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What are smart contracts?

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PDAX

July 11, 2022

5 min read

BeginnerEthereumDeFi

TL;DR

Smart contracts are programs that are written into a blockchain and are executed whenever certain predetermined parameters are met. They are designed to automate a transaction or agreement without needing an executor, middleman, or third party.

What are smart contracts?

Smart contracts represent the most significant evolution in the world of decentralized finance (DeFi) and cryptocurrency to date. When cryptocurrency first came around with the birth of Bitcoin, the blockchain platform that it was built on functioned entirely as a decentralized ledger system to track and monitor transactions, with bitcoin functioning solely as a currency.

But when Ethereum came into the picture at the head of second-generation blockchains, the technology became more than just a ledger. It became a programmable platform that could run and execute programs and applications. And with the help of “smart contracts”, these decentralized applications (dApps) could operate and carry out complex transactions such as loans, bills, mortgage payments, insurance claims, and governance protocols–just to name a few–all with just the use of algorithms.  

In fact, the use cases of smart contracts are practically limitless. As long as it is an agreement whose conditions can be encoded as an algorithm, it can be made into a smart contract and be run on a blockchain. “Flexibility” is the main feature that second-generation blockchains like Ethereum are able to provide.

How do smart contracts work?

The biggest appeal of smart contracts is that it doesn’t require the intervention or participation of intermediary parties in order for the transaction to be executed. An agreement can be fulfilled directly between two parties just as long as the smart contract's required inputs are met. 

To illustrate, we can take a look at a crowdfunding platform like Kickstarter. There are three entities that are involved in any transaction that takes place on the platform: the entrepreneur looking to start a business, investors who have the cash, and Kickstarter.

The platform is structured in a way that entrepreneurs can set up crowdfunding pages for their proposed business ventures. Investors who roam the site and are convinced of the potential of a venture can then choose to fund it in exchange for a percentage of the future profits. 

Kickstarter then functions as the intermediary wherein it receives the investments of people who use the site and pass it on to the entrepreneurs. Kickstarter also has the responsibility of executing refunds or returns of investment to the original investors depending on the agreed-upon terms and the performance of the venture. In short, Kickstarter functions as the third party to facilitate “trust” between the two other parties and make their agreement work for them. 

On the other hand, dApps that have the same business model as Kickstarter are able to work faster and more efficiently since they only need to rely on smart contracts.  Smart contracts take the place of the intermediary and allow for seamless peer-to-peer transactions to be carried out simply by meeting the conditions indicated in the contract. Hence, with smart contracts, investors can directly send their funds to the entrepreneurs. The smart contract can be set up to only release the funds in staggered increments (or vesting periods) based on the progress of the venture so that investors can be assured that their money will be used properly. Likewise, once the venture is up and running, the smart contract can direct the return of investments automatically to investors once certain profit targets have been attained. 

In short, drafting a traditional paper contract between business partners often needs a third party to oversee and enforce it such as lawyers and judges, while a smart contract is an independent computer code that operates automatically on its own terms–saving both parties a lot of time, effort and money.

Smart contracts are also customizable according to the needs of either party and are highly transparent, allowing both parties to view each other’s progress in complying with the terms indicated.  

Additionally, since smart contracts reside on a blockchain, that means the data they carry are also immutable and distributed. Being immutable means that they can’t be manipulated, deleted, or compromised in any way. While being distributed means that the execution of the contract is authenticated securely across a blockchain network instead of just being stored in one computer or one database. 

Smart contracts are the future

Even though smart contracts are a relatively new technology, they are already widely applied in a variety of use cases, especially in DeFi where the smart contract takes the place of banks in offering financial products and services like lending, borrowing, savings accounts, and leveraged investing options to make them more accessible and convenient to a wider audience. When previously such financial instruments were only available to a few, they can now be participated in even by the unbanked. 

Smart contracts are also already being used to facilitate sales and transfers of non-fungible tokens (NFTS). NFTs are tradeable digital assets that come in the form of images, audio files, video files, in-game items, and other virtual objects that have unique traits and characteristics that determine their value on the market. NFT auctions, for example, make use of smart contracts to automatically transfer ownership to winning bids upon confirmation of payment, all without the need for any auctioneer to oversee the sale. 

The potential of smart contracts is far-reaching and it is not so difficult to imagine the application of smart contracts in other industries such as education, healthcare, supply chain, energy, travel, and more. With smart contracts, the difficulty of initiating trust between parties might just become a thing of the past.  

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DISCLAIMER: The statements in this article do not constitute financial advice. PDAX does not guarantee the technical and financial integrity of the digital asset and its ecosystem. Any and all trading involving the digital asset is subject to the user’s risk and discretion and must be done after adequate and in-depth research and analysis.

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