What are Smart Contracts? – Explanation for Beginners & Examples

What are smart contracts anyway? In recent years, cryptocurrencies have established themselves as an asset class. Smart contracts have played a significant role in this development. In this article, we’ll explain what smart contracts are, how they work, and what advantages and disadvantages arise.

What are Smart Contracts? Definition and Explanation

Smart contract means intelligent contract and describes a program code that independently performs a predefined action, provided that a pre-defined event occurs.

At the same time, it is possible to define a specific alternative consequence if the event does not occur. The current contract system could thus be largely automated. Supporters also believe in improved security, reliability and cost reduction compared to traditional contracts.

The term Smart Contract was coined by cryptographer and programmer Nick Szabo in the 1990s, but it has only experienced a boom since the emergence of cryptocurrencies, especially since the release of Ethereum in 2015.

In the field of Blockchain Smart contracts are now associated with a decentrally hosted program code that acts censorship-free and completely objectively. To guarantee objectivity and fact-based reliability, so-called blockchain oracles are used.

These feed smart contracts with specific data. Oracles are responsible for protecting smart contracts against errors, falsifications or manipulations. The best-known oracle is Chainlink.

Functioning of Smart Contracts

Smart contracts are basically simple programs. Instead of existing on a central computer or server, they exist as content of a blockchain in many places. This is why we speak of decentralization. Every participant in the network, who acts as a network node and therefore houses an image of the blockchain on his device, serves a large number of smart contracts as a server.

Smart contracts can be written by anyone. Most of the development takes place within the framework of public decentralized programs – these are called dApps. Dedicated programming languages are increasingly being used.

The best-known programming language of this type is Solidity, developed by Ethereum. dApps then provide a public interface in the form of a website. Interested users can reach and sign the smart contract there. The signing also includes the payment of a network fee by the user.

If a triggering event occurs after signing, the smart contract is executed automatically. Such an event can be, for example, the deposit of a certain amount of money, which in turn releases another amount of money or another cryptocurrency.

Simple if-then functions are used to trigger the event. The processing is carried out by a network of computers that operate the underlying blockchain. Not every blockchain is capable of hosting and executing smart contracts.

Differences between Smart Contracts and Classic Contracts

The differences between smart contracts and classic contracts become apparent when you compare the two variants.

Conventional contracts between two parties are based on mutual trust. Documents are often exchanged in addition, which inform the other party about data and facts.

In contrast, smart contracts function completely trustlessly. Trust between the contracting parties is not necessary, as a previously made agreement is automatically processed by neutral program code. This means that there is no censorship. Any user can participate in public smart contracts, provided that he meets the basic conditions. His specific identity does not play a role.

Human intermediaries are completely eliminated when using intelligent contracts. The implication: This makes smart contracts potentially cheaper by eliminating the need for labor.

Due to the transparent nature of most blockchains and therefore also of smart contracts, it is possible to trace whether a user is participating in a specific intelligent contract. There is an image of this on every network node of the blockchain. The manipulation of a smart contract is therefore almost impossible compared to the conventional contract.

Application Area of Smart Contracts

In April 2023, the most popular smart contracts are contracts that govern the investment of funds on the staking platform Lido Finance and on the lending platform Aave. A smart contract from MakerDAO, which enables the creation of the stablecoin DAI, is also very popular.

Ultimately, the most popular smart contracts can currently be summarized under the category “DeFi”. However, they are not limited to this. The possible applications are far-reaching. The only limit here is your imagination.

Small projects with revolutionary ideas already exist. The Swiss city of Zug trialed from 2018 to 2020 the processing of various administrative processes with the help of smart contracts. They also explored the possibility of holding democratic elections via the blockchain. Smart contracts are required for this.

Where are Smart Contracts Already Being Used?

The most popular uses of smart contracts are in the financial sector. Decentralized finance (DeFi) is particularly noticeable here. Smart contracts are also increasingly found in classical finance (TradFi).

There they can take on important tasks for banks – for example in the insurance industry, in the context of AML and KYC or for audits. Often, additional data that is written on the blockchain can also be used.

Smart contracts facilitate the trading of financial assets. Automation reduces costs that would otherwise be incurred by personnel review and avoids errors.

In addition, smart contracts can be used in the form of tokens, so that classic financial assets such as shares can be issued in tokenized form. This simplifies the handling and trading of the assets. The Swiss company Mt. Pelerin tokenized shares. As part of the Zukunftsfinanzierungsgesetzes soll die Idee rasche Popularisierung in Deutschland erfahren.

Smart contracts are also very popular in the gaming sector. Here they are responsible for fulfilling the functions of blockchain content. NFTs in particular play a central role. NFTs also only work thanks to intelligent contracts.

The real estate market is considered an enormous growth market for smart contracts. IOTA is already cooperating with the real estate company PropOps for this purpose. So far, it is mainly about a more effective use of data.

The interaction of important information and smart contracts is also of great interest to the healthcare sector. Further applications can be found in public administration, crowdfunding, logistics or in the area of identity verification.

Smart Contract Examples

Most NFTs in 2023 are based on the ERC-721 token standard. Various companies and organizations have also developed tokens that are based on the smart contract standard ERC-20 or its modern modification ERC-777.

Smart contracts of the ERC-20 standard form the lonely frontrunner in the Ethereum ecosystem as well as in direct comparison with all other blockchains according to many key figures.

The use of these standardized smart contracts ensures that the tokens created in this way function according to certain specifications. This includes interoperability with other smart contracts in DeFi and many other applications.

At the end of 2022, Tether provided the most popular contract by transaction numbers with the USDT Token This is an ERC-20 contract that issues a US dollar-based stablecoin.

On the second rank follows the v3-SwapRouter02 of the DEX Uniswap, which is followed by USDT competitor USDC in third place in terms of absolute transactions. The NFT market OpenSea lands on the top ranks with three different smart contracts. Accumulated, they even reach the second highest key figure overall.

The smart contract of the Ethereum Name Service (ENS), through which users can purchase Web3 domains, is also popular. All of these contracts live on the Ethereum blockchain. With a market dominance of around 60 percent in April 2023, it is the market leader, but by far not the only blockchain with smart contracts.

The 5 Best Smart Contract Coins (Platforms)

After the invention of Bitcoin, smart contracts are the most important development in the crypto industry. The area of “DeFi” and “Smart Contract Platforms” is therefore highly competitive. Many developers hope to conquer a decisive market share in Web3. Its potential is considered huge.

In April 2023, Ethereum, BNB, Cardano, Solana and Polkadot are the five largest smart contract platforms by market capitalization. ETH leads the way with 230 billion US dollars and DOT closes the list with 7.3 billion US dollars.

CoinPro lists the five best smart contract coins below. Whether these representatives are actually the best of their kind from a technical point of view is debatable. At the time of going to press, however, they are the most popular Layer-1 blockchains that focus on smart contracts.

Ethereum

Ethereum (ETH) is the founder of smart contract platforms. The project was released in 2015 and eight years later already has 729 different dApps. More than 30 billion US dollars are locked in the DeFi area of the ecosystem.

BNB

BNB (BNB) was founded in July 2017 by the crypto exchange Binance. Since April 23, 2019, the BNB Chain has its own blockchain that supports smart contracts. 576 different dApps add up to a TVL of five billion US dollars.

Cardano

Cardano (ADA) was released in 2015 by Ethereum co-founder Charles Hoskinson with the aim of offering a better alternative that is significantly more scalable than ETH. 146 million US dollars are locked in 18 different decentralized applications. You can find more information in our basic article on Cardano (ADA).

Solana

Solana (SOL) was released in 2020. Through extremely high scalability, the project wants to become the first blockchain that is suitable for mass adoption. The TVL of 100 dApps is 288 million US dollars.

Polkadot

Polkadot (DOT) was conceived in 2017 and released in 2020 by Ethereum co-founder Gavin Wood. The focus is on interoperability and cross-chain functions. Polkadot itself does not maintain a DeFi ecosystem. 15 autonomous parachains record 181 dApps and a TVL of around 185 million US dollars.

Advantages of Smart Contracts

Smart contracts offer numerous advantages over conventional contracts. These five points are the most important advantages of smart contracts:

1. Immutability and neutrality: The contract contents are stored on the blockchain. A smart contract cannot be changed. Once it is deployed, it remains on the blockchain either forever or until it is deleted. A user is not evaluated by a smart contract and therefore no censorship takes place. In order to be able to interact with the contract, only predefined conditions must be met. Creators and both contracting parties can act pseudonymously and anonymously.
2. Third parties are eliminated: Intermediaries, i.e. third parties, are eliminated when using smart contracts. These include notaries and lawyers, who fulfill important roles for conventional contracts. Instead, nodes of the network execute the smart contracts.
3. Automation: The if-then structure ensures that after an event occurs, the subsequent event is automatically triggered. If person A and person B conclude a smart contract and A fulfills his condition, the network carries out the necessary action that is defined in advance as a reaction. It is not necessary for B to intervene himself at this time or to inform a third party.
4. Decentralization: The decentralized functioning of the intelligent contracts ensures that the underlying data is distributed around the globe in the network. This makes the program code very secure against manipulation. A central instance has no decision-making power over smart contracts – even if the judiciary declares the contract invalid or rechtswidrig erklärt.
5. Effizienz: Ist der notwendige Programmcode einmal geschrieben und auf der Blockchain veröffentlicht, arbeiten Smart Contracts sehr kosteneffizient, da menschliche Arbeit komplett entfällt.

Disadvantages of Smart Contracts

In addition to the advantages, smart contracts also have some disadvantages. The disadvantages of smart contracts include:

1. Human errors: The contracts are based on program code that people develop. Where people work, mistakes can happen or even be inserted intentionally. “Code is law” – the program code is law – even in the event of possible errors.
2. Legal certainty: In principle, digital contracts are to be handled in the same way as classic contracts. They are legally binding if both parties voluntarily decide to agree to them. However, from a legal point of view, they are not contracts. Instead, smart contracts only execute what the contract content is. If a transaction occurs, this could lead to a contract being concluded. Nevertheless, legal certainty is uncertain, for example, when an error occurs.
3. Immutability: While immutability can certainly be an advantage, this property can also be a disadvantage. If a smart contract is faulty, it will normally still be executed. Different blockchains apply different measures to minimize the resulting risks. Ethereum offers the function of self-destruction, which can be linked to events and thus prevent damage as an emergency stop. The use of this option increases the complexity of the program and may open up further attack vectors. To reduce technical risks, Ethereum replaced the self-destruction function with an emergency stop function on April 13, 2023 with the Shanghai Upgrade.
   
4. Development: Smart contracts require knowledge of programming languages, most of which are new. The creation of the contract can be very complex and expensive depending on the function.

Conclusion on Smart Contracts

Smart contracts already form one of the most important contents for blockchain technology. Thanks to them, decentralization can also be extended to fields that would otherwise have remained unaffected by cryptocurrencies themselves.

The full potential of this new type of contract cannot yet be estimated today. So far, there are hardly any limits to them. Nevertheless, their integration outside the crypto industry is very low at the current time.

The focus of the actual application is currently in the DeFi sector. The future will show how well smart contracts prove themselves in other areas. Until then, you can buy cryptocurrencies if you are convinced of a particular smart contract platform and want to benefit from the performance.

FAQ – Frequently Asked Questions about Smart Contracts

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