Deal or No Deal: Smart Contracts Explained

Smart contracts are why the currency part of cryptocurrency is an outmoded term to define the space as a whole. Ethereum’s introduction of smart contracts envisaged a future where human agreements could be made on-chain. Agreements that are inviolable, trustless, automatic, and secure. Smart contracts are the fundamental technology that makes the blockchain useful for business, finance, insurance, art, real estate, and much more besides.

Yet, you may ask, what on earth are they? Let’s find out.

What is a Smart Contract?

A smart contract is a deterministic piece of code on a blockchain that executes automatically when the conditions of the contract are met. The classic example is that of a vending machine, which accepts input dollars and spits out soda (and change) according to its programming.

A smart contract is the same. It’s a code that states IF this THEN that. Send an Ethereum to the contract, and you will receive the output coded into the contract – for example, 20 $ATOM tokens. No counterparty is required to facilitate this trade. No one is overseeing the execution. Rather, the blockchain itself authenticates the transaction, and the contract executes automatically on confirmation.

This type of token exchange forms the underlying basis for automated market makers and is what makes decentralized finance possible.

Why Are Smart Contracts So Special?

This only scratches the surface of what smart contracts are capable of. Smart contracts are immutable, inviolable agreements that are completely open. Anyone can go on the blockchain and read a smart contract and understand its functions before sending funds or otherwise interacting with the contract. There is no human error, no judicial oversight is needed, and the agreement is distributed. Deals cannot be altered. If Lando Calrissian and Vader used a smart contract for their deal, Vader would not have been able to alter it further.

This type of distributed, immutable agreement is a fantastic vehicle for investment and is the crux of why smart contracts are game-changing. Let’s say a pool of investors agree to commit funds to a smart contract that states if the weather in June reaches an average of 90 degrees Fahrenheit (~32.2 degrees Celsius) or above, then they agree to send their funds to farmers suffering from the heatwave.

However, if the weather remains under that average, they receive a premium (paid by the farmers, who have also entered the contract) on their investment. Voila, you’ve just created insurance on-chain, with none of the legal headaches or the fear that the other party will try and break the deal. This type of smart contract would rely on real-world data fed from Oracles (like Chainlink). Yet smart contracts can, of course, solely rely on data already on the blockchain (say, the price of Bitcoin at a specified moment)

Why Do Smart Contracts Create Efficiency?

Crucially, a smart contract can also call, receive, and send funds to other smart contracts. That means a smart contract can be built that executes only if another smart contract does, or does not, execute. In this way, you can layer financial products and other types of agreements on top of one another, creating an open finance system where everyone is – trustless – playing by the rules.

The efficiencies inherent in this allocation and reallocation of capital depending on certain factors is what makes DeFi such a tantalizing prospect, as everyone knows where they stand, and legal jurisprudence can be assured by everyone involved in the contract. When funds are sent to a smart contract, the contract owns the funds. If properly written, and that’s where due diligence comes in, then no one, not even the person who wrote it, can access them. The only way to access them is if the conditions of the contract are met (or not met).

Smart contracts’ great advantage is their ability to remove unnecessary intermediaries in all types of data and value exchange. When people talk about the efficiencies of the blockchain – whether in finance, insurance, or anything else – they are principally referring to the idea that immutable, verifiable code creates a better system of exchange than currently could ever exist.

One day, you may be able to sell your house on the blockchain. Simply create a smart contract with the deed, place it in a smart contract, and once the funds are received, the ownership of the house is automatically transferred. No agents, no brokers, no escrow, and instantaneous fund transfer. The possibilities are, frankly, endless – and they’ve only just begun.