Blockchain

Smart Contracts

Definition

A smart contract is a decentralized computer program running on a blockchain network that automatically and deterministically executes agreements based on predefined conditions.

Introduced in their current form by the Ethereum blockchain, smart contracts are a fundamental building block for the Web3 industry; the foundation for DeFi, NFT, gaming, and other applications that have gained prominence in Web3.

Whether to codify arbitrary agreement terms between mutually untrusting parties, create automated and decentralized exchanges, or create both fungible and non-fungible tokens, smart contracts are how developers build decentralized applications on blockchains. Read on for a simple introduction to smart contracts and what they mean for society.

What Is a Smart Contract?

Smart contracts are computer programs that are hosted and executed on a blockchain network. Each smart contract consists of code specifying predetermined conditions that, when met, trigger outcomes. By running on a decentralized blockchain instead of a centralized server, smart contracts allow multiple parties to come to a shared result in an accurate, timely, and tamper-proof manner.

Smart contracts are a powerful infrastructure for automation because they are not controlled by a central administrator and are not vulnerable to single points of attack by malicious entities. When applied to multi-party digital agreements, smart contract applications can reduce counterparty risk, increase efficiency, lower costs, and provide new levels of transparency into processes.

Blockchains and Smart Contracts

Smart contract-enabled blockchains unlock the ability for developers to write arbitrary application logic on top of the decentralized consensus that blockchains natively provide. That’s why blockchains, smart contracts, and applications can be thought of in terms of a hierarchical relationship: Applications (including tokens) are created by the code from a smart contract (or multiple connected smart contracts). The actions defined in a smart contract are, in turn, executed and stored by the underlying blockchain network.

How Do Smart Contracts Work?

Smart contracts are tamper-proof programs on blockchains with the following logic: “if/when x event happens, then execute y action.” One smart contract can have multiple different conditions, and one application can have multiple different smart contracts to support an interconnected set of processes. There are also multiple smart contract languages for programming, with Ethereum’s Solidity being the most popular.

Any developer can create a smart contract and deploy it on a public blockchain for their own purposes, e.g., a personal yield aggregator that automatically shifts their funds to the highest-earning application. However, many smart contracts involve multiple independent parties that may or may not know one another and don’t necessarily trust one another. The smart contract defines exactly how users can interact with it, involving who can interact with the smart contract, at what times, and what inputs result in what outputs. The result is multi-party digital agreements that evolve from today’s probabilistic state to a new deterministic state where they are guaranteed to execute according to their code.

Do All Blockchains Have Smart Contracts?

Not all blockchains can run smart contracts. While blockchains and layer-2 networks including Arbitrum, Avalanche, Base, BNB Chain, and Ethereum are examples of smart-contract-compatible blockchains, blockchains like the base Bitcoin blockchain do not have native smart contract capability. The key difference between these blockchains is the ability of an underlying blockchain to execute and store arbitrary logic.

History of Smart Contracts

Smart contracts were first coined by American computer scientist Nick Szabo in 1994. In his seminal writing, he defined a smart contract as “a computerized transaction protocol that executes the terms of a contract,” aiming to “satisfy common contractual conditions, minimize exceptions both malicious and accidental, and minimize the need for trusted intermediaries.”

While a general notion of smart contracts could be seen in systems like vending machines, blockchains formed the foundation of smart contracts that were digital, tamper-proof, and permissionless. The introduction of the Bitcoin blockchain in 2009 supported arguably the first protocol smart contract—establishing conditions that had to be satisfied to transfer Bitcoins between users on the network.

The Bitcoin blockchain then evolved to offer another major type of smart contract in 2012 called a multi-signature transaction. A multisig transaction requires a defined number of people (public keys) to sign a transaction with their private keys before it’s considered valid, increasing the security of user funds.

A simple framework for a multisig transaction on the Bitcoin blockchain requires 2 out of 3 private keys to sign off on a transaction before it’s considered valid. Blockchains began to experiment over the next few years by adding new programmatic conditions (called operation codes or opcodes). However, the next major leap in smart contracts came with the publication of the Ethereum whitepaper by Vitalik Buterin in 2013. In 2015, Ethereum launched as a new type of blockchain for programmable smart contracts.

Smart Contract Examples

One purpose of a smart contract is to automate a specific business process between a distinct group of entities. These entities collectively agree on all the smart contract’s terms like payouts, process flow, and dispute resolutions. A simple smart contract example for global trade may have terms like:

Other smart contracts support public decentralized applications (dApps) that anyone can interact with without needing any permissions. Public dApps are often open-source, allowing anyone to inspect how they function. One example of a public dApp is a decentralized lending/borrowing market, which may have the following terms:

Enforceability of Smart Contracts

Because they run on top of blockchains, smart contracts are automatically and deterministically executed exactly as programmed. In the context of enforcement, this means that no party involved in a smart contract transaction can change its outcome or renege on the terms outlined in the contract.

Smart contracts can eliminate counterparty risk but introduce smart contract risk, which is the risk that a smart contract’s code has an exploit or flaw. Smart contracts always run as programmed, so if the program is faulty, the contract will execute the faulty code as expected.

Additionally, some contracts are simply unenforceable through code. For instance, lending protocols often require overcollateralized loans because there's no way to guarantee repayment unless the full amount is already in a smart contract. In such cases, combining smart contracts with off-chain systems like credit scores and legal contracts can help mitigate counterparty risk.

Benefits and Limitations

Smart contracts offer a safer, more verifiable way of creating societal agreements involving the transfer of value and data. However, the landscape of blockchains and smart contracts is still developing, and developers face various limitations as they work to build the verifiable web.

Smart Contract Benefits

Most traditional digital agreements involve parties that don’t know each other, introducing risks that either may not uphold their commitments. To resolve this, digital agreements are often executed by larger, centralized institutions like banks. While this reduces risk, it also creates a situation where these institutions exert influence over the contracts.

Smart contracts improve upon digital agreements by offering several advantages:

Smart Contract Use Cases