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Smart Contract in the Blockchain – what is it exactly?

Smart contracts are the great innovation of blockchain technology. Put simply, they are computer protocols that fulfill the function of contracts. And these “smart contracts” have great potential for the future. We explain how they work.

Blockchain technology is the innovation of Satoshi Nakamoto. Without this technology, cryptocurrencies would simply not be possible. Vitalik Buterin drove the next innovation with his Ethereum blockchain. It is also referred to as “Blockchain 2.0.” Ethereum enabled the development of decentralized applications (dApps) and smart contracts for the first time.

The history of smart contracts

When it comes to smart contracts, Nick Szabo was the first to introduce the concept of smart contracts. That was in 1994, when he published the article “Formalizing and Securing Relationships on Public Networks.” But in countries like England or even the USA, no one really took notice of the beginnings of smart contracts. Nick Szabo is an interesting figure in the crypto world. He is a computer scientist, a legal scholar and an expert in cryptography. Some consider him to be the real Satoshi Nakamoto. In 1998, he published “Bit Gold,” a precursor to Bitcoin.

According to his definition, contracts are “promises based on a meeting of minds.” These promises eventually formalize into contracts, which can be protected by law. Digital transformation and the Internet are creating new opportunities, but they cannot guarantee contract certainty. Third-party algorithms and tools can help.

Ethereum: with smart contracts from the start

But it would be a while before smart contracts made their way into the world of cryptocurrencies. Bitcoin itself was smart contract-enabled (though that could change with Taproot). The number one cryptocurrency focuses solely on its function as a store of value and digital currency. In 2015, the Ethereum blockchain went online. The creation of Vitalik Buterin, Gavin Wood and Jeffrey Wilcke soon rose to become the number two cryptocurrency by market capitalization. From the beginning, it was all about smart contracts and decentralized applications.

A common, global platform

A new ecosystem based on the blockchain emerged. The result is a kind of “world computer.” In an interview with Havard International Review, Vitalik Buterin explains, “The idea behind the world computer metaphor is that Ethereum is a common, global platform. A platform where anyone can upload this code that we call smart contracts. Anyone can publish them, can send transactions to them to interact with them, and the code can run on the blockchain.” There are now a number of smart contract platforms. These include cryptos such as Ethereum (ETH), Cardano (ADA), Polkadot (DOT) or Tezos (TRX). Fan tokens like Chiliz or new tokens like Dohrnii rely on smart contracts.

How exactly do smart contracts work?

Actually, smart contracts are protocols that perform certain tasks on their own. But only when predefined conditions occur. The protocols are code and act exactly as the developers have programmed them. This is also one of their great advantages: they are unbiased and fair according to their programming. Their code is publicly and transparently stored on the blockchain. Investors or interested parties in England or the USA – all of us – can also view and check the code. It is advantageous to have programming knowledge. And check whether everything is also above board.

Digital contracts usually run automatically

In most cases, digital contracts are based on so-called “if-then” functions. As soon as a certain event occurs and certain information is available, the contract automatically executes the prescribed steps. Human intervention is not necessary. There are all kinds of application areas for this. An important topic in the crypto space in recent years is “Decentralized Finance”. Here, too, it is the digital contracts that automatically handle the trading of cryptocurrencies. And they do so with little effort, quickly and without additional costs.

The advantages of smart contracts

  • Automation: the contracts act autonomously, on their own, and for the most part without human intervention. As soon as the conditions specified in the code occur, the contracts immediately execute the functions. No bureaucrat has to first give his stamp of approval or check everything. The entire process is faster and less expensive than comparable transactions.
  • Neutrality: “Code is Law” is the motto. The blockchain performs tasks exactly as they are written in the code. They do not discriminate and cannot be manipulated. Everyone can expect to be treated like everyone else. In this sense, the contracts are also “trustless.” This does not mean that they cannot be trusted. Instead, trust is simply not necessary.
  • Transparency: the code is completely public on the blockchain. Anyone can review it and make sure it is also fair and error-free. What the contract contains, the conditions, factors and how it acts: Everything is verifiable by everyone.
  • Security: the cryptographic encryption of the blockchain technology also takes effect in the programmed contracts. This means that the contracts are extremely difficult or impossible to manipulate or rewrite. For that, hackers would have to spend vast amounts of computing power or financial resources. It is simply not practical. Furthermore, the blockchain stores all relevant data in a tamper-proof manner. And laws such as the DLT Act in Switzerland regulate blockchain transactions.
  • No paperwork: since everything is purely digital, there is no need for documents or other physical storage media. Many smart contract platforms rely on proof-of-stake, so they consume very little energy.

Disadvantages of smart contracts

Running smart contracts on blockchains comes with privacy and IT security risks, as the following points show:

  • Only as good as their code: No software can ever be perfect. Ultimately, it is humans who write the digital contracts. And they can also make mistakes. In the worst case, this can lead to billions of euros in damage. DeFi hacks are on the increase. In August 2021, for example, hackers captured 600.3 million U.S. dollars by exploiting an exploit in the Poly Network.
  • IT security risk: The Ethereum blockchain serves as an example. A significant proportion of smart contracts executed on the Ethereum blockchain contain references to mutable data or other smart contracts. This was reported by Swiss Infosec. In other words, it does not work without trust in third parties, as the Ethereum system promises users. After all, many observers are checking the systems’ open-source code and uncovering bugs.
  • Unclear legal situation: to date, lawmakers are struggling with how to classify automated, digital contracts. The automation of a wide variety of processes leads to legal uncertainties when it comes to liability for damages and breaches of law.
  • Inflexible: once data lands on the blockchain, it is fixed. Corrections are difficult to make, and users have few options to revoke.
  • Self-contained: both smart contracts and blockchains form self-contained systems. As such, they have difficulty accessing real-world data. Therefore, smart contract platforms rely on third parties who can provide this data. And that provides further gateways for tampering or errors. Oracle services are designed to remedy this.
Graphic on a decentralized financial system.
Finance and banking are interested in blockchain and smart contract technology.

Application examples and benefits of smart contracts

Central to the application of contracts are the automation and acceleration of processes. In addition, the smart contracts store the content and data in a tamper-proof manner. A wide variety of application areas come into question for this:

  • Finance: As the DeFi sector shows, there is a demand for fast, non-bureaucratic financial products. Cryptos as a means of payment are the future for many. Digital contracts create trust because trust is not necessary, and process data transparently. That even the banking industry has an interest in blockchain technology and digital contracts is shown by the R3 Consortium. This consists of, among others, the Commonwealth Bank of Australia, Danske Bank, ING Bank and many more.
  • Logistics: Blockchain can be used to transparently track the manufacturing and transportation route anywhere in the world. The entire supply chain can be automated using digital contracts, from manufacturing to customer acceptance. All participants have access to the delivery and product data and can check it at any time. Potential applications range all the way to smart factories or smart cities.
  • Healthcare: Patient data can be managed decentrally with the help of blockchain technology. Patients can decide for themselves which data they make available to whom. Doctors, hospitals and insurance companies gain access to the data and do not have to create individual files.
  • Insurance companies: Smart contracts decide how to handle an insurance claim based solely on their programming. Example of a car accident: An insured person takes his car to a repair shop. The garage checks the damage and passes on the repair costs to the insurance company. The contract checks the data and if everything is correct, it transfers the funds. This reduces bureaucracy and speeds up the process. Insured parties can enjoy neutral and fair treatment. Blockchain also plays a role in the Cardossier project.
  • Voting: Votes can be recorded transparently and tamper-proof with the help of the blockchain. Coupled to an ID system, digital contracts can ensure that everything is done correctly during the vote. This principle can be applied to governments, associations and organizations.
  • Tokenization: real estate, artwork, classic car tokens, wine, stocks and much more can be tokenized. Smart contracts automate this process and ensure that ownership is clearly secured. The blockchain technology itself enables the tokenization of assets.

What do I need to watch out for as an investor?

Smart contracts are a piece of the future, an important tool on the way to more digitalization. Cryptocurrencies with smart contracts are therefore among the most promising investments. This is already evident in Ethereum, the number 2 right after Bitcoin. Ethereum is not the only candidate, however. Other platforms such as Cardano and Polkadot stand ready as competitors.

The success of these cryptocurrencies will ultimately be decided by how much people use them. The more users there are, the more programmers write dApps, the larger the network, the more successful the cryptocurrency. It is therefore important to consider the fundamental data when making potential investments. Blockchains that can connect to the real world and provide a use case will stand as winners.

What are decentralized applications (dApps)?

Basically, decentralized applications (dApps) are like regular apps. They are software with a wide variety of tasks. However, they are decentralized because they run on the peer-to-peer network of the blockchain. This saves the middle man, interaction is instant, cheap, and data is stored securely on the distributed ledger

FAQ – Frequently Asked Questions

In which programming language are smart contracts written?

Depending on the blockchain, the programming languages are different. Ethereum, for example, uses Solidity, a programming language developed specifically for it. EOS supports C++ and NEO allows contracts to be programmed with JavaScript or JAVA.

What are the areas of application?

The applications are numerous and could encompass every area of life in the future. Smart contracts can be used in logistics, insurance, voting, healthcare, finance and commerce, and tokenization.

Are smart contracts secure?

They are as secure as they are programmed to be. Ultimately, it is also only humans who write the code, and humans make mistakes. However, the code is freely available to everyone. Anyone can review it and thus point out errors or write better code.

Smart Contract explained in the film

Alexander Naumann

Freelance Author | Master in Indology and Pre-Islamic Archaeology Areas of focus: Tokenization | NFTs | Cryptocurrencies | Blockchain Technology

Alexander Naumann

Freier Autor | Master in Indologie und vorislamischer Archäologie
Schwerpunkte: Tokenisierung | NFTs | Kryptowährungen | Blockchain-Technologie