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How do Smart Contracts work?

Blockchain and smart contracts are frequently brought up together. Smart contracts have been a significant addition to blockchain technology since the introduction of blockchain 2.0 (which is when blockchain acquired its first use case outside of Bitcoin in 2014). They do not have to be difficult to understand even though they are extremely technical in nature.

We’ll walk you through the fundamentals of smart contracts in this guide. You’ll discover what they are, how they operate, the situations in which they apply, and even the fundamentals of drafting one.

What Is a Smart Contract

Smart contracts are simply a programmed variant of standard contracts, to put it simply. Its goal is to automatically initiate a previously agreed-upon contract after all prerequisites have been satisfied. This can considerably decrease the amount of fine print intended to favour one party, even at the expense of the other, because every condition must be explicitly programmed to execute.

Although programmable blockchain implementations gave rise to the term “smart contracts,” they have existed for much longer. Nick Szabo, a computer scientist, attorney, and cryptographer, first introduced the idea of smart contracts in the 1990s. “A set of promises, stated in digital form, including procedures within which the parties act on these promises,” was how he described them.

Despite their name, smart contracts are not always regarded by the law as a genuine, binding agreement, unlike conventional contracts. They are not necessary in the implementation of blockchain, though. They are described as “a collection of code and data (sometimes referred to as functions and state) that is deployed using cryptographically signed transactions on the blockchain network,” according to the US National Institute of Standards and Technology. In line with this notion, Ethereum and other blockchains function.

It may be clear to people who are familiar with blockchain how smart contracts fit into its design. There is no place for intermediaries and third parties in a truly decentralised environment where nobody possesses substantial amounts of power.

How a Smart Contract Operates

But understanding what a smart contract is doesn’t always explain how it functions.

Smart contracts are composed of several functions that are defined on them, to put it simply. Users communicate with them by sending a transaction that causes a specific function to be performed. Each of these functions is thoroughly explained so that consumers can know exactly what they’re about to perform.

The network’s users decide what smart contracts are. As long as they have enough native coins to deploy, anyone who can programme in the smart contract language can create their own. The price itself is influenced by the requirements of the network you’re using for deployment.

A trade agreement would serve as a real-world illustration. The two sides would typically seek out a neutral third party to make sure everything is carried out exactly as agreed upon once they have worked out the details (what each is receiving in exchange, the conditions, and any circumstances that would cause them to renegotiate the arrangement). However, neutral third parties are expensive, and you can’t always rely on them to remain impartial or simply not try to take advantage of the situation for their own gain. The simplest option would be to fully eliminate this third party. But then, who will serve as a mediator?

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Since only machines are capable of neutrality, people have always chosen it. Despite recent technical advancements, it is still impossible for machines to have independent preferences and interests. As smart contracts cannot accomplish anything that was not expressly programmed in, writing a smart contract enables all parties to discuss the specifics of the trade publicly and transparently, so preventing potential fraud. This lowers total costs as well because deploying and then triggering a smart contract is less expensive than hiring a lawyer.

Smart contracts ensure that everything will be carried out exactly as it was intended to be. These scripts may frequently be read and understood with some basic programming expertise because they are not particularly difficult programmes. This is critical to maintaining transparency and fostering positive working relationships with other network participants.

What Are the Uses of Smart Contracts?

Smart contracts can be used for almost anything as long as it can be coded, which is one of its main benefits. Certain usage scenarios are undoubtedly more typical than others. Among the better instances are:

  • Digital identity: There is concern about what information you are providing with businesses whose websites you are viewing in a time of questionable internet privacy. It is simple to digitise this with the help of smart contracts, where it might share your preferences for content curation without really revealing your personal information.
  • Securities: There is a lot of conflict between various stakeholders in the financial industry as a whole, particularly when it comes to holding and selling securities. Intermediaries may be completely eliminated if everything was automated via smart contracts. The computer would then assume control and start controlling obligation, making dividend payments and possibly other automatic payments.
  • Mortgages and loans: Are two topics that frequently give people pause. By implementing smart contract payments, it would be possible to reduce the overall cost that is often borne by the third party, maintain a favourable interest rate, and make sure there is no exploitable fine print. Setting up recurring monthly payments might also make the process simpler for everyone involved.
  • Supply chain: As one of the most well-known applications of blockchain, supply chain management makes extensive use of smart contracts. Implementing smart contracts can increase transparency and dramatically reduce the possibility of fraud by automating inventory tracking and providing automatic updates to all parties involved.
  • Escrow:  Is one of the processes that would profit from automation, just like other third-party-dependent operations. When using smart contracts, money is kept in a secure location until all requirements for its release have been satisfied. Through complete transparency and, perhaps most importantly, affordability, this may almost remove the risk of theft and fraud.
  • Health systems: Because medical information is so sensitive, most countries have rules protecting it from illegal access. Smart contracts allow people to control who has access to their data as well as how that data is protected. Ultimately, people may offer medical researchers with access to their data for a charge, reducing a considerable portion of ethical problems for all parties involved.
  • Salaries: Paying paid personnel automatically could result in huge financial savings for corporations. These adjustments can be rapidly and simply adjusted, even if they need to take vacation days into consideration. The idea might also apply to hourly workers.

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The list of application cases for smart contracts is by no means complete. However, it just serves to highlight the huge range of uses for the technology that go beyond what most people imagine. Smart contracts might be used for much more than the use cases described here with the correct infrastructure.

The advantages of smart contracts

From what we’ve shown so far, it’s possible to infer many of the advantages smart contracts provide to the way you do business. However, some go beyond what would seem apparent at first. Let’s examine them more closely.

  • Trust: or, perhaps more precisely, trustlessness, refers to the idea that you don’t have to assume that someone will carry out the conditions you’ve set. You can trust that everything will go exactly as it is stated because a smart contract has no autonomy of its own.
  • Security: Compared to many other technological solutions, encryption, the foundation upon which blockchain (and, by extension, smart contracts) is constructed, keeps everything a great deal more secure.
  • Speed: Compared to managing everything manually, adopting smart contracts is a big improvement. Moving everything to smart contracts can be the time-saving solution your company has been looking for, especially when it comes to intermediaries, who can take a while depending on their own procedures.
  • Savings: By applying the same reasoning as with the aspect of speed, eliminating outside interference also allows you to avoid paying for their services.
  • Autonomy: Independence from middlemen provides you more freedom to choose what your smart contract should accomplish on your own or in collaboration with other interested parties. Additionally, with fewer players, there is much less possibility of someone making a mistake (or even influencing).
  • Accuracy: A smart contract is physically unable of acting in any other way than how it is instructed in its code, unless a mistake has been preprogrammed into the contract.
  • Transparency: You may read the smart contract to see if it was made in accordance with your needs or wants, and the fact that it is public also makes it transparent.
  • Ease of understanding: It’s true that code can often be written in highly complex ways that make it difficult to understand (and utilise). However, high-quality code will be simple to read and utilise, making it much easier than slogging through lengthy, complex legal paperwork.

Depending on your unique use case, smart contracts may offer additional advantages. Most significantly, they all simplify things, which is what they all share in common.

Potential Drawbacks

Obviously, technology is not a cure-all. Particularly in the case of blockchain technology and smart contracts. They are frequently anticipated to be able to do far more than they actually can, mainly since they are still relatively new and solve issues that have existed across many industries. These are some potential problems with smart contracts:

  • Not legally binding: Contrary to what their name suggests, smart contracts are not always actual contracts. They might not be admissible in court, but this can vary from case to case.
  • Regulatory ambiguity: In a similar vein, because the technology is so new, there are frequently no laws in place. Navigating these legal concerns can be difficult because they may or may not be important depending on the type of transaction.
  • Taxation: In a similar vein, how might contract transactions be tax-smart? Although some of these may have precedents in traditional finance, the rise of cryptocurrency has introduced some new elements.
  • Taking care of bugs: Even the finest programmers make mistakes since no code is error-free. Due to the irreversible nature of blockchain transactions, some of them might not be discovered until it is too late. In other words, errors can be expensive.
  • Contract cancellation: Because smart contracts are so literal, it’s frequently impossible to cancel them the way you might with a typical contract, that is, in court.
    Simply put, not everyone is familiar with the fundamentals of coding.
  • Not everyone can read code: While theoretically, smart contracts should be more straightforward than documents on paper, as they don’t permit fine print. However, if you can’t read the code, anyone can write anything they want with you none the wiser.
  • They can’t get real-world information: smart contracts can’t access information from outside the blockchain because that might jeopardize consensus. So-called oracles are used to overcome this obstacle.

The significance of each of these disadvantages, like the value of the advantages we enumerated, depends on the purpose for which you’re using smart contracts. However, if you’re considering implementing smart contracts, knowing these advantages and disadvantages will help you make a well-informed choice.

What Is An Oracle?

We repeatedly mentioned that the purpose of both blockchain and smart contracts is to eliminate reliance on third parties while discussing them. There are some circumstances, nevertheless, where this cannot be avoided. One of those circumstances is when real-world data must be fed into smart contracts without the need to continuously search for it manually.

Such third parties are blockchain oracles. They serve as the connection between off-chain data—what we refer to as the real world—and on-chain data, which is found on the blockchain. This aids in extending the application of smart contracts. Without oracles, smart contracts would only be able to function with the limited amount of data that they can gather from the blockchain itself.

Oracles are also frequently decentralised to prevent data manipulation. This indicates that they are all transmitting the same data, and that the majority’s data is regarded as accurate. When an oracle consistently contradicts the others, it can be assumed to be malicious and punished. There are numerous varieties of oracles, and the one that is used will rely on the requirements of the network and its users.

Writing a Smart Contract

You must be knowledgeable of at least one programming language used for this purpose in order to create a smart contract. Solidity and Vyper are the two developer-friendly languages available on the Ethereum network. You will also need gas: the more complex a transaction in the smart contract, the more gas it will need. The total fee paid equals the total amount of gas utilised multiplied by the gas price because each transaction defines the amount of gas it is willing to pay to execute certain code.

What you want a smart contract to do will largely determine how to write one. Even if you have only the most fundamental programming expertise, the simpler it is, the quicker you can do it.

It will be necessary to compile the contract before deploying it on the blockchain. Compiling will also let you to ascertain whether everything has been written accurately and is operating as intended.

The Ethereum website contains very detailed descriptions of how their smart contracts function if you want to learn more.


This guide demonstrates how smart contracts can automate tasks that would normally need to be completed manually while maintaining the security, transparency, and immutability that blockchain technology is known for. Even while smart contracts have significant limitations, they nonetheless effectively address real problems, thus being able to utilise one (and even create one yourself!) is a valuable skill. To begin with, however, just being aware of how they operate is a fantastic place to start.

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