What are Smart Contracts? – Explanation for Beginners & Examples

Smart Contracts: Key Takeaways

• Smart contracts are digital agreements that are automatically executed once certain conditions are met.
• They run on a blockchain and operate without a central authority like banks or notaries.
• Smart contracts are used in finance, logistics, and insurance, among other areas.

Smart contracts are among the most important applications of blockchain technology. They enable digital agreements to be executed automatically and without a central authority.

In recent years, cryptocurrencies have established themselves as an asset class. Smart contracts have played a significant role in this development, as they create new possibilities for automated transactions and processes.

In this article, we explain what smart contracts are, how they work, and their resulting advantages and disadvantages.

What are Smart Contracts? Definition and Explanation

A smart contract is a program code that automatically executes a predefined action once certain conditions are met. The term translates to “intelligent contract.”

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 in the 1990s by cryptographer and programmer Nick Szabo, 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 today, smart contracts are understood as programs that are stored decentrally and executed automatically. To guarantee objectivity and fact-based reliability, so-called blockchain oracles are used.

Functioning of Smart Contracts

Smart contracts function according to the “if-then” principle: If a defined condition is met, a predefined action is automatically executed.

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.

In some cases, smart contracts require additional data from the real world, such as prices or external events. This is where so-called oracles come into play. These provide the necessary information but also represent a potential vulnerability, as they integrate an external data source.

Smart contracts can be written by anyone. Development usually takes place within the framework of public decentralized programs, known as dApps (decentralized apps).

Dedicated programming languages are increasingly being used for this. The best-known programming language of this type is Solidity, developed by Ethereum. Decentralized apps then provide a public interface in the form of a website. Interested users can access and sign the smart contract there. 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.

Differences between Smart Contracts and Classic Contracts

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. A previously made agreement is automatically executed by program code as soon as the defined conditions are met. Any user can participate in public smart contracts, provided they meet the basic conditions. Their specific identity plays no role in this.

Human intermediaries are completely eliminated when using smart contracts. The implication: This can make processes more cost-effective by eliminating 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

Smart contracts are used in various areas today. They are particularly widespread in finance, for example, in staking, lending, or the creation of stablecoins.

Ultimately, the most popular smart contracts can currently be summarized under the category of “DeFi.” However, they are not limited to this. The potential applications of smart contracts are far-reaching. Only imagination sets limits here.

A practical example is the City of Zug in Switzerland, which tested various blockchain-based administrative processes between 2018 and 2020. The extent to which digital voting could be implemented via smart contracts was also investigated.

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, such as in insurance, within the framework of AML and KYC (Know-Your-Customer), or for audits. Often, additional data recorded 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.

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.

Smart contracts are also used outside the financial sector. In the gaming sector, they form the basis for NFTs and digital assets. In the real estate sector, they enable more efficient transaction processing.

Smart Contract Examples

Smart contracts are used in various areas today. They are particularly widespread in finance, gaming, digital identities, and blockchain-based domains. New applications are also emerging in the travel industry, for example, for bookings, payments, or digital proofs. You can find out more in our article on Smart Contracts in Tourism.

The following table shows some well-known examples of smart contract applications:

Application Area	Example	Period	Benefit
DeFi / Lending	Aave	since 2020	Automated lending and interest markets without traditional banks
Blockchain Domains	Ethereum Name Service (ENS)	since 2017	Readable wallet addresses and digital names on a blockchain basis
Gaming / Digital Assets	Axie Infinity	since 2018	Ownership, trading, and use of NFT-based in-game items
Digital Identity	Sovrin Network	since 2017	Management of digital identities and proofs without a central authority
Public Administration	City of Zug	2018 to 2020	Testing of digital administrative processes and blockchain-based voting
Tourism / Travel-Tech	Camino Network	since 2023	Blockchain infrastructure for travel bookings, digital proofs, and automated processes

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.

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 – considered the leading platform for smart contracts and offers the largest ecosystem of applications
• BNB Chain – widely used in decentralized applications and closely linked to the Binance crypto exchange
• Solana – characterized by high speed and low transaction costs
• Cardano – pursues a scientifically oriented approach with a focus on security and scalability
• Polkadot – enables the connection of various blockchains and focuses on interoperability

These platforms differ primarily in their technical orientation, scalability, and usage. Which platform is used in an individual case depends on the respective application.

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 declared illegal.
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 usually still be executed. Different blockchains apply various measures to minimize the resulting risks. Ethereum offers a self-destruct function that can be linked to events and thus prevent damage as an emergency stop. Using this option increases the complexity of the program and potentially opens up further attack vectors.
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 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 not yet very advanced at present.

The focus of actual application today is in the DeFi sector. How well smart contracts prove themselves in other areas will be seen in the future.

FAQ – Frequently Asked Questions about Smart Contracts

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