What is a Smart Contract in Blockchain and How Does it Work

A traditional contract, as a rule, is in a paper version and contains many paragraphs and pages. Smart (this is how the word smart is translated) contract is a document that has no paper counterpart. Besides, it cannot even be called a document in the conventional sense, since all the terms of a smart contract are recorded in machine code embedded in blockchain.

The use of blockchain assumes that all the rules specified in smart contracts are replicated by all nodes of the network, they are mandatory and cannot be changed. For the first time, the idea of using digital contracts was proposed by Nick Szabo, the US cryptographer. It happened in 1993, long before the advent of cryptocurrencies. Still, a good initiative designed to formalize the use of computer networks based on special protocols found no support among developers.

Sabo’s ideas were brought to life only in 2008, when the first Bitcoin cryptocurrency appeared, based on the use of a blockchain with fixed rules for conducting transactions and mining tokens. But the algorithms of smart contracts were fully implemented in 2013 on the basis of the Ethereum blockchain. It initially provided for the possibility of using applications with a full-fledged smart contract without making any changes to the structure of the blockchain.

How a blockchain smart contract operates

Simply put, the principle of operation of a smart contract can be described as follows: it is a digital protocol that allows you to make transactions without the presence of such a component as trust, which is mandatory for offline transactions. In other words, when using a smart contract, you will not know anything about the other party, but you will be sure that you will not be cheated, because if the conditions prescribed in the blockchain are not met, the transaction will not take place.

From a technical point of view, a smart contract is an analogue of a deterministic program code (App). This code is capable of performing some actions, indicating when and under what conditions to do it. The use of blockchain ensures that the terms of the transaction will be valid for all participants equally within a distributed system at the address level. The latter are directly associated with the participants of the transaction. Addresses that are not registered in the smart contract belong to external accounts and are called EOA.

Thus, the Ethereum smart contract specifies the terms of the transaction itself and has two public keys: one identifies the author of the contract and is his address, the other identifies the contract itself. To integrate a contract into blockchain, it is necessary to perform the corresponding transaction, and in order to activate it, the EOA must refer to its unique identifier. In this case, the terms of the transaction will be checked, and once they are fulfilled, the corresponding section of the code will be executed.

To be fair, we should note that in fact a smart contract is not “smart” in the traditional sense. Moreover, it is not a legal contract.

Advantages of smart contracts on blockchain

But what does the use of blockchain digital contracts give? Let’s consider the main features of smart contracts, which are also their advantages:

• Implementation in the blockchain implies that the smart contract is replicated to all nodes of the network – it is not stored on centralized servers, minimizing the level of vulnerability.
• No other actions apart from those prescribed in smart contract code will be performed. The fulfillment of specific conditions is also mandatory, as is the result of the transaction, regardless of who its participants are;
• Everything that can be automated within the framework of the program code will be performed without the participation of intermediaries. On the other hand, if the smart contract is not activated, it is simply stored in a certain block of blockchain and does not perform any actions;
• After smart contract is deployed on blockchain, it can not be changed. This eliminates the possibility of manipulating the terms of contract. It will be possible to delete it only if it is provided by the code (in the Ethereum blockchain, the SELFDESTRUCT function is responsible for this);
• Possibility of fine-tuning. It is provided at the encoding level of smart contract. In the Ethereum blockchain, which is Turing-complete, smart contracts can be used to create decentralized applications of various types and purposes;
• Since the smart contract is implemented on a public blockchain, its code is available to everyone.

From all of the above, it follows that the use of SC has a number of advantages that are unavailable for traditional centralized transactions. As for the scope of their use, it is quite extensive. Most often, smart contracts are used to carry out transactions like money transfers (including fiat). Smart contracts that allow users to create their own tokens are becoming more popular, there are options for implementing crypto wallets, decentralized crypto exchanges. But it is not necessary that smart contracts on the blockchain should be linked to cryptocurrency. They are also used to create games, voting systems, mobile Apps, in the healthcare sector, and to build supply chains. And this list is constantly being updated.

Limitations

Since a smart contract is a program code that uses the language of a particular blockchain, it may well contain errors and vulnerabilities, especially if it is written by a not too experienced and qualified programmer. It is clear that the functionality of smart contracts will be weaker than centralized analogues, not limited by the terms of the blockchain.

The inability to change the terms of a smart contract as a whole is a blessing, but sometimes it becomes a problem. This happened in 2016, when millions of ETH were stolen as a result of hacking an autonomous DAO organization operating on the Ethereum blockchain. To get the money back, the developers had to implement a hard fork – essentially creating another token. This is the result of an incorrectly written smart contract.

The lack of legal status can also be a problem, but this situation is typical for the entire cryptocurrency industry.

Finally, we note one more important point. The fulfillment of SC terms is monitored by oracles – special software bots. Here, too, there are some loopholes for manipulation at the level of those sources that are used in the smart contract.

Summarizing

There is no doubt that the modern world of cryptocurrencies based on a decentralized blockchain can no longer be imagined without smart contracts. And if today the end user may not come into direct contact with smart contracts, carrying out transactions and transactions, then in the future this technology is likely to become widespread. In any case, the scope of their use is constantly expanding, penetrating into all new niches.