What Is a Smart Contract and How Does It Work?

Introduced to the Ethereum blockchain in 2014, smart contracts were first defined by Nick Szabo, a computer scientist who developed one of the first virtual currencies two decades earlier.

But what is a smart contract? How does it work? What are its benefits and downsides? Can you create one without coding knowledge? Learn that and more in this detailed exploration of one of the most significant elements of the crypto world.

How Do Smart Contracts Work?

If you want to have smart contracts explained thoroughly, you need to understand how they work. Once an agreement is made, it’s put into the smart contract code, after which the contract is deployed. After that, the contract will be executed once all the necessary criteria are fulfilled and the transactions or actions are recorded on the ledger, concluding the procedure.

Let’s see how this works in more detail, avoiding technical jargon as much as possible.

Writing the Smart Contract Code

The first step is for the parties to agree on the terms and conditions of the contract and determine how it will operate, most notably, what criteria must be met for the contract to be fulfilled.

Then, the parties can use this to develop a smart contract on their own or use a smart contract provider. They will code the parameters into the programming language while verifying the security of the contract throughout the process. Issues with the code are the leading cause of breached smart contracts, which is why they must be written carefully.

Deploying the Contract

Once the contract is ready, it’s published on the blockchain network. The contract is uploaded just like any regular crypto transaction. Once the blockchain verifies this, the smart contract becomes active and cannot be altered, reversed, or deleted.

The contract then starts following changes to the blockchain or other reliable sources to determine whether and when the agreed-upon actions have taken place. As long as the action can be verified in the digital realm, such as a payment made or date reached, the contract can follow it.

Execution & Recording on the Ledger

Ethereum smart contracts (and, for that matter, most other blockchains’ smart contracts) follow a simple “if-then” formula, so once the parameters are met, pre-agreed actions are executed. For instance, the buyer’s possession of an asset was recorded, so the contract executes the payment and transfers funds to the seller.

Once completed, the results of the contract are published on the blockchain. The network verifies this, logs the completion time, and stores the agreement so it can be viewed freely at any time.

Benefits of Smart Contracts

Based on what you’ve read so far on how a smart contract in the crypto world works, you can likely already guess the many benefits it provides. However, let’s elaborate on the most important ones.

1. Automation: Smart contracts are self-executing, automatically enforcing the terms of an agreement between parties. This saves time, streamlines the process, and reduces the potential for errors. Moreover, they eliminate the need for complex intermediaries, with the only middleman being the smart contract provider.
2. Transparency: As mentioned, smart contracts are publicly available on the blockchain, meaning everyone can view them, what they executed, and the code used. This ensures full auditability, leaving little room for anyone to break the terms or tamper with the smart contract.
3. Decentralization: Since they operate on the blockchain, smart contracts don’t rely on central authorities. This makes them fully transparent and decentralized. Furthermore, the risk of fraud and censorship is lowered, and there are fewer points of failure compared to centralized platforms.

Disadvantages of Smart Contracts

Smart contracts sound almost perfect, but like everything else, they have a few notable downsides, which we’ll cover below.

1. Complex: One of the most significant disadvantages of smart contracts in blockchain is that they can be challenging to understand. We’ve done our best to explain how they work, but as you can already guess, more profound knowledge of the technical side is needed to understand them fully. That said, regular users don’t need to be aware of all the complexities involved.
2. Not Easy to Change or Fix: Smart contracts are difficult to change or fix even before they are deployed. They consist of complex code, so it takes someone with extensive knowledge to make changes. Also, if a problem or a possible point of entry is uncovered, it’s not always easy to fix the issue and ensure the contract is safe from hackers. When it comes to changing after being deployed, most smart contracts come without this function, but if they do, they are considered unsafe because a party has a key to changing the terms whenever they want to.
3. Risk of Hacking: Smart contracts are always at risk of being hacked. Naturally, most standard smart contracts don’t contain any loopholes in the coding that can be used as a point of entry, but mistakes can be made by coders, especially with a completely new smart contract where the code is written from scratch.

What Are the Different Types of Smart Contracts?

Since smart contracts can be used for a wide range of reasons in the cryptocurrency world, there are also many different types of smart contracts. Let’s cover the main types connected to popular use cases.

Financial Contracts 

Finance, specifically DeFi, is a common application of smart contracts. These contracts digitize and automate financial agreements, like various types of trades on DEXs and other DeFi platforms.

For instance, Compound Finance, a decentralized lending and borrowing platform, relies heavily on smart contracts to facilitate lending and borrowing.

Tokenization Contracts 

Smart contracts are used as engines to create and manage digital tokens on a specific blockchain, like ERC-20 tokens on the Ethereum chain or even NFTs.

For instance, one of the most famous stablecoins on the planet, Tether (USDT), relies on smart contracts to function. When it’s issued on different blockchains, it’s managed with a specific smart contract.

Supply Chain Contracts

Supply chain contracts are smart contracts that automate and streamline various processes in supply chains. They can track the movement of goods, automate payments, manage inventory, and more.

A good example is VeChain, a blockchain ecosystem designed to improve supply chain management. Smart contracts are one of the core components of this blockchain, automating and executing various processes.

Decentralized Finance (DeFi) Contracts

DeFi smart contracts are the building blocks of decentralized finance, as they are all about decentralization, transparency, and the permissionless method of using blockchain technology. Smart contracts effectively execute the majority of transactions in DeFi platforms.

This is especially the case with DEXs like Uniswap, which uses smart contracts to control liquidity pools that contain all the reserves of cryptocurrencies traded on the platform.

Governance Contracts

Smart contracts are also utilized by various crypto projects and DAOs in their governance. Typically, they encode decision-making processes and project rules, enabling the organization to stay transparent about how it functions.

A good example here is MakerDAO and its DAI stablecoin. Smart contracts are utilized to maintain the stable exchange rate of the coin by adjusting the supply according to what the market dictates.

Can You Create Smart Contracts Without Coding

Yes, it’s entirely possible to create smart contracts without complex coding knowledge. If you don’t want to rely on platforms using smart contracts to facilitate trades and other specific use cases, there are no-code/low-code smart contract development platforms that make this process simpler for blockchain developers.

In essence, you are free to define the rules and the logic of the contract, but you don’t have to write the code. You can use visual interfaces to connect blocks that represent the conditions and actions of the contract.

Good examples of such platforms are Bunzz, Thirdweb, and Bueno. Thirdweb, for example, lets you create NFTs, DAOs, and various other Web3 apps using tools and templates.

Conclusion

Smart contracts have led us to a new era of decentralization, transparency, and automation in the digital world. By automating almost any type of agreement, they are able to increase efficiency for all parties involved. More than that, they lead to decreased costs and better security.

Even though they come with a few challenges, like their complexity and risk of hacking, their benefits surpass all of that. With banking and many other sectors exploring the use of smart contracts, it’s clear that they will continue advancing and improving how we operate in the digital realm.

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