What’s a smart contract?
- A smart contract is a self-executing agreement designed to operate on the blockchain, that negates intermediaries, enhances transparency, and increases trust.
- Created in 1994 by Nick Szabo and first incorporated on the Ethereum blockchain, smart contracts automate transactions and enforce terms autonomously.
- There are different types of smart contracts but they all operate based on the “if x, then y” logic, ensuring actions are executed only when specific conditions are met. Once deployed, smart contracts are immutable and trustless.
- Smart contracts are foundational to Web3, with applications in DeFi, NFTs, the Metaverse, and decentralized applications. They have certain risks such as their inflexibility and the potential for scams.
Blockchain technology is the foundation of cryptocurrencies such as Bitcoin. But it’s the humble smart contract that laid the foundation for DeFi’s $192 billion TVL ecosystem, not to mention Web3. Smart contracts are a transformative technology, enabling complex transactions to be facilitated by blockchain. They can reduce the need for intermediaries, increase transparency and trust. Despite their importance, smart contracts can often seem quite technical and are poorly understood. Let’s change that!
Smart contract definition
Smart contracts are self-executing digital contracts stored on the blockchain. They have the terms of their agreement directly written into lines of code and automatically execute when predefined conditions are met. This permits a seamless, trustless transaction.
Computer scientist and cryptographer Nick Szabo first created smart contracts in 1994. He envisioned a digital protocol that could facilitate, verify, or enforce the negotiation or performance of a contract. The idea gained practical application with blockchain technology, which served as a framework for trustless value transfers.
The Ethereum blockchain was the first major network to incorporate smart contracts as a central functionality. In doing so, it became a platform for the development of DeFi, apps, and the Metaverse.
Smart contracts have a couple of characteristics that make them unique.
Autonomous
Smart contracts operate autonomously once deployed on the blockchain. This means they run independently without requiring human intervention to enforce the terms of the contract. The code is responsible for managing the agreement, ensuring that actions are carried out as specified.
Consider a vending machine as a simple analogy for an autonomous smart contract. Once a user inputs money and selects a product, the machine automatically dispenses the product without human intervention.
Programmed with conditions
Smart contracts are programmed to execute specific actions when certain predefined conditions are met. This conditional logic ensures that all parties adhere to the terms of the contract, and the actions are triggered only when the agreed-upon criteria are satisfied.
In a crowdfunding scenario, a smart contract can be set up to release funds to a project creator only if a minimum funding goal is reached by a certain deadline. If the goal is not met, the funds will be returned to the backers.
Immutable
Once a smart contract is released onto the blockchain, the code cannot be altered. This immutability ensures the integrity and security of the contract, as it prevents any party from unilaterally changing the terms or tampering with the contract.
A smart contract used for a real estate transaction will have all terms (e.g., payment amount, transfer of ownership) fixed at the time of deployment. Neither party can modify the contract terms later.
Trustless
Smart contracts create a trustless environment where the parties involved do not need to know or trust each other in order for the contract to be executed. The blockchain and the code of the contract provide the necessary trust and ensure that the contract terms are enforced automatically, and transparently.
For example, in a decentralized exchange, users can trade cryptocurrencies without trusting the counterparty. This is the very foundation of decentralized finance, revolutionizing the way we think about agreements and transactions.
How do smart contracts work?
Smart contracts bind agreeing parties to a set of conditions that are coded into the smart contract. The conditions take the form of an “if x, then y” statement, ensuring that specific actions occur only when certain criteria are satisfied. But what’s the exact process?
- Creation
- Deployment
- Detection
- Self-execution
- Changes recorded on the blockchain
Creation
Once the two parties agree on the specific terms and conditions, they can create a smart contract in a programming language. Smart contracts can also be created with the help of a smart contract provider.
Deployment
The next step is to deploy it on the blockchain. Just like a regular crypto transaction, once verified the smart contract becomes active and immutable.
Detecting conditions
The contract will then be live on the blockchain and start to actively monitor for predefined conditions. These conditions can be anything from a specific date to receiving a predetermined amount of cryptocurrency and more.
Self-execution
The conditions above serve as triggers for the smart contract. Once a trigger has been activated, the smart contract will self-execute and complete the action(s) on which the parties agreed. These actions can be the transferring of funds, registering asset ownership and more.
Changes recorded on the blockchain
All changes caused by the smart contract are recorded on the blockchain’s public ledger, verifying and logging the transaction while storing the completed agreement for ongoing accessibility. This allows for full transparency and allows anyone to check the legitimacy of the contract at all times.
Types of smart contract
“Smart contracts” is the wider term but there are different types and each of them has its distinct purpose.
Legal smart contract
Legal smart contracts are digital versions of traditional legal agreements. They are designed to be legally binding and can be used for a variety of purposes, such as lease agreements, wills, and escrow services. Let’s say John and Jane enter a smart contract for apartment rental. The legal smart contract can manage rent payments and security deposit returns based on whether the rent is paid on time.
Decentralized autonomous organizations (DAO)
DAOs are organizations governed by smart contracts instead of traditional management structures. In other words, there is no CEO or executive board, just some code. They operate autonomously, making decisions based on predefined rules encoded into the smart contracts. DAOs enable decentralized governance and allow stakeholders to vote on proposals and changes to the organization.
Application logic contracts (ALC)
These contracts govern how data and commands are exchanged between machines, systems, or software applications and the blockchain. For example, if an international shipment reaches a certain checkpoint, a device can signal the application to update the data on the blockchain.
Where are smart contracts used
Smart contracts are the foundation of Web3 and have a plethora of use cases, finding applications in almost every sector you can imagine.
Decentralized finance (DeFi)
Smart contracts are the backbone of the DeFi ecosystem. They enable decentralized lending, borrowing, trading, and investing without the need for traditional financial intermediaries. Examples of smart contracts in DeFi include automated market makers and decentralized exchanges.
Uniswap is one good example of a DAO in action. It’s a DeFi protocol owned entirely by its community. Rewards are distributed according to each member’s UNI holdings, and tokens also function as governance tools, enabling community members to vote on changes to the protocol. All of this is written into the protocol’s smart contract, enabling it to operate seamlessly despite a completely anonymous community.
Supply chain management
Smart contract have become a popular technology for supply chain monitoring, because they enable accurate tracking of goods without human intervention. By using an oracle (a piece of technology that feeds real world data to the blockchain) in conjunction with smart contracts, large parts of international shipping operations can be automated.
Non fungible tokens (NFTs)
Smart contracts power NFTs by ensuring the uniqueness and ownership of digital assets, as well as controlling elements such as total supply. They facilitate the creation, transfer, and sale of NFTs on various blockchain platforms, enabling artists and creators to monetize their work.
Metaverse
In the Metaverse, smart contracts manage virtual real estate, in-game assets, and other digital goods. They enable secure and transparent transactions, allowing users to buy, sell, and trade items within the Metaverse environment.
Decentralized applications (dApps)
Smart contracts underpin Web3’s decentralized applications, producing a universe of consumer services all run by code. For example, when you use Brave Browser, you earn the native currency Basic Attention Tokens relative to the amount of time you spend watching adverts. This transactional relationship is controlled by smart contract. From gaming to supply chain management, decentralized apps like these rely on smart contracts to execute their functions accurately and transparently.
Tokenized and synthetic assets
Smart contracts enable the creation and trading of tokenized and synthetic assets. These digital representations of real-world assets, such as stocks or commodities, allow for fractional ownership and increased liquidity on different platforms.
Blockchain bridges and wrapped tokens
If you’ve ever used a blockchain bridge, wETH (wrapped Ether) or wBTC (wrapped Bitcoin), you’ve interacted with a smart contract. So-called blockchain bridges operate by “wrapping” one token with code that makes it behave like another. For example, wrapped Bitcoin enables you to use your Bitcoin on Ethereum based applications, so that you can benefit from the DeFi system without buying Ethereum based tokens. Blockchain bridges achieve this by wrapping the Bitcoin with a smart contract.
Smart contract scams
Smart contracts are everywhere in web3 and have become a really common vector for deploying scams. The most widespread ones are known as “wallet drainers”, malicious smart contracts containing code designed to empty your wallet. This makes it important that you’re smart contract literate. Smart contract scams usually include some sort of function that allows them to perform malicious acts. Here are a few functions you might want to keep an eye out for:
SetApprovalforAll
This function can have legitimate use cases but it can often be used for illegal activity. If you approve SetApprovalforAll, you’re essentially giving access to all your ERC tokens and NFTs. This goes for future ones as well. If you’re buying, minting, swapping, or transferring an NFT or trading tokens, you should not be seeing this function. The only acceptable encounter is when you’re listing a specific NFT on an NFT marketplace.
SafeTransferFrom
The next function is SafeTransferFrom and it’s commonly used when you want to transfer one of your NFTs to a different wallet. However, if you’re minting or buying an NFT or signing up for an allow list, you should not be seeing this function.
SendEth
Last but not certainly not least, there’s the SendEth function. It’s similar to SafeTransferFrom but it’s limited to the ETH token. SendEth allows for the transfer of ETH and the only time it’s acceptable to see it is when you’re sending ETH to another wallet. If you’re buying, selling, transferring, swapping, or minting an NFT and SendEth is in there, something’s probably not right.
How to revoke a smart contract
If you have any doubts about the approvals you’ve given so far, you can check and revoke all approvals with Revoke Cash. Even if you approved a malicious transaction, it might not be too late to prevent damage by revoking it.
How to create your own smart contract
Developing smart contracts is very technical – in fact, there is a lack of developers in the industry with this skill. Writing a proper smart contract from scratch requires a set of specific skills but don’t let that get you down. Thanks to platforms such as Manifold, you can deploy a smart contract in a matter of minutes without any programming knowledge required.
With Manifold, you can create your own NFT collection and choose from extensions for your NFTs that will help you customize them to your liking. Some examples of extensions include:
- Dynamic Content NFTs – Your NFTs will be able to change color based on external factors (weather etc.)
- Lazy Minting – You won’t have to pre-mint every single NFT in your collection, saving you some fees
- Swappable NFTs – Allows users to redeem an NFT they own for another one of the same collection
Benefits of smart contracts
Smart contracts empower the Web3 space and offer some significant benefits that make them ever so popular.
Transparent
Smart contracts operate entirely on a public blockchain, ensuring their complete transparency. All parties can view the contract’s terms and track its execution, fostering trust and accountability for everyone involved.
Trustless
Smart contracts eliminate the need for intermediaries and reduce the risk of fraud, and manipulation. The blockchain ensures that the contract is executed as written, regardless of the parties involved.
Efficient
Automating contract execution reduces the time and costs associated with traditional contract management. Smart contracts streamline processes, making them faster and more efficient than their traditional counterparts.
Accurate
Smart contracts execute with absolute precision, eliminating the potential for human error and discrepancies. The coded terms ensure that the contract’s conditions are met exactly as specified.
Risks of smart contracts
Despite all their advantages, smart contracts also have some potential risks that arise from their digital nature.
Inflexible
The immutable nature of smart contracts can also be seen as a potential negative. Once deployed, smart contracts cannot be modified. This inflexibility can be a drawback if the contract’s terms need to change due to unforeseen circumstances. To resolve this, a completely new contract has to be created.
Can’t capture human detail
Smart contracts are limited to quantitative data and predefined conditions. They cannot capture qualitative value or adapt to complex, subjective scenarios that may arise in real-world applications. For example, say you had a payment plan enforced by a smart contract. The conditions state that if you miss a payment, you’ll be charged a fine. Whereas a normal payment plan might take into account your history, health conditions or natural disasters, a smart contract can’t do that. If you miss a payment, you’ll be fined. So while code is extremely efficient, it lacks the ability to consider human factors.
Closing thoughts
Smart contracts used blockchain technology as a framework to create a world of service that run autonomously and don’t require any personal data. However, they also come with risks and potential vulnerabilities. By understanding how smart contracts work, their applications, and the associated risks, users and developers can harness their power while mitigating potential pitfalls. As blockchain technology continues to evolve, smart contracts will undoubtedly play a crucial role in shaping the future of decentralized systems.
Frequently asked questions
How do I create a smart contract?
Creating a smart contract involves several steps. First, define the contract’s purpose and terms clearly. Next, choose a blockchain platform, such as Ethereum, and a programming language like Solidity. Write the contract code, specifying the conditions and outcomes. Thoroughly test the contract in a development environment to identify and fix any bugs. Once the contract is error-free, deploy it to the blockchain network. After deployment, monitor the contract to ensure it functions as intended and remains secure against potential vulnerabilities. If you don’t have any programming knowledge, you can use ThirdWeb to customize and deploy a smart contract but the options are limited.
What’s a smart contract scam?
A smart contract scam is a fraudulent activity where malicious actors exploit vulnerabilities in smart contracts to deceive users and steal their assets. These scams often involve deceptive coding, phishing contracts, and rug pulls. For instance, attackers may create contracts with hidden backdoors that drain users’ funds upon approval, or they might set up fake projects, lure investors, and then withdraw all funds, leaving investors with worthless tokens.
