What Is A Smart Contract, And How Does It Work?

Blockchain technology – or, more specifically, distributed ledger technology – is changing the world as we speak.

And we've barely scratched the surface of its potential.

Distributed ledger technologies bring a host of opportunities to revolutionize the way we conduct business across industries, but none more so important than the advent of smart contract technology.

Smart contracts have proven that they can streamline business processes, manage transactions, reduce transaction fees, circumvent intermediaries, improve business synergies, and facilitate global trade.

As their name implies, smart contracts outline the terms and conditions of an agreement between two or multiple parties.

The main difference is that the terms and conditions contained therein are executed by the smart contract's code running on a blockchain as opposed to a piece of paper. This is what makes a smart contract, well, "smart."

Before smart contracts, the basic premise behind digital currency like Bitcoin was to send and receive money without a central authority, such as a bank or payment processor.

Smart contracts iterate on that basic premise, allowing the decentralization and secure automation of any type of agreement or transaction, regardless of complexity.

And since many smart contracts run on blockchain networks like Solana or Ethereum, they possess built-in accessibility, security, and reliability.

That said, let's take a closer look at how smart contracts work – and why digital contracts will play a pivotal role in contract law and wider adoption of distributed ledger technology in the future.

What Is A Smart Contract?

In a nutshell, smart contracts refer to self-executing protocols or computer programs stored on a blockchain that execute automated transactions depending on the achievement of specific conditions as stipulated in the smart contract's code.

More specifically, smart contract code carries out the automated execution of agreements so that all parties involved can determine the result without the involvement of a central authority or delays in processing.

The idea behind smart contracts was first conceptualized by American computer scientist Nick Szabo in 1998, who likened the concept to a vending machine.

Here's how a simple, smart contract works, according to Szabo. Let's say you walk up to a vending machine that sells soda pop for $0.25.

If you put $0.50 into the machine and select your favorite soda, the vending machine is programmed to do three things: 1) to release your soda and give you $0.25 in change, 2) ask you to make another selection if your item is sold out, or 3) return your $0.50.

Just like vending machines that automate purchases without the need for a shopkeeper or a clerk to step in as an intermediary, a smart contract can automate literally any kind of transaction.

Ethereum is a leading smart contract platform, but a whole slew of competitors have emerged in the wake of its success – including Avalanche, Polkadot, Solana, and Algorand.

Particularly Solana is gaining a lot of popularity lately, and that is also why we decided to go with Solana first in our Metacrafters Smart Contract Course. 

Anyone can create and deploy a smart contract on a blockchain network that supports them. They are publicly verifiable, meaning anyone interested can examine the code, logic, and what they do.

How Do Smart Contracts Work?

A smart contract is a computer program that executes a pre-programmed algorithm in response to specific events or milestones based on the smart contract's terms and logic.

Smart contract execution can facilitate the exchange of value, money, and services, including any type of data manipulation such as a gradual release of personally identifiable or privacy-protected information to address specific requests. This can include changing names on land titles, the release of user funds, or the transfer of digital assets under escrow.

Plenty of smart contract architectures exist as far as how they can be developed, managed, and edited. They can also be integrated into a wide array of payment processing mechanisms or decentralized exchanges that may include a wide selection of crypto assets.

However, it must be noted that smart contracts aren't legally binding under contract law.

Their fundamental role is to automatically run logic that executes processes, tasks, or transactions as a response to the achievement of a specific set of conditions.

How Do Developers Create Smart Contracts?

Smart contracts are created when business teams work with smart contract developers to describe their requirements and business logic for the smart contract when certain conditions are met.

For instance, these conditions could include the receipt of payment, the arrival of a shipment, or a utility meter reading threshold.

Smart contracts can also support more sophisticated logic, such as calculating derivative financial instrument values and subsequently processing trades based on hitting certain levels, releasing a digital asset as loan collateral in the event of payment, or the disbursement of funds by an insurance company in the event of a fire, loss, or death as stipulated on an insurance policy.

Then, the programmers will encode business logic to establish the smart contract and test it to make sure that the code works as expected.

Once the program is written, another team takes over auditing the security of the smart contract in question. The smart contract audit can also be handed off to a company whose specialty lies in vetting smart contract security, such as CertiK.

Following the smart contract's final approval, it is then deployed on-chain on a distributed ledger or blockchain network.

Once the smart contract is deployed, it is then configured to monitor event updates from a cryptographically-secure streaming external data source known as an "oracle," which the smart contract executes itself upon attaining the conditions set forth on the smart contract code based on data it receives from one or more oracles.

What Are The Benefits of Smart Contracts?

Distributed ledger technologies are an ideal vessel for storing smart contracts due to the blockchain's inherent immutability and security. It's virtually impossible to lose or tamper with the data stored on a blockchain without rolling it back to a previous state, which then compromises the blockchain's integrity.

Another advantage that blockchain technology brings to the table is flexibility. The blockchain allows developers to store any type of data, giving them a wide array of transaction options to implement.

Furthermore, Ethereum smart contracts could help organizations streamline business processes and make transactions more secure, cheaper, and efficient. In doing so, they lower transaction costs across the board.

The real-world use cases are rising by the day despite bearish market conditions.

For instance, blockchain technology has been used in Illinois to track property title transfers. In Cook County, Illinois, the Recorder of Deeds became the first land titling office in the United States to record title transfers on-chain in 2016.

Each time a title transfer occurs, property buyers would receive a digital coin besides the original physical title deed that can be used to prove one's ownership.

Smart contracts can be used to facilitate global trade, represent a healthcare or insurance payment, record and monitor supply chains, or track royalties for creative industries and ensure artists will be paid their due. Practically anything involving data can be tokenized and encoded into immutable, programmable smart contract code.

Ethereum is by far the most popular smart contract platform, with its eponymous cryptocurrency serving as its native token. The developer community of Ethereum created Solidity, the pre-eminent smart contract programming language for writing smart contract applications designed to run on blockchains that support the Ethereum Virtual Machine (EVM) execution environment.

Why Are Smart Contracts Important?

Prior to smart contracts, blockchains mainly served as money transfer networks but didn’t really offer much in the way of additional functionality. Thanks to the integration of smart contracts, the cryptocurrency community has expanded into a thriving ecosystem of interconnected blockchains that host a multitude of different dApps that serve a variety of functions.

So, what are smart contracts used for? Smart contracts power everything from decentralized finance (DeFi) and supply chain tracking to non-fungible tokens and gaming protocols. As with any token that is transferred on the blockchain, all smart contract transactions are recorded on the blockchain and, in general, are unable to be reversed or changed.

DeFi has perhaps been one of the most significant developments to arise from smart contract technology as it aims to transform the banking and financial industries, helping to bring banking to the masses and cut out the high-fee middlemen.

Decentralized exchanges, lending and borrowing platforms, and stablecoin protocols all owe their existence to smart contract technology, which allows users to access these services from anywhere in the world without the need for a financial institution.

What Are the Limitations of Smart Contracts?

Perhaps the most salient of smart contracts' inherent limitations is that their blockchain-based platform infrastructures have no external connectivity with external systems to validate whether real-world events occur.

Smart contracts cannot access computational resources without internet connectivity, therefore restricting their utility like a computer without an internet connection does. Without connectivity, they cannot tell what the price of a digital asset or any other data point required to run the smart contract logic is  before it is triggered.

Summary

Regardless of the broader crypto industry's periodic ebbs and flows, smart contracts are here to stay over the long run. The toothpaste can't be put back in the tube. The unbridled potential of smart contracts are more than enough to bring about future adoption and utility across industries in the future.

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