While blockchain protocols allow for the recording of transactions in a trustless, distributed, peer-to-peer manner using a public ledger, without the need for any central authorities, smart contracts greatly expand the power and potential of blockchain technology for real-world use cases.
For example, today, the Ethereum network routinely facilitates the transfer of tens of billions of dollars of value, with over $110 billion currently locked in its smart contracts as of Q1 2022, to facilitate decentralized asset exchange involving lending, insurance and payments. The Terra network follows second with over $29 billion locked inside its smart contracts.
What Are Smart Contracts?
Smart contracts are digital contracts or programs stored on a blockchain that execute according to predefined terms and parameters, set in the form of code that governs how they function and which conditions allow them to perform which range of actions.
Functions and Limitations
Since smart contracts allow for the code alone to have the ability to influence many types of exchanges between two parties, such as controlling lending and credit markets or liquidity provisioning, one of the most interesting byproducts of smart contracts is the removal of intermediaries.
Smart contracts are typically used to automate the execution of an agreement so that all participants can be immediately sure of the outcome without the involvement of intermediaries.
Smart contracts remove the need for intermediaries and extraneous paperwork in the traditional lending and credit markets, as codes within allow users to facilitate the terms of a loan on a permissionless blockchain, which can be openly audited anytime.
Smart contracts can also be used to automate a workflow and trigger the following action when certain conditions are met, such as when a time period is reached, or when a certain number of investors fulfill the maximum quota designated in a contract.
Once a clearly defined condition is met, the contract is executed immediately without the dependence on a human party to get involved. It is automated, and there is no need for paperwork or time to send reconciling errors that may result from this action in the traditional physical contracts world, in finance or otherwise. It is not only more efficient, but also saves time in extraneous overhead costs.
The benefits of smart contracts are immense and include security, savings in costs that would otherwise go to intermediaries, increased trust, transparency, and efficiency.
Due to reduced dependency on human and third-party involvement, and because encrypted records of transactions on public blockchains are openly accessible by all parties, there is no need to doubt the accuracy of the data, as blockchains achieve consensus to record transactions by nature.
Additionally, because each transaction and record on a blockchain is connected to the previous record in the ledger, there is increased security in transaction records, transparency and ease of audit.
How Do Smart Contracts Work?
Smart contracts work by following the simple structure of if/then statements that are often used in code but presented on the blockchain, which has many benefits.
When certain conditions are met, a network of computers then executes the actions coded in the contract. These actions can range from all kinds of activities, including releasing funds to appropriate parties, issuing rewards on a timely basis for participating in an event, registering a physical or digital asset such as an NFT or a collectible, or simply sending a notification.
When the smart contract executes an action, the outcome and transaction data are recorded on the public ledger, blockchain, thereby updating it. Due to the immutable nature of blockchain, the data recorded cannot be adjusted. Therefore, smart contracts are often used for financial and other transactions.
Smart contracts also allow developers to add as many exact stipulations as needed to satisfy the task. Before programming a smart contract, developers must first establish its scope and terms, agree on the relevant if/then conditions that govern the transactions and explore possible exceptions and vulnerabilities. Finally, they must think of how to resolve disputes that may arise during the undertaking agreement.
Limitations of Smart Contracts
One major limitation is that because they are still relatively new and often open-source, even the most vetted smart contracts bear the risks of being hacked and several billion in locked funds lost to hackers and thieves. Funds lost to DeFi hacks totaled over $1.3 billion in 2021 alone.
Because smart contracts are often configured in ways that make them difficult or impossible to change, adjusting them can be time-consuming and expensive. Any error in the code, intentional or not (from rogue developers that may have better control over the code and seek to jeopardize other parties), can be devastating financially or, at the least, time-consuming to fix.
The other limitation is that smart contracts can involve vague terms that are sometimes hard to put into code to meet specific conditions. However, the technology and its capabilities continue to evolve very fast.
Examples & Applications of Smart Contracts
Let’s look at some real-world applications of smart contracts and examples of how they are being used in blockchain today, in the decentralized finance (DeFi) ecosystem and for businesses already utilizing the capabilities of blockchain.
Smart contracts can be used to monitor supply chains and allow the end consumer, the manufacturer and the producer to safeguard and monitor the supply chain history for greater access to transparency.
This can reduce issues in transport, save on costs, and provide trusted and reliable data for sensitive items that must be authenticated or closely monitored throughout the transport process, for example, temperature-controlled medications or high-end luxury items.
Smart contracts used in insurance can enable faster verifiable data exchanges, visibility, and automated underwriting transactions. They help reduce fraud and abuse in insurance with improved traceability and automated claims settlement if certain conditions in a smart contract are met, which cuts costs due to reducing the need for intermediaries and ensures accurate data.
Smart contracts are widely applicable in the healthcare sector as well. Some examples include resolving disputes, triggering the following steps in a treatment or evaluation plan when certain conditions are met, and achieving better reliability as pharmaceutical products move through the supply chain.
Audit trails recorded on the blockchain ledger can reduce counterfeit drugs and help locate faulty products recalled or dispense correct doses on a time-locked schedule.
For financial services, the opportunity for smart contracts is massive. Settlement times can be instant where smart contracts allow for more complexity in agreements and locking funds inside of them across several parties, for example.
There are already extensive uses of smart contracts in today’s thriving DeFi ecosystems on both Ethereum and Terra, with Ethereum’s thriving decentralized lending and credit markets like Aave and Maker facilitating crypto-collateralized loans executed fully via smart contracts.
For financial services, the opportunity for smart contracts is massive. Settlement times can be instant where smart contracts allow for more complexity in agreements and locking funds inside of them across several parties, for example.
There are already extensive uses of smart contracts in today’s thriving DeFi ecosystems on both Ethereum and Terra, with Ethereum’s thriving decentralized lending and credit markets like Aave and Maker facilitating crypto-collateralized loans executed fully via smart contracts.
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