Blockchain Basics: Smart Contracts 101
By: Sunita Rao, Tokenization @ Republic
We began our series on decentralized finance last week with a spotlight on the Algorand blockchain and why we’re excited to build Republic Note with the protocol — read about it here if you missed it!
This week, we’re digging deeper into the mechanics of blockchain with the concept of smart contracts. While ‘smart contract’ is a term that’s referenced regularly within the blockchain space, it’s imperative to understand the fundamental role it plays in the fast-emerging sector of decentralized finance. So let’s dig in!
Introduction
The exchange of goods between two parties goes back to the beginning of human history — it is one of the foundational elements of civilization. Whether it’s farmers trading crops for cash at a market, or complicated corporate mergers with many intermediaries, the process of exchange can take many forms. However, there are a few constants: the market, trust, exchange, custody, and time. Accommodating these aspects can be complicated and costly, but blockchain-based smart contracts bring automation into the exchange equation and a fundamental reorganization of the way humans exchange value.
Simply stated: Over blockchain protocols like Ethereum and Algorand, smart contracts automate the process of documenting and executing actions of all parties involved in an agreement. The term smart contract itself was first introduced by cryptographer Nick Szabo about 20 years ago and has become one of the foundational functionalities of blockchain tech today. A smart contract is a code that executes rules in a deterministic way (ex: if, then statements). Combining smart contracts with cryptocurrencies gives rise to the innovation of ‘programmable money’. In a decentralized platform where consensus is formed amongst many, rather than controlled by a few, smart contracts remove the problematic human element and bias from law and agreements to create open, accessible, and equitable processes for transactions and value exchange
We’re dedicating an entire article to the subject of smart contracts because of the incredible functionality that the technology has brought to the foundation and mechanics of blockchain and cryptocurrency, as well as the ever-emerging use cases for real-world applications of smart contracts.
The Mechanics
Smart contracts execute transactions that are recorded directly onto a blockchain’s data records. They are entirely deterministic, fully automated, and cannot be changed or altered once executed. A foremost function of smart contracts is the ability to reliably and continuously execute. For a smart contract agreement to execute, all parties involved in the transaction process apply what are effectively electronic signatures. This ensures security and accountability for smart contracts. Users of smart-contract-enabled blockchain networks can feel safe and secure in their transactions because trust is built into the code and cannot be altered.
Further, smart contracts are also able to utilize data from outside the blockchain to aid in execution. Smart contracts get data and information from outside the blockchain through what’s called an oracle. Oracles provide smart contracts with data from the outside world to enable transactions that are reliant on information, data, or occurrences that take place off-chain and in the real world.
One of the largest uses for smart contracts today is in the world of decentralized finance, or DeFi. DeFi is leveraging smart contracts to replace the traditional financial infrastructure and this technology is growing at an exponential rate. Our crypto team hosted this informative webinar explaining the interplay between DeFi and existing financial infrastructure, take a listen to it here.
By now, it’s clear that smart contracts are a remarkable innovation and an essential building block of today’s leading blockchain infrastructures. But how can they add value in real-world industries? Let’s take a look…
Use cases for smart contracts outside of DeFi
Smart contracts are currently most widely utilized within cryptocurrency and blockchain. However, there are myriad other uses for smart contracts that make them valuable for real-world application. For example, smart contracts are being implemented within supply chain operations, loans/mortgages, insurance, and finance. Below is an extensive list of areas that smart contracts are being utilized right now.
It’s a positive sign to see that blockchain and smart contract technology is increasingly being used in a broader sense than just cryptocurrency and transaction agreements. It also points to a larger trend of smart contracts ushering in a new age of transparency, reliability, and security within transactions — something new in many of these real-world industries.
The Potential Risks of Smart Contracts
While the concept of smart contracts aims to automate and execute rules on the blockchain, it’s not always fool-proof, and there is room for human error. One of the biggest risks for smart contracts is the rare occurrence of bugs within the code. Further, depending on the governance structure and protocol, it can be hard to adjust existing smart contracts once they are already in place. Another downside is smart contracts don’t address one of the biggest pain points within blockchain infrastructure: gas fees, which we talked about more in our previous blog post. That said, blockchain technology is a rapidly evolving sector, and a global, distributed community of developers are working to make the contracts even more efficient. We believe the future is promising for the continued technological growth and usage of smart contracts within blockchain.
Conclusion
As the decentralized ecosystem continues to grow and technology advances, smart contracts will usher in a new understanding of the nature of agreements and transactions. The technology is bringing automation, reliability, transparency, and security from the blockchain sector to a wide range of industries with tangible benefits for people all over the globe. Acknowledging this, the question then becomes the management and governance of smart contract-enabled platforms to achieve the equitability that the technology promises. In a blog post in the near future, we’ll discuss the intersection of blockchain and governance structures.
To learn more, follow Republic Crypto on Twitter, and join our Telegram community to get the most up-to-date information from the Republic team. We’re continuing to cover many more topics within the Decentralized Finance space on our Medium page so keep an eye out for our next blog post soon!
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