Have you heard about smart contracts in cryptocurrencies but are not sure how they work? This article will cover how this technology works and why it’s beneficial.

According to CryptoSlate, cryptocurrencies employing the use of smart contracts dominate almost 30% of the entire market. The world of blockchain technology is filled with several buzzwords, and one of the most prominent is ‘smart contracts.’

An image describing the main process behind smart contracts

Despite seeming like a new concept, the concept was created as far back as 1994 by the legendary American scientist and cryptographer Nick Szabo. The American had the goal of digitizing electronic transaction methods without any intermediaries. 

Szabo even created what is recognized as the first idea of a virtual currency, ‘bit gold’ in 1998, which was never implemented. However, it became somewhat of a precursor to Bitcoin that came onto the scene in 2009, with some experts even suggesting Szabo may be the face behind the mysterious Satoshi Nakamoto.

Yet, the concept of smart contracts started becoming popular in 2015 with the release of the second-largest cryptocurrency, Ethereum, co-founded by several people, including the famous Vitalik Buterin.

Smart contracts are particularly prevalent in the world of decentralized finance (DeFi), a movement spearheaded by numerous popular projects like Ethereum, Polkadot, Cardano, Uniswap, TRON, NEM, Tezos, Stellar, and many more. 

But what are smart contracts, how do they work, and what are some real-world examples of their implementation? Let’s find out.

What is a smart contract?

A smart contract is a programmed contract designed to fulfill a set of pre-programmed instructions autonomously without the need for a middleman. Such contracts exist on a blockchain that is duplicated and executed by all nodes or computers within that network.

Once the preset conditions in the agreement have been met, the transaction becomes irreversible and is identifiable by everyone in a particular ledger. Hence, they foster transparency, distribution, accuracy, and immutability.

One of the critical motivations for smart contracts is having an entirely trustless protocol where operations that would typically need third-party verification can be carried out automatically, quickly, safely, and efficiently.

Essentially, these digital agreements allow for a myriad of transactions to happen with two parties who don’t need to know or trust each other. Smart contracts automate processes that would naturally be costly, time-consuming, and labor-intensive.

How does a smart contract work?

Smart contracts are created by blockchain developers using a software program working on simple ‘if-then’ conditions provided by two or more parties. For illustrative purposes, let’s consider a straightforward scenario.

Let’s imagine Scott wanted to buy a car online from Mike. A typical smart contract agreement on Ethereum would run along the lines of “When Scott pays 3 ETH to Mike, then Mike will receive delivery of his car.”

Of course, this example is over-simplified, but we’ll learn soon how these contracts eradicate overhead. Smart contracts are highly customizable, and parties can place as many stipulations in them as they would in real life (including a framework for resolving disputes) to ensure a satisfactory transaction. 

These conditions will still have the ‘if-then’ parameters from start to finish until everything in the contract has been fulfilled. Let’s consider how a typical activity of selling a car online would work without a smart contract. 

One would need to list their vehicle on a site like Gumtree or Cars, communicate with people, find a suitable payment system, consider the exchange of registration, and other processes. Each stage requires interacting with different services, which is time-consuming and costly.

Of course, a smart contract isn’t the be-all and end-all, but we can automate many of these interactions without intermediaries.

Current use cases in cryptocurrencies

In one of the previous sections, we had listed some potential scenarios where smart contracts would be applicable. Yet, it’s better to detail some identifiable and relatable use cases relevant to cryptocurrencies.

Presently, smart contracts have been most prominently used within DeFi, as mentioned before. DeFi echoes many of these principles of smart contracts as it allows for previously centralized financial transactions to occur without middlemen.

Instead of having a centralized derivatives broker like Robinhood, we have protocols like dYdX and Augur, which are entirely decentralized. Rather than using exchanges like Binance or Coinbase, we have platforms like Uniswap, PancakeSwap, and SushiSwap. 

Users can borrow and lend their cryptocurrencies without any bank-like institutions facilitating the deals. These are a few examples of smart contract applications. In fact, many dApps (decentralized applications) are merely bundled-up smart contracts, allowing platforms to perform more sophisticated things as autonomously as possible.

Below is a list of popular platforms with smart contract functionality:

  • MakerDAO: a dApp enabling users to lend and borrow various cryptocurrencies
  • Uniswap: presently the largest decentralized exchange for swapping ERC20 tokens
  • dYdX: a decentralized exchange for using margin and perpetuals trading on a handful of crypto markets
  • CryptoKitties: a blockchain-based game for allowing create NFTs of unique virtual cats

Final word

Smart contracts are still a relatively new aspect of blockchain technology, and developers are still having some teething issues. For starters, a lack of security protection or just bad code can cause unintentional and severe problems. Moreover, such agreements aren’t perfect because of their immutability; they become irreversible once a contract is in place. 

This has led to some detrimental results, most notably the Ethereum DAO (decentralized autonomous organization) hack in 2016, where a mysterious hacker stole $60 million worth of ETH by exploiting vulnerabilities within Ethereum’s codebase.

Nonetheless, software creators still undoubtedly desire to explore the scope of capabilities that smart contracts can perform.

Smart contracts should disrupt numerous dealings like finance, identity operations, record-keeping, real estate, insurance, voting, medical research, stocktaking, and the list goes on. Hence, cryptocurrencies are only the tip of the iceberg when considering the influence of smart contracts.