payment and delivery confirmation. In that case, the contract automatically releases the funds to the appropriate party.
Business teams collaborate with developers to communicate their specifications for how they want their contracts to respond to certain situations or events before beginning the development process. Simple events could include authorization of payment, receipt of cargo, or a certain electric meter reading threshold.
The developers then create the logic and test it on a smart contract-writing system to ensure it works as planned. Once written, the application is sent to a different team for security evaluation. This might be an in-house specialist or a company that specializes in assessing security. After it has been authorized, the contract is implemented on an existing blockchain system.
Through proper automation, they suffered delays, reduced costs and eliminated potential human errors. All the activities are handled via codes and recorded on blockchain.
Workings of Smart Contracts
Below is a simple summary of the processes involved in the functioning of these blockchain based contracts:
- The parties agree to conduct a business or exchange, even deciding the criteria that should be attained.
- The parties then employ the power of developers in creating the codes.
- The code/contract is then deployed on the blockchain, becoming an immortal part of the decentralized ledger
- The contracts monitor conditions like dates, payments, etc
- Once the predetermined threshold is hit, the smart contract implements the agreed actions.
- Data is immediately recorded on the chain.
Business teams collaborate with developers to communicate their specifications for how they want their contract to act in response to certain situations or events before beginning the process of developing. Simple events could include authorization of payment, receipt of cargo, or a certain electric meter reading threshold.
The developers then create the logic and test it on a smart contract-writing system to make sure it really works as planned. Once written, the application is sent to a different team for an evaluation of security. This might be an in-house specialist or a company that specializes in assessing the security. The contract is implemented on an existing blockchain system after it has been authorized.
How Smart Contracts Work in Powering DeFi
Ever since their dawn, smart contracts have been the engine driving the realm of decentralized finance (DeFi). They are autonomous systems that simplify complex processes. These systems allow transactions to execute agreements instantly, securely, and transparently.
In the world of DeFI, these autonomous contracts handle everything, including the most popular. Here are some of their key use cases in DeFi:
How Smart Contracts in Lending and Borrowing Platforms
Traditional finance has banks and financial institutions functioning as intermediaries between borrowers and lenders. However, in DeFi, these contracts eliminate the need for middlemen, meaning everyone can borrow and lend assets directly through these platforms.
The long lending and borrowing process, which includes interest rate calculations and loan term enforcement, is handled via a smart contract. If a borrower fails to maintain the collateral as set, the smart contract automatically liquidates the assets to repay the lender.
On platforms like Aave and Compound, lenders deposit assets into liquidity pools, earning interest, while borrowers can take out loans by providing collateral. The smart contracts ensure all transactions occur securely and transparently, without the need for a bank.
How Smart Contracts in Decentralized Exchanges (DEXs)
The second application of smart contracts in DeFi relates directly to decentralized exchange (DEX) platforms. These digital contracts facilitate trades using liquidity pools, where users deposit pairs of tokens.
When you want to exchange one asset for another, the smart contract autonomously matches you to other traders using algorithms designed to determine pricing based on supply and demand.
A good example is Uniswap, a popular decentralized exchange. Traders can swap tokens directly from their wallets, and smart contracts handle the entire process, including calculating the current exchange rate and executing the trade.
How Smart Contracts in Yield Farming & Liquidity Mining
Yield farming and liquidity mining are key DeFi mechanisms that allow users to earn rewards for providing liquidity to protocols. In these 2 systems, the user deposits tokens directly into liquidity pools and earns rewards in returns.
Smart contracts automate the process of distributing rewards based primarily on liquidity and stake length.
Consider platforms like SushiSwap and Balancer. In these networks, blockchain based contracts track each user’s deposits and distribute rewards based on stake. Some of these tokens can be exchanged or even used in governance.
How Smart Contracts in Staking Mechanisms
One of DeFi’s most recently popularized concepts is staking, where users lock tokens in a protocol to help secure the network or validate transactions. In return, the striker earns rewards in the form of additional tokens.
At the heart of staking are smart contracts that automate the processes, which include locking up tokens, calculating rewards, and releasing them at predefined intervals. This ensures fairness and transparency in how staking rewards are distributed. On Ethereum 2.0, users participate by staking ETH to support the Network’s Proof of stake.
How Smart Contracts in Stablecoins
Stablecoins are a class of digital assets that maintain stable value, mostly pegged to a fiat currency like the US dollar. At the heart of stablecoin functionality are smart contracts that mainly control the issuance and stabilization of stablecoins, either through collateralized mechanisms (backed by other assets) or algorithmic systems that adjust supply and demand to maintain the peg.
Take the example of DAI, a stablecoin issued by MakerDAO. Users lock up assets like ETH as collateral in smart contracts, and the system issues DAI tokens based on the value of the collateral.
What Can Smart Contracts Be Used For?
Smart contracts are used in various sectors for multiple reasons, including managing supply chains and protecting intellectual property. The most popular way to implement these contracts is through the use of blockchain technology, a method of storing safe and permanent transaction records.
Here are a few applications:
Financial Transactions:
Smart contracts revolutionize financial transactions by removing the need for intermediaries like banks. With predefined rules encoded in the contract, transactions occur automatically upon meeting specified conditions.
This speeds up the process and improves security, lowering the possibility of fraud. Financing services become easier to access for a wider audience through the efficient and economical use of micro-transactions, like quick fund transfers and fractional ownership.
Supply Chain Management:
In supply chain management, smart contracts automate critical processes, improving efficiency and reducing operational costs. Order fulfilment becomes seamless, with smart contracts automatically triggering the release of payments upon successful delivery.
The blockchain provides accuracy and traceability by recording each stage of the supply chain, which improves quality assurance. This automation minimizes errors, delays, and disputes among stakeholders.
Legal Agreements:
Smart contracts change the legal landscape by properly automating and maintaining agreements. Smart contracts offer decentralized alternatives to traditional security services and enhance the process by securely holding funds until specific conditions are met.
The smooth management of intellectual property transactions, licensing contracts, and royalty payments lowers administrative burdens, and guarantees authors receive just compensation. Blockchain technology’s integrity enhances and secures legal procedures.
Cross-Border Transactions:
Smart contracts make cross-border transactions more efficient by automating and implementing business contracts. Smart contracts facilitate international trade by automating payment execution and maintaining adherence to customs regulations.
Blockchain’s transparency minimizes the danger of fraud in cross-border transactions, increasing confidence among trading partners. This automated approach to international trading can decrease delays and administrative complications, which benefits international businesses.
Also, read: The Basics of Blockchain Everyone Should Know.
Challenges and Risks of Smart Contracts in DeFi
Here are a few challenges and risks associated with smart contracts, especially in the DeFi realm:
- Smart contract vulnerabilities — Smart contracts are susceptible to coding bugs and security flaws that can negatively affect projects built on them.
- Regulatory challenges — Decentralized finance operates primarily on grey areas, with smart contacts functioning without oversight. A lack of legal clarity leaves users exposed.
- Oracles and data dependence — The dependence of smart contracts on oracles and third-party data providers leaves them vulnerable.
- Scalability and gas fees — DeFi platforms leveraging Ethereum have suffered major scalability issues as a result of low speed and network congestion. This has also led to high gas charges.
- Lack of knowledge — The smart contract space is hugely complex, increasing the risk of errors for users.
Conclusion: The Future of Smart Contracts in DeFi
Smart contracts are evolving at lightning speed, with scaling solutions like Layer 2 technologies bolstering speed, scalability and reducing gas charges. The birth of cross-chain interoperability also enables smart contracts to interact seamlessly across various blockchains, further expanding DeFi’s capabilities.
Moreover, AI-driven smart contracts may bring even greater efficiency by adapting and evolving based on market conditions.
In the long term, smart contracts have the potential to disrupt traditional finance by offering a decentralized, transparent, and cost-effective alternative. Smart contracts will play a crucial role in shaping the future of finance. To stay ahead, it’s vital to explore and understand their potential in the growing DeFi ecosystem.