What Are Smart Contracts?

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In the world of crypto, smart contracts are commonly part of the conversation. However, even among those who are regularly investing in the landscape, questions about what smart contracts are and how they work are common.

While smart contracts are technically complex, the concept behind them is pretty straightforward. If you’d like to learn more about what smart contracts are, how they work and what they’re used for, check out the basics to get started.

Smart Contracts 101

In the simplest sense, a smart contract is a program that automatically executes when the conditions of the execution agreement are met. That usually involves a triggering action, not unlike what you see with traditional contracts.

For example, most traditional contracts are deemed valid once the proper signatures are acquired. With those signatures, the agreement can execute officially, allowing whatever is stated within the contract to occur. With smart contracts, the mechanisms are the primary difference; they involve automated workflows and processes within a purely digital landscape.

Smart contracts relate to crypto blockchains in several ways. First, smart contracts are often the framework for transactions and associated verifications on a currency’s blockchain. Whether it’s initiating trades or ensuring that transactions are authentic and legitimate, smart contract-style processes are in use. The contract is a program that checks to make sure the proper conditions are met and that the desired outcome happens — all with limited intervention from people and often without the need for third parties.

Second, other kinds of smart contract programs reside on the underlying blockchain network. The blockchain is essentially a host of the records and any code for contract-related actions. Once the triggering event takes place, the code executes until the outlined outcome occurs. This maintains any records regarding the nature of the transaction within the blockchain itself.

It’s important to note that – like crypto itself – smart contracts aren’t limited to blockchain. For example, a cryptocurrency called Iota doesn’t use blockchain, but it does have smart contract capabilities.

The Purpose of Smart Contracts

Generally, smart contracts are mechanisms for completing crypto and blockchain transactions. That can include transitioning cryptocurrency between two wallets, sending notifications, placing orders and updating records, among other tasks.

With blockchain-based smart contracts, the primary purpose is to formalize an agreement and ensure a transaction is completed in a way that meets all involved parties’ needs. Blockchain has inherent transparency. Additionally, the transaction is usually irreversible. As a result, there’s a built-in level of security that isn’t available through other contracting approaches.

How Smart Contracts Work

In most cases, smart contracts are based on “if/then” statements. The code in the blockchain contains a condition or triggering action — the “if” part of the equation, as in “if X happens.” Once the condition is met or the triggering action occurs, the code initiates a process to achieve a pre-determined, agreed-upon outcome, the “then” portion of the statement — if X happens, then Y happens.”

While simplifying it in that manner may make it seem like there can only be one condition or triggering action, that isn’t the case. There can be as many stipulations as the involved parties feel are necessary. However, the basic framework still uses the “if/then” structure, creating a roadmap for the transaction.

The beauty of smart contracts is that little intervention is required from people once the agreement is established. Instead, as long as all parties meet the stated conditions or take the determined actions, the code will handle the rest.

The Pros and Cons of Smart Contracts

As you might expect, there are pros and cons to using smart contracts. When it comes to advantages, trust, transparency and security are some of the biggest. Any contract terms are clearly visible to all involved parties. They can’t be altered once the agreement is in place. Similarly, blockchain records are transparent, inherently secure and mainly irreversible.

Using smart contracts is also a quick, efficient way to execute agreements. Once the triggering action occurs or the condition is met, an automated process handles the rest. There’s no need for additional paperwork or individual transfers. Instead, the program manages the entire process, which simplifies things.

In many cases, smart contracts are also cost-efficient. There’s no need for intermediaries to handle the nuances of the transaction, resulting in a cost savings. Plus, there’s some automatic redundancy for records stored on the blockchain. This prevents data from getting lost if a single system fails.

When it comes to drawbacks, the most significant is usually that the smart contracts are based on a particular blockchain. While this isn’t inherently problematic, it can make certain transactions harder to coordinate between currencies.

Additionally, smart contracts can be very difficult to update, even if there’s a clear need, such as to correct an error. Similarly, if a smart contract with a mistake in the code executes, reversing the transaction can be challenging. Smart contracts are technically complex. Because that’s the case, people who want to use them may have a more challenging time creating or acquiring the necessary code.

Encountering Smart Contracts as a Crypto Investor

As a crypto investor, the most common smart contracts you’ll probably encounter are agreements relating to cryptocurrency transactions. For example, buying products or services with crypto or even trading cryptocurrency often involves some degree of smart contract. Without the proper conditions, the transaction doesn’t move forward. However, once the triggering actions happen, everything executes without additional intervention from the included parties.

However, that only scratches the surface of what investors might encounter. For example, smart contracts can initiate trade requests – either buying or selling – once a crypto reaches a specific price point. If you’re an investor with voting rights involving a cryptocurrency, smart contracts can serve as the basis for voting, with a particular action executing (or not) based on the recorded majority opinion.

Ultimately, smart contracts are a foundational concept within many cryptocurrencies. However, much of their greatest potential lies outside the world of crypto. In a transactional world, they create an opportunity to seamlessly execute a range of actions, all while keeping information secure, transparent and accessible.