Smart Contracts: What They Are and How They Work

What Are Smart Contracts

Smart contracts are programs with predefined conditions that they are built to enforce. This innovative technology automates a wide range of processes in digital environments, delivering transparency and reliability for agreement execution.

American developer and cryptographer Nick Szabo is widely recognized as the creator of the smart contract concept. He introduced the idea in 1994, well before modern blockchain platforms emerged.

Smart contracts gained mainstream popularity with Ethereum, the second-largest cryptocurrency by market cap. Ethereum enabled developers to build smart contracts for various applications using the specialized Solidity programming language. As a result, Ethereum became the first platform to make smart contracts widely accessible.

Importantly, Ethereum is not the only blockchain supporting this technology—other platforms, including Cardano, Polkadot, Solana, and additional modern ecosystems, also enable smart contract deployment.

How Smart Contracts Work

Technically, a smart contract is program code in which a developer specifies certain conditions and requirements in advance. Once activated, the contract automatically monitors those conditions and executes the corresponding actions.

For example, suppose a landlord wants to rent out a property for 30,000 rubles in cryptocurrency each month, with payment due on the 10th. Here’s how a smart contract would function in this scenario:

• Agreement Stage: The parties negotiate contract terms and define specific requirements. A developer or automated platform enters all necessary details into the smart contract and deploys it to the blockchain.

• Data Integration: The smart contract needs up-to-date information on the tenant’s account balance. To obtain this, the system connects to an oracle—a specialized service that enables the program to access external data sources and real-world information.

• Automatic Execution: On the scheduled payment date (the 10th), the smart contract queries the tenant’s account via the oracle. If sufficient funds are available, the program automatically transfers the payment to the property owner’s wallet. If the required balance is not present, the contract terms are not fulfilled, and the system records a violation.

Purpose of Smart Contracts

Smart contracts automate blockchain-based transactions and operations. As digital contracts, they eliminate intermediaries, reducing costs and accelerating execution.

Smart contracts see widespread use in financial services, logistics, insurance, supply chain management, and many other fields. They deliver transparency and guarantee that terms are met without third-party involvement.

Smart contracts interact with tokens on various blockchain platforms, including coins following Ethereum’s ERC-20 standard, now the de facto standard for token creation.

Some smart contracts are capable of handling multiple tasks in parallel. Known as asynchronous contracts, this type significantly boosts the efficiency of processing many operations at once.

Smart Contract Characteristics

• Programmability: Smart contract terms are highly flexible and can be tailored to the specific requirements of a project or business process. Developers may build simple or complex logical structures.

• Trustless Operation: Blockchain-based smart contracts eliminate the need for trust between parties and require no human intervention. The code operates exactly as written.

• Autonomy: Smart contracts execute their rules automatically, without external management or oversight. Once activated, they function independently.

• Security: Advanced cryptography protects smart contracts, making them resistant to hacking and unauthorized changes.

• Verifiability: Every operation within a smart contract proves that all conditions were checked in advance. All actions are recorded on the blockchain and available for audit.

Where Smart Contracts Can Be Used

Smart contracts have virtually limitless applications. They can handle rent payments, automate insurance payouts, manage supply chains, and address countless other tasks.

Examples of real-world usage:

• Corporate Law: In Wyoming, USA, CryptoFed was established via smart contract. In July 2021, it was officially registered, becoming the first state-recognized decentralized autonomous organization in the United States.

• Financial Sector: Goldman Sachs, a major U.S. financial institution, executed a large repo transaction through JPMorgan’s blockchain network using smart contracts, demonstrating traditional finance’s embrace of innovative technology.

• Decentralized Finance: Smart contracts are foundational to the DeFi ecosystem, enabling automated lending protocols, asset exchanges, and liquidity management.

Advantages and Disadvantages of Smart Contracts

Advantages

• Process Automation: Businesses can automate countless processes, reducing manual labor and speeding up operations.

• Transparency: Smart contracts provide full transparency for contract compliance. All participants can track the fulfillment of obligations.

• Self-Monitoring: The system automatically monitors contract compliance without third-party oversight or intermediaries.

• Immutability: All smart contract data is recorded on the blockchain. Terms cannot be changed after deployment and activation.

• Security and Anonymity: The technology enables secure, anonymous financial transactions, protecting participant data through cryptography.

• Error Reduction: Automation minimizes human errors common in manual document processing.

• Simplified Documentation: Digitizing agreements streamlines document management, eliminating the need for physical paperwork and significantly accelerating workflows.

Disadvantages

• Software Bugs: Coding errors in smart contracts can cause substantial financial losses. Once deployed, fixes are often difficult or impossible.

• Specialist Requirement: Developing quality smart contracts may require hiring skilled developers, raising initial costs.

• Lack of Legal Framework: Most countries lack comprehensive legal standards for smart contracts, resulting in legal uncertainty.

• Oracle Dependency: Smart contracts rely on oracles for external data, which can become single points of failure or introduce inaccurate information.

Conclusions

Smart contracts are a universal technology enabling automation across industries. They deliver transparency, security, and efficiency for fulfilling contractual obligations.

Nonetheless, smart contracts face significant challenges that can be addressed through legal frameworks, improved security standards, and rigorous programming. As the blockchain industry evolves and experience with smart contracts grows, these challenges are gradually being resolved.

The outlook for smart contracts is strong—this technology continues to advance, finding new applications and becoming increasingly accessible to a wider user base.

FAQ

What are smart contracts and how are they different from traditional contracts?

Smart contracts are programs on the blockchain that automatically enforce agreement terms without intermediaries. Unlike traditional contracts that require manual review and execution, smart contracts are executed directly by code, guaranteeing transparency.

How do smart contracts work? What is their execution process?

Smart contracts operate in three stages: data submission, verification, and execution. When the data matches the specified terms, the contract automatically enforces its logic with no intermediaries. This occurs on the blockchain in real time.

What are some practical use cases for smart contracts?

Smart contracts are used in financial transactions, insurance, supply chain management, and automating legal agreements. They automatically execute terms with no intermediaries.

How do Ethereum smart contracts differ from Bitcoin scripts?

Ethereum uses Solidity, supporting complex logic and Turing completeness to enable decentralized applications. Bitcoin Script is far simpler and only handles transfers. Ethereum offers significantly greater functionality.

What are the advantages and disadvantages of smart contracts?

Advantages: automatic execution, immutability, transparency, and cost reduction. Disadvantages: code complexity, potential vulnerabilities, irreversibility of errors, and scalability limitations.

What security threats and vulnerabilities exist in smart contracts?

Smart contracts face risks such as coding errors, reentrancy attacks, and integer overflows. Vulnerabilities may result in asset loss. The historic DAO attack caused millions in losses. Security audits and thorough testing reduce these risks.

How do you develop and deploy smart contracts? Which programming languages should you learn?

Learn Solidity or Vyper for smart contract development. Use frameworks like Hardhat or Truffle for building and deploying contracts. For blockchain interaction, use Web3.js or Ethers.js.