Smart Contracts: Their Role and Operation in Blockchain

Introduced in their current form by the Ethereum blockchain, smart contracts are a fundamental building block for the burgeoning Web3 industry. They underpin a diverse range of applications, including DeFi, NFTs, gaming, and more, playing a pivotal role in their growth and prominence in the Web3 domain. Serving as the basis for decentralized applications on blockchains, smart contracts are pivotal for developers, enabling them to codify agreements between parties, automate decentralized exchanges, and create both fungible and non-fungible tokens.

Smart contracts represent the evolution of traditional contracts in the digital age. Written in virtual language, they have the capacity to execute and enforce themselves autonomously and automatically, based on programmed parameters. The integration of blockchain technology amplifies their value, bolstering security, transparency, and trust among signatories. This eliminates the risks of misunderstandings, falsifications, or alterations and reduces the need for intermediaries. The promise of smart contracts lies in their potential to simplify complex processes, like buying a house, which typically involves banks, notaries, land registries, and extensive paperwork. With blockchain and smart contracts, these processes can be streamlined, enhancing trust, security, and transparency between the involved parties.

What Is Smart Contract?

A smart contract is a groundbreaking innovation in the realm of blockchain technology, conceptualized in the 1990s by Nick Szabo, a trailblazing figure in modern computer science. Szabo, who also invented the virtual currency "Bit Gold" in 1998, defined smart contracts as virtual promises with protocols that ensure their enforcement. Though the Bitcoin protocol can be viewed as a rudimentary form of a smart contract, with Ethereum's advent, the creation and implementation of these contracts have been significantly streamlined.

Smart contracts function as automated programs or protocols on a blockchain, activating upon the fulfillment of certain preset conditions. These self-executing contracts, inscribed directly into code, detail the terms of agreements between buyers and sellers. They play a pivotal role in making transactions traceable, transparent, and irreversible, thereby eliminating intermediaries and reducing time delays.

Hosted on blockchain networks, smart contracts are coded with specific conditions that trigger certain outcomes. Their decentralized nature on blockchains ensures accuracy, timeliness, and security, making them tamper-proof. This technology is crucial for automating multi-party digital agreements, lowering risks, enhancing efficiency, reducing costs, and increasing transparency in various processes.

Moreover, smart contracts extend beyond the automation of contractual actions. Szabo, often speculated to be the real Satoshi Nakamoto (a claim he denies), envisioned these contracts as mechanisms to extend electronic transaction methods like POS (point of sale) into the digital domain. He foresaw their application in complex financial instruments like derivatives and bonds, allowing for intricate payment term structures while minimizing transaction costs.

Smart contracts on the blockchain are self-executing scripts that automate contractual obligations. They do not contain traditional legal language but are composed of programming commands that execute actions when specified conditions are met. These innovative contracts, first proposed by Szabo, have transformed the way digital transactions and agreements are conducted, heralding a new era of efficiency and security in the digital world.

How do Smart Contracts work?

Smart contracts, essentially tamper-proof programs hosted on blockchains, operate on a fundamental logic of "if/when x event happens, then execute y action". These contracts can encompass multiple conditions, and a single application might integrate numerous smart contracts for a complex network of processes. Developers can create and deploy these contracts on public blockchains for various purposes, including personal financial applications like automated yield aggregators.

The appeal of smart contracts lies in their ability to facilitate trusted transactions between independent and often anonymous parties without the need for central authorities or legal systems. While Ethereum is currently the leading platform for smart contracts, other blockchains like EOS, Neo, Tezos, Tron, Polkadot, and Algorand also support them. Smart contracts on Ethereum and similar networks are written in various programming languages, such as Solidity, Web Assembly, and Michelson. Their code is stored on the blockchain, making it transparent and publicly verifiable, allowing anyone to inspect the contract's code and its current operational state.

Each node in the network stores a copy of all smart contracts alongside the blockchain and transaction data. When a smart contract receives funds, all nodes execute its code to reach a consensus on the outcome, ensuring secure operations without a central authority. To execute a smart contract on networks like Ethereum, users generally pay a fee termed as “gas”.

Smart contracts work by adhering to simple "if/when...then..." statements coded into the blockchain. They autonomously perform actions like releasing funds, registering assets, or issuing notifications once conditions are met. The blockchain's immutable nature ensures that these transactions are permanent and visible only to authorized parties. These contracts can include numerous stipulations, requiring participants to agree on the representation of transactions on the blockchain, the governing rules, potential exceptions, and dispute resolution mechanisms.

Notably, not all blockchains can run smart contracts. While some, including Ethereum, Arbitrum, Avalanche, Base, BNB Chain, support them, others like Bitcoin's base blockchain do not. The distinction lies in a blockchain's ability to execute and store arbitrary logic. Once deployed, smart contracts are generally immutable, even by their creators, with a few exceptions, ensuring resistance to censorship or shutdown.

Smart Contract Benefits and Limitations

Smart contracts, as an innovative component of blockchain technology, present a more secure and verifiable way of establishing societal agreements, particularly those involving the transfer of value and data. Despite their nascent stage and inherent limitations, they offer considerable benefits over traditional digital agreements.

One of the primary advantages of smart contracts is their ability to conduct transactions without intermediaries, thereby reducing counterparty risk typically associated with digital agreements reliant on centralized institutions. This not only streamlines processes but also limits the influence exerted by these larger entities. Smart contracts execute automatically when certain conditions are met, enhancing accuracy, speed, and efficiency. The elimination of paperwork and manual data entry further minimizes errors and delays.

In terms of trust and transparency, smart contracts ensure the integrity of information, as transactions are encrypted and shared among participants without the involvement of third parties. This level of security is bolstered by the blockchain's structure; records are extremely difficult to hack, and altering any single record would require tampering with the entire chain.

From a financial perspective, smart contracts offer significant savings by eliminating intermediaries, thus reducing associated fees and time delays. They also promote sustainability by cutting down on paper usage and reducing pollution through decreased travel for physical document verification.

Moreover, smart contracts assure reliability through their storage in a distributed network, making them virtually immutable and resistant to forgery. Each contract is replicated across the network's nodes, ensuring it cannot be lost. Participants gain independence as they make arrangements directly, without the need for intermediaries. The precision of these contracts virtually eliminates errors in terms and processing.

While the smart contract landscape is still developing, major advancements involve connecting them with real-world data and systems outside the blockchain. This evolution, facilitated by platforms like Chainlink, allows smart contracts to interface with external data and traditional systems, significantly expanding their functionality. By enabling such external connections, smart contracts can transcend the limitations of isolated blockchain networks, integrating more comprehensively into diverse industries and use cases.

Smart Contract Use Cases

Token smart contracts are used to create, track, and assign ownership rights to specific digital tokens existing on blockchain networks. The token contract programs functionalities into the tokens it issues, providing holders features like utility/insurance in a dApp (utility token), voting weight in a protocol (governance token), equity in a company (security token), ownership claim to a unique real-world or digital asset (non-fungible token), and more. For example, the FIL token is used to pay for Filecoin’s decentralized storage services and the COMP token allows users to participate in the governance of Compound protocol.

Financial Products (DeFi)

Decentralized finance (DeFi) consists of applications that use smart contracts to recreate traditional financial products and services such as money markets, options, stablecoins, exchanges, and asset management, as well as combine multiple services to create new financial primitives via permissionless composability. The smart contract can hold user’s funds in escrow and distribute them between users based on predefined conditions. For example, BarnBridge uses smart contracts to automate trades for users wanting fixed asset exposure to a price pair (e.g., 45% token A, 55% token B), and Aave uses smart contracts to facilitate lending and borrowing in a permissionless and decentralized manner.

Aave supports decentralized lending markets by using asset prices to determine a user’s borrowing borrower and to see if loans are undercollateralized and subject to liquidation

Gaming and NFTs

Blockchain-based games use smart contracts for tamper-proof execution of in-game actions. One example is PoolTogether, a no-loss savings game where users stake their funds in a shared pool that is then routed into a money market where it earns interest. After a predefined time period, the game ends and a winner is randomly awarded all the accrued interest while everyone else can withdraw their original deposit. Similarly, limited-edition NFTs can have fair distribution models and RPGs can support unpredictable loot drops using randomness, helping to ensure all users have a fair shot at getting rare digital assets. Many projects access randomness using Chainlink Verifiable Random Function (VRF)—a random number generator (RNG) that uses cryptography to prove it's tamper-proof, meaning the RNG process is publicly auditable.

MLB baseball player Trey Mancini did an NFT drop to raise money for cancer patient support, where Chainlink VRF was used to randomly assign additional utility to some NFTs

Insurance

Parametric insurance is a type of insurance where a payout is tied directly to a specific predefined event. Smart contracts provide tamper-proof infrastructure for creating parametric insurance contracts that trigger based on data inputs. For example, crop insurance can be created using smart contracts, where a user purchases a policy based on specific weather information like seasonal rainfall in a geographic location. At the end of the policy, the smart contract will automatically issue a payout if the amount of rainfall in the specific location exceeds the original stated amount. Not only do end-users receive timely payouts with less overhead, but the supply side of insurance can become open to the public via smart contracts. The smart contract allows users to deposit funds into a pool and then distributes collected premiums to pool participants based on the percentage of their contribution to the pool.

Smart Contract and Crowdfunding

Smart contracts on the Ethereum blockchain offer the innovative capability to create digital tokens, which can be used for various transactions. You have the option to develop and circulate your own digital currency by creating a tradable digital token. These tokens adhere to a standard coin API, such as Ethereum's ERC 2.0 standards, which enable seamless interaction with any compatible wallet for exchanges. This results in the creation of a tradable token with a predetermined supply, effectively turning the platform into a digital central bank that issues its own currency.

Consider a scenario where you're starting a business and need funding. The challenge lies in finding someone willing to lend money without established trust. This is where Ethereum-based smart contracts come into play. You can set up a smart contract that securely holds funds from contributors until a specific date is reached or a funding goal is met. Depending on the outcome, the funds can either be released to the project owners or refunded to the contributors.

Traditional centralized crowdfunding systems often face challenges related to management and trust. To address these issues, Decentralized Autonomous Organizations (DAOs) are increasingly being used for crowdfunding purposes. In a DAO, the terms of the crowdfunding are embedded within the smart contract, and each participant is awarded a token representing their contribution. This ensures that every contribution is transparently recorded on the Blockchain, enhancing trust and accountability in the crowdfunding process.

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