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Many investors have come to accept that cryptocurrencies have a place in many portfolios. However, some don’t understand the functions of cryptocurrencies beyond their use as a digital asset and digital currency.
One of the most important crypto functions is smart contracts, which can be difficult to wrap your head around. Understanding smart contracts could make a difference in which cryptocurrencies you buy and how you use them.
“As the world is pivoting to more of a digital world, smart contracts are a component to better understand,” senior IBM executive Anouk Brumfield said. “Smart contracts are not paper contracts, but, in essence, the set of rules that all parties agree to; it is software stored and run on a blockchain. Blockchain, in simple terms, is a distributed ledger that drives trust and transparency.”
What are smart contracts?
The Ethereum blockchain was the first to host smart contracts, which some would argue are one of the most useful applications of blockchain technology. Smart contracts execute themselves, automating various business applications as they run on a decentralized blockchain. However, they only execute if certain conditions are met.
Since smart contracts require a decentralized network, they remove the need for an intermediary in transactions. For example, a conventional contract requires a court to step in if one of the parties violates the terms of the contract.
However, any consequences for violating smart contracts occur automatically without the need for an intermediary to enforce them. They set the terms of the contract in computer code, enabling automatic execution when certain conditions are met.
Smart contracts are essentially programs stored on a blockchain. They can also be used to automate workflow by triggering the action after a set of conditions is completed. Smart contracts can perhaps better be described as business rules written in computer code using if/ then language.
For a more technical definition, we can look to the U.S. National Institute of Standards and Technology. It describes them as a “collection of code and data (sometimes referred to as functions and state) that is deployed using cryptographically signed transactions on the blockchain network.”
Although Ethereum was the first blockchain to be designed with smart contracts in mind, they are not limited to Ethereum or any other particular blockchain or decentralized network.
The history of smart contracts
According to CoinDesk, the concept of a smart contract can be traced back to 1993 when cryptographer and computer scientist Nick Szabo described it as a sort of digital vending machine. The original whitepaper about the Ethereum blockchain described the Bitcoin network as supporting very basic smart contracts.
Every transaction conducted on the Bitcoin blockchain is essentially a smart contract because the network only approves the transaction after specific conditions are met. In the case of Bitcoin, the user produces a digital signature that proves they own that particular token.
When Ethereum came along, smart contracts became far more complicated than transactions on the Bitcoin blockchain. The Ethereum blockchain allows developers to create smart contracts capable of a wide variety of different automated actions. Once a developer codes a smart contract, anyone with access to the protocol can use it.
Applications of smart contracts
Despite their name, smart contracts don’t necessarily constitute a binding legal agreement between two or more parties. Instead, they offer a way to automate the performance of certain obligations that must occur after some other action is taken. Some examples of smart contract protocols in use today are the Ethereum apps MakerDAO and Compound, which use smart contracts for lending and earning interest.
Due to the wide array of potential applications of smart contracts on the Ethereum blockchain, developers can create smart contracts that do almost anything they want. Some common applications include multi-signature accounts, which only allow funds in the account to be spent when a set percentage of people agree.
Smart contracts can also be created to manage and automate agreements between users. For example, the developer could set a certain action to occur if or when one user wants to redeem something. Smart contracts can also be developed to pull data from the outside world using oracles, which pull data from the outside world into the blockchain to be utilized for the smart contract.
Smart contracts can be created to work with other smart contracts or even for something as basic as storing information about an application like membership records or domain registration information. Storing the data on a blockchain means it can never be erased or changed.
Smart contracts can also be used to store someone’s digital identity, manage a supply chain, conduct financial trading, automate mortgages, automate government operations, and more. One of the areas of greatest potential for smart contracts is the financial sector, where they can have numerous applications.
Advantages and disadvantages of smart contracts
As with anything, there are advantages and disadvantages to smart contracts. Perhaps the most obvious one is that they are automatic because they trigger actions automatically when certain conditions are met. This makes businesses or governments run more efficiently and creates trust between parties when they otherwise might not trust each other.
Smart contracts are also secure because they are encrypted and can’t be changed, which means any data stored in a smart contract on a blockchain can’t be changed. They make automation and transactions more cost-effective by removing intermediaries, and they cause actions to be executed much faster than other methods. If the developer codes the smart contract correctly, it will always be accurate and without errors. Brumfield added transparency, reliability and security as additional advantages.
On the other hand, the fact that they can’t be changed can pose problems for a variety of reasons, like if there is an error in the code. Additionally, like conventional contracts, there can always be loopholes, and developers could make a mistake in creating them, causing them to have vulnerabilities or bugs. Hackers could find ways to exploit a bug in some smart contracts, enabling them to steal millions of dollars’ worth of cryptocurrency.
Finally, due to the newness of smart contract technology, the legal regulation for their enforcement is weak. Further, some people might not trust smart contracts because they don’t understand the tech. According to Brumfield, some additional disadvantages include the lack of flexibility to make changes, challenges with managing complexities, and the lack of mass adoption and scalability.
“In essence, smart contracts make processes faster, increase security, keep costs down while providing transparency,” Brumfield concluded. “As adoption increases, we may see other advantages and/or disadvantages.”
Final thoughts
It’s anyone’s guess whether smart contracts will become a regular part of daily life. We are still in the early days of this technology, so it’s impossible to know whether they have a future.
However, the potential applications of smart contracts are virtually endless, so placing a bet on the technology by investing in it isn’t necessarily a bad move, although it is purely speculative right now.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
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