Smart Contracts 101: A Beginner’s Guide

8 min read

If you want to enter or better understand the crypto space, the first step is to familiarize yourself with specific terms, including smart contracts. Smart contracts are revolutionizing the way we think about contracts, transactions, and business processes.

That’s why, in this beginner’s guide, we will provide you with a solid foundation in the basics of smart contracts and how they work, so you can start exploring the potential of this innovative technology.

What are Smart Contracts?

Simply put, smart contracts are self-executing programs that can automate the process of verifying, executing, and enforcing the terms of a contract. These contracts can be written in code, and once they are deployed on the blockchain network, they are tamper-proof and immutable.

Smart contracts have the potential to revolutionize the way we do business by eliminating the need for intermediaries and reducing the costs associated with traditional contract management. 

The smart contract can be programmed to execute automatically once certain conditions are met.

Also, smart contracts can be used in a variety of industries, from supply chain management to real estate transactions, and have the potential to streamline processes and increase transparency.

How Do Smart Contracts Work?

Smart contracts work on the principle of “IF-WHEN-THEN” statements, which are executed automatically once certain conditions are met. The code executes a particular task only when specific predefined conditions are satisfied, providing an efficient and transparent method for managing transactions.

For instance, when buying a property using Ethereum smart contracts, the parties involved can set conditions like “IF/WHEN the X party transfers the property to my name, then I’ll pay the sum of money agreed upon.” Alternatively, they can set “IF/WHEN I pay the sum of money agreed upon, then the X party will transfer the property in my name.”

Smart contracts can include an unlimited number of conditions, and only when these conditions are successfully met will the smart contract execute and validate the transaction. The involved parties can interact with each other in real-time without the involvement of a third party, saving both time and money.

In the upsurge, since smart contracts are stored in a decentralized ledger, they offer a higher level of security against fraud. The contracts are encrypted, making them difficult to hack or alter, and the decentralized nature of the ledger ensures that the contract cannot be deleted or tampered with. Smart contracts also provide the involved parties with the option of anonymity if necessary.

Example of Smart Contract in Action

Smart contracts have numerous potential applications, from supply chain management to real estate transactions. Here’s a simple example to illustrate how they work:

Let’s say that Alice wants to buy a car from Bob. They agree on a price of $10,000, but they don’t want to involve a third-party intermediary like a bank to handle the transaction. Instead, they decide to use a smart contract on the Ethereum network.

Alice creates the smart contract code, which specifies that when she sends $10,000 worth of Ether to the contract address, ownership of the car’s digital title will be transferred to her. The contract code also specifies that if Alice doesn’t send the Ether within a specified timeframe, the contract will be canceled, and the car’s digital title will remain with Bob.

Once the contract is deployed on the Ethereum network, Alice sends the $10,000 worth of Ether to the contract address. The smart contract automatically verifies that the conditions have been met (i.e., that Alice sent the correct amount of Ether within the specified timeframe), and ownership of the car’s digital title is transferred to Alice.

This is just one example of how smart contracts can be used to facilitate trustless transactions without the need for intermediaries. As blockchain technology evolves, we expect to see even more innovative use cases for smart contracts.

How Smart Contracts Came into Existence

The idea of smart contracts was first introduced by Nick Szabo, an American computer scientist, in 1994. He also invented a virtual currency called “Bit Gold” in 1998, a decade before Bitcoin was created. However, some rumors suggest that Szabo is Bitcoin’s anonymous creator, but he has denied this claim.

Szabo’s concept of smart contracts involved computerized transaction protocols that could execute the terms of a contract. He aimed to extend the functionality of electronic transaction methods, such as point of sale (POS), to the digital world. In his paper, he also proposed using smart contracts for executing contracts for synthetic assets, such as derivatives and bonds. He stated that these new securities could be traded with low transaction costs, thanks to the computerized analysis of complex term structures.

Smart contracts do not contain the legal language or terms of a contract between two parties. Instead, they are scripts with the programming language, such as if/then statements, functions, and module imports, that automate the actions specified in a contract. Many of Szabo’s predictions in the paper came true even before the advent of blockchain technology. For instance, derivatives trading is now mainly conducted through computer networks using complex term structures.

Benefits of Smart Contracts

Smart contracts offer several benefits that traditional contracts simply cannot match. Here are some of the key benefits of smart contracts:

  • Speed, Efficiency, and Accuracy – Smart contracts can execute immediately when the predetermined conditions are met, thanks to their digital and automated nature. This eliminates the need for paperwork and the associated time-consuming errors that can arise from manual document processing.
  • Trust and Transparency – Since smart contracts don’t require third-party intermediaries, and transaction records are securely encrypted and shared across participants, there’s no need to worry about fraudulent activities or personal benefit alteration. Everything is transparent, and participants can trust that the agreement will be carried out as specified.
  • Security – Smart contracts leverage the security features of blockchain technology, including encryption and decentralization, to provide a high level of protection against hackers and cyberattacks. Each record is linked to the preceding and succeeding records on the distributed ledger, making it difficult for hackers to change a single record without tampering with the entire chain.
  • Savings – Smart contracts eliminate intermediaries, such as banks and brokers, and the associated fees and time delays. As a result, participants can enjoy significant savings, particularly for high-value transactions.

Is It Possible to Modify or Remove a Smart Contract?

To put it simply, smart contracts cannot be changed once they are deployed on a blockchain. They are permanent and immutable.

However, there are certain cases where particular modifications can be made. For example, in the Ethereum network, if the creator has added a specific function called “SELFDESTRUCT” to the code, they can delete the contract and replace it with a new one in the future. The smart contract cannot be deleted if this function is not included in the code.

There are also upgradeable smart contracts that provide developers with more flexibility over contracts’ immutability. Upgradeable smart contracts can be created in various ways, with varying levels of complexity. Smart contracts can be divided into smaller contracts where some of them are immutable while others have the “delete” function enabled. This allows for some parts of the code to be replaced while others remain intact.

Limitations

Smart contracts have some limitations that should be considered. Since humans write smart contracts, there is always a risk of human error or vulnerability in the code. It’s crucial to have experienced programmers write and deploys smart contracts, especially when dealing with sensitive information or large amounts of money.

Centralized systems are argued to provide similar solutions and functionalities as smart contracts, but the key difference is that smart contracts are run on a distributed P2P network, which is much harder to hack. However, being immutable can have drawbacks. In 2016, a Decentralized Autonomous Organization (DAO) called “The DAO” was hacked, resulting in millions of Ether (ETH) being stolen. The smart contract code was immutable, and developers could not fix it. This led to a hard fork and the creation of a second Ethereum chain.

Also, smart contracts’ legal status is uncertain in most countries, and they don’t always suit the current legal framework. For example, many contracts require proper identification and age verification of both parties, which may be threatened by blockchain technology’s pseudonymity and lack of intermediaries. Despite potential solutions, the legal enforceability of smart contracts remains a challenge, especially on borderless, distributed networks.

Smart Contracts Pros and Cons

Smart contracts have a range of pros and cons, including the following:

Pros:

  • Elimination of Intermediaries: Smart contracts remove the need for intermediaries, making transactions faster and less expensive.
  • Efficiency: Smart contracts automate the execution of contracts and reduce the time and effort required to process them manually.
  • Accuracy: Since smart contracts are automated, there is no risk of human error.
  • Immutability: Smart contract code is immutable, meaning that once it is executed on the blockchain, it cannot be changed.

Cons:

  • Permanence: Smart contracts are permanent and cannot be altered or corrected once deployed on the blockchain, so it is critical to ensure that the code is correct before execution.
  • The Human Factor: Smart contracts rely on programmers to write accurate code that addresses all aspects of the contract’s terms and conditions, including edge cases.
  • Loopholes: Smart contract code may contain loopholes or other vulnerabilities that can be exploited, potentially leading to contract execution in bad faith.

Key Takeaways

  • Smart contracts are self-executing programs that can automate the process of verifying, executing, and enforcing the terms of a contract.
  • Smart contracts work on the principle of “IF-WHEN-THEN” statements, which are executed automatically once certain conditions are met.
  • Smart contracts can be used in a variety of industries, from supply chain management to real estate transactions, and have the potential to streamline processes and increase transparency.
  • Smart contracts offer several benefits: speed, efficiency, accuracy, trust and transparency, security, and savings.
  • Smart contracts cannot be modified or removed once deployed on the blockchain network, making them tamper-proof and immutable.
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