Understanding what a smart contract is, begins with knowing that it is a program that runs on a blockchain network. Another thing to note is it is tamper-proof and set to execute when specific predetermined conditions are met.
These contracts are programs that run on computers and are executed and hosted on a blockchain network. Every contract has certain predefined conditions that will trigger specific outcomes when they are met. They also allow several parties to agree on a result accurately, timely and guarantee that it is protected from being tampered with.
By not being managed by a central authority, proper smart contract execution provides crucial infrastructure for automation. They are also protected from single-point assaults conducted by malicious entities such as hackers. When smart contracts are used on multi-party digital agreements, they significantly lower counter-party risk, raise overall efficiency, reduce costs, and maintain better transparency.
In 1994, Nick Szabo, an American computer scientist, was the first to coin the term smart contract, giving a generic definition in his seminal writing.
The Bitcoin blockchain's appearance in 2009 supported the first protocol smart contract where a program established certain conditions that would provide a specific result when certain conditions were met. This was used to transfer digital assets such as Bitcoins between parties on the blockchain network via private keys and passing authentication processes.
Over time, the Bitcoin blockchain technology evolved in 2012 to offer a new simple smart contract called a multi-signature transaction. This required a specific number of people, or public keys, to sign off on a transaction using unique private keys before the contract was considered valid. As a result, the new system significantly increased the level of security of a user's funds by reducing the risk of having lost or stolen private keys.
Over the next few years, the blockchain technology industry began adding brand new conditions in programs (operation codes or opcodes). But the next major step in smart contracts was the moment when Vitalik Buterin published the Ethereum whitepaper in 2013. Ethereum launched as a brand new type of blockchain for programmable smart contracts in 2015.
The Ethereum smart contracts blockchain began offering a "world computer" that would run several independent smart contracts simultaneously instead of letting the blockchain act as a single smart contract application or only offering a handful of opcodes.
While you might know what smart contracts are, understanding how they work is an entirely separate matter. Simply put, a single smart contract can have several conditions, and one application can have various contracts to support interrelated processes. Ethereum's Solidity is the most popular among smart contract languages that are used for programming.
Another benefit of smart contracts is that they define precisely how users need to interact with it, who can interact with it, at what times they can interact with it, and what results they can expect from specific inputs. This assures users that other smart contracts will most probably execute the results that they desire.
The main advantage that smart contracts offer is reducing the level of risk that two parties, who don't know each other, take when they are involved in the majority of traditional digital agreements. This is because there is a chance that either of the two participants could forego their end of the bargain. This is called counterparty risk.
This problem is mitigated by using more prominent, centralized institutions, such as a bank, to uphold the contract's terms on the parties involved. These contracts can either be conducted between an individual and a company or may include a large company playing the role of a trusted middleman.
While this process reduces counterparty risk, it also creates another dilemma where the more significant, centralized host can exert its authority over the contracts. This issue is improved upon by smart contracts that provide the following advantages:
One key feature of smart contracts is letting the transaction run on decentralized blockchain infrastructure technology. This means that there is no one point of vulnerability that hackers or digital assailants can take advantage of, unlike many platforms susceptible to cyber attacks. Furthermore, within a smart contract's terms, no centralized or trusted intermediary can be bribed. It does not allow for either party involved or central admin to exploit or tamper with the results.
Smart contracts also provide a high level of reliability by having the deal's logic processed redundantly and having a decentralized network of nodes verify it. This allows the agreement to achieve a certain level of defense against tamper attempts. In addition, it has high accuracy that virtually guarantees that the contract will result according to its terms, making smart contracts much more reliable than other processes.
Smart contracts can mitigate the ability of for-profit intermediaries to take advantage of their position to benefit themselves financially. This is done by using a decentralized network to provide and enforce the terms of the transaction.
Multiple parties involved in a smart contract can benefit from increased efficiency due to the automation of the agreement's back-end processes. This means that there is no need to wait for manual data input, and no time is wasted waiting for the counterparty to hold their end of the bargain. It also removes the need for an intermediary to handle transactions.
Due to being a relatively new technology, there are many ways that smart contracts are used due to their significantly beneficial features, and the following is a list of the most common ones:
Widespread use of smart contracts is in blockchain-based games such as Axie Infinity and CryptoMines that benefit from smart contracts' tamper-proof use of various in-game actions. Another example is PoolTogether, where players stake their funds that is later routed into a money market, earning interest. A winner is randomly decided after a predetermined period and is rewarded all the accrued interest. The rest of the users can then withdraw the funds they initially deposited.
Applications used in decentralized finance, commonly known as DeFi, also utilize smart contracts to improve services and simplify processes. For example, users can use smart contracts to hold their funds in escrow and distribute them to other users based on predetermined conditions.
A type of insurance where the payout is directly tied to certain predefined events is called parametric insurance. Smart contracts provide much-needed security to the infrastructure that is responsible for creating parametric insurance.
Users can use token smart contracts to create, monitor, and designate ownership rights to digital tokens stored on blockchain networks. The tokens that the contracts issue contain functionalities and features that are beneficial to users.
One of the primary disadvantages of smart contracts is that the blockchain networks they run on are isolated. This means that they have no inherent connection to the outside world. This leads to the inability to communicate with external systems to confirm events in the real world. They are also unable to access computation resources that are relatively much more cost-efficient to use or create.
Smart contracts are currently being developed to include connections to real-world data and other systems outside the blockchain network. Once this is achieved, they will be able to expand inputs and outputs within the process.