This article aims to provide an overview of smart contracts and their rising relevance. If you are unfamiliar with DeFi, consider reading our introductory article on DeFi here first. You might also want to read our articles on blockchain and crypto before reading this article.
What Are Smart Contracts?
At the core of a blockchain-based ecosystem lies smart contracts, which are self-automating contracts with terms written into code. They are responsible for executing every transaction made on a blockchain network.
Compared to a traditional paper-based contract, smart contracts initiate and execute the transactions agreed by parties without any human input. They facilitate immutable and accessible agreements for organizations while scaling back on the formality and costs associated with traditional contracts.
How Do Smart Contracts Work?
The term was coined in 1994 by Nick Szabo, an American computer scientist, and cryptographer. In his article, Szabo gave the famous example of a vending machine to describe the mechanics of a smart contract. If the purchaser inserts money into the machine (i.e., satisfying the conditions of the contract), the machine automatically honors the terms of the agreement and delivers the snack and remaining change. Like a vending machine, smart contracts can automate any kind of exchange without a human intermediary.
Smart contracts operate using the simple “if/when… then…” statements which govern their transactions. Once the predetermined conditions of the agreement are met and verified, these contracts execute the code immediately. This code is repeated across multiple nodes of the decentralized blockchain network. These actions can take any form, ranging from releasing funds to sending notifications or issuing a parking ticket. Find out more about the programming languages used to write smart contracts here.
Benefits of Smart Contracts
Information in the contract is visible to all parties involved in the transaction and within the blockchain network. It is impossible to alter the contract without immediate detection.
The encryption of blockchain transaction records makes them difficult to hack. Moreover, as each transaction record is linked together in the blockchain, hackers would have to change the entire chain to change one record.
Efficiency and Accuracy
As smart contracts are digital and self-executing, it reduces the time spent on processing paperwork and reconciling errors that often result from manually arranging documents.
Smart contracts reduce the reliance on financial intermediaries to manage the transactions, eliminating time delays and service fees.
High Degree of Composability
Composability is the ability for components of a single system to be reconfigured and integrated into other larger frameworks and mechanisms. The output of one system becomes the input of another, connecting them like a puzzle piece. In DeFi, we are interested in 2 types of composability: syntactic and morphological.
A protocol’s smart contracts must be made public to achieve syntactic composability. Its decentralized applications (dApps) can thus call on another protocol’s contracts for its own ecosystem. This expands on the limits of a single contract and allows for greater versatility and dynamism. Not starting from scratch will enable projects to focus on developing the parts missing in their code, making them more efficient.
Risks of Smart Contracts
Any issues in smart contracts may result in costly errors and the potential loss of the parties’ assets. Due to the blockchain’s immutable nature, transactions made by faulty or fraudulent contracts cannot be annulled by the parties involved.
Recent examples show hackers exploiting the errors in the coding of smart contracts to drain the accounts of the parties involved. In August 2021, a hacker capitalized on a Poly Network smart contract vulnerability. He successfully managed to steal $600 million in digital tokens, making this one of the largest DeFi hacks.
Complex Programming Language
Despite the increase in smart contract templates, the complexity of programming languages itself makes them inaccessible to many. Most people find it difficult to evaluate code and understand if the contracts will perform as intended.
Due to the lack of intermediaries, legal and regulatory frameworks for developing and operating smart contracts are still nascent. It is unclear which party should be held responsible for a faulty contract.
Real-World Use of Smart Contracts
While most smart contracts deal with financial assets currently, they have the potential to revolutionize other industries. Here is a non-exhaustive list of how smart contracts can be used in other fields:
As DeFi begins to experiment with legal signing, smart contracts represent the next step in integrating technology into the legal system. Using smart contracts to form legal agreements can lower the indirect costs of using intermediaries, such as lawyers. Recently, Arizona authorized smart contracts to create enforceable legal agreements. Also, marriage licenses can now be legally issued via blockchain technology in California.
Smart contracts can reduce the potential for hidden costs associated with title transfers and closing and broker fees. Moreover, smart contracts can streamline rental mortgage agreements and warranty and insurance clauses. Read more on the tokenization of real estate here.
Retail chains, such as Home Depot, utilize smart contracts to prevent disputes with their suppliers. Vendors and retailers gain greater visibility into the supply chain with smart contracts, helping strengthen the trust between both parties, and reducing time spent on conflict resolution.
Smart Contracts Are Here to Stay
Despite their risks, smart contracts are undeniably valuable. They reduce billions of indirect costs while also improving system efficiency drastically. Additionally, smart contract audits have been developed and established to ensure the reliability and durability of the code. Although they require further development before their wider adoption, especially in complex business agreements and relationships, these contracts possess the power to radically change society’s approach toward contracts.
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