How do smart contracts work and why are they important?

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WRITTEN BY Abel Stokes 265 views date-icon 2024-08-02 11:51:02

The term ‘smart contract’ was first coined by computer scientist and cryptographer Nick Szabo in the 1990s. In his publication, Szabo defines a smart contract as ‘a set of promises specified in digital form, including the protocols under which the parties fulfil those promises.’ Smart contracts are the foundation of the blockchain and cryptocurrency space. As the blockchain has grown in popularity, smart contracts have flourished - especially with the emergence of Ethereum, one of the most popular blockchains that supports smart contracts.

How do smart contracts work?

A smart contract is a self-executing computer programme that runs on the blockchain. This type of contract is designed to automatically execute and control events and actions according to conditions specified in code. This code contains a set of rules and data that follow the logic ‘if/when x happens, then execute y’ where x is the event and y is the action. It is a normal application that implements certain business rules, but uses the blockchain as the execution environment. We can draw an analogy to the operation of a vending machine: given the right inputs, a certain outcome is guaranteed.

Simply put, smart contracts can be seen as a digitised way of executing contracts on the blockchain. Like traditional digital agreements, smart contracts involve two or more contracting parties and are technically legally enforceable. While some parallels can be drawn between traditional and smart contracts, they are not identical. Smart contracts, as a tool, can help us move towards a more decentralised world and they are not intended to replace standard agreements.

Ethereum smart contracts

Smart contracts are executed by blockchain nodes after processing transactions sent by a user, such as when exchanging tokens from ETH to ORC. Blockchain nodes, such as computers, authorise and confirm transactions, and communicate with other nodes in the network. These transactions are then executed by every node in the network to verify their results. If all nodes validate the transactions, the contract status is updated accordingly. The process is automated and carried out by code, eliminating the need for a third party to execute the contract.

Depending on the type of transaction, a contract can perform various functions: reading or writing data to its private memory, storing money on its balance, sending or receiving messages or money from users or other contracts, and creating new contracts.

How do smart contracts work?

Benefits of smart contracts

Smart contracts offer a number of advantages that make them attractive to a variety of fields. Firstly, their automation allows them to operate autonomously without the need for human intervention. Due to transparency, actions in smart contracts are visible to all participants, which creates trust and increases the transparency of transactions. Security is ensured by storing encrypted and immutable transaction records in the blockchain, eliminating the possibility of counterfeiting. Accuracy is achieved through the use of ‘if-then’ operators, allowing machines to execute business logic without the errors inherent in manual work.

The speed and efficiency of smart contracts is significantly higher due to their execution over the Internet, eliminating the need for intermediaries and speeding up the process. It is also important to note that smart contracts can be less costly than traditional methods of contract execution, as they help avoid the associated delays and costs. This makes smart contracts a promising tool for those looking to optimise their business processes and reduce costs.

Disadvantages of smart contracts

Smart contracts, despite their popularity and promises to revolutionise many areas, face a number of serious challenges. One of the key ones is poor regulation: to date, there are no clear rules governing the use and execution of smart contracts. This leaves a lot of room for uncertainty and potential abuse.

In addition, smart contracts have immutability, which on the one hand is an advantage as it ensures transparency and reliability of transactions, but on the other hand creates problems when the original contract contains errors or does not work as planned. Once deployed, it is impossible to change the smart contract, which can lead to significant losses and difficulties for users.

Another important issue is the potential vulnerability of smart contracts. Even small errors or flaws in the code can make them a target for hackers. There have already been cases in history where vulnerabilities in smart contracts have resulted in large financial losses. Thus, despite all their advantages, smart contracts require careful analysis and improvement to minimise risks and keep users safe.

Conclusion

While smart contracts may seem complex, they represent a meaningful innovation worth exploring. When using them, be sure to apply appropriate transaction interfaces unless you have the technical skills to interact directly with a smart contract. Otherwise, without the necessary knowledge, you risk sending funds directly to the contract address, which will not activate its functions and will result in irreversible loss of funds.

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