Day 14 of 100 | Crypto Basics | 5 min read
What is a Smart Contract?
Master what is a smart contract? in this comprehensive lesson. Build your cryptocurrency knowledge step by step.
### Code That Executes Itself
Smart contracts are one of the most transformative innovations to emerge from blockchain technology. They are programs that run on a blockchain and execute automatically when predetermined conditions are met. Understanding smart contracts opens up a world of possibilities beyond simple cryptocurrency transactions, including decentralized finance, non-fungible tokens, and decentralized autonomous organizations.
### What Is a Smart Contract
A smart contract is, at its core, a piece of computer code that lives on a blockchain. Unlike regular programs that run on a company's servers, smart contracts run on a decentralized network of computers. This means no single entity controls them, and they execute exactly as programmed without possibility of censorship, downtime, or interference.
[TIP] The term smart contract was coined by computer scientist Nick Szabo in the 1990s, years before blockchain existed. He envisioned contracts that could execute themselves without requiring trust in a third party. Blockchain finally made this vision technically feasible.
Think about how traditional contracts work. Two parties agree to terms, perhaps in writing. If one party does not fulfill their obligations, the other party must seek enforcement through the legal system. This process is slow, expensive, and requires trust in legal institutions.
Smart contracts flip this model. The terms of the agreement are written in code. When the conditions are met, the contract executes automatically. There is no need to trust the other party or rely on enforcement mechanisms because the execution is guaranteed by the blockchain.
[EXAMPLE] Consider a simple escrow arrangement. Normally, a trusted third party holds funds until certain conditions are met. With a smart contract, the code itself becomes the escrow agent. Funds are locked in the contract, and they are released automatically when the conditions programmed into the contract are satisfied. No trust in a third party is needed.
### How Smart Contracts Work
Smart contracts are deployed to a blockchain like Ethereum by sending a special transaction that includes the contract's code. Once deployed, the contract has its own address on the blockchain, just like a user account would.
Users interact with smart contracts by sending transactions to the contract's address. These transactions can include cryptocurrency, data, or both. The contract receives the transaction, executes its code based on the input, and produces outputs that are recorded on the blockchain.
[KEY] Crucially, smart contract execution is deterministic. Given the same inputs and starting state, the contract will always produce the same outputs. This is essential for a decentralized network where thousands of computers must agree on the results. Every node runs the same code and reaches the same conclusions.
The execution of smart contracts is paid for with transaction fees, often called gas in Ethereum. These fees compensate the network's validators for the computational resources used to execute the contract. More complex operations require more gas.
All smart contract interactions are recorded on the blockchain and are publicly visible. Anyone can see what a contract does and verify that it works as described. This transparency is a key advantage over traditional systems where the inner workings are hidden.
### Smart Contract Capabilities
Smart contracts can do many things, limited mainly by the creativity of their developers and the capabilities of the blockchain platform.
Financial transactions are the most common use case. Smart contracts can hold, send, and receive cryptocurrency. They can distribute funds according to complex rules, manage pooled resources, and automate financial operations.
Token creation is another major application. The majority of tokens in the cryptocurrency ecosystem are not their own blockchains but are smart contracts running on platforms like Ethereum. The contract keeps track of who owns how many tokens and handles transfers between addresses.
[EXAMPLE] When you buy a new token on Ethereum, you are not buying something separate from Ethereum. You are interacting with a smart contract that maintains a ledger of token balances. The contract updates its records to reflect your purchase, and these records are stored on the Ethereum blockchain.
Decentralized applications, or dApps, combine smart contracts with user interfaces to create applications that work without central servers. From decentralized exchanges to lending platforms to games, dApps leverage smart contracts to provide services that traditionally required trusted intermediaries.
Governance mechanisms can be built with smart contracts. Decentralized autonomous organizations use smart contracts to manage voting, treasury, and other organizational functions. Token holders can vote on proposals, and the results are executed automatically by the contract.
### Smart Contract Platforms
While Ethereum is the largest and most established smart contract platform, it is not the only option.
Ethereum pioneered general-purpose smart contracts and has the largest ecosystem of developers, applications, and users. Its smart contracts are written in a language called Solidity. Despite facing challenges with scalability and high transaction fees during periods of congestion, Ethereum remains the dominant platform for smart contracts.
[TIP] When evaluating smart contract platforms, consider not just the technology but also the ecosystem. A platform with more developers, users, and applications offers more opportunities for interaction and learning, even if its technology is not the most cutting-edge.
Solana offers high throughput and low fees by using a different consensus mechanism and architectural design. It has attracted developers building applications that require fast, inexpensive transactions, such as high-frequency trading protocols.
Avalanche, Polkadot, Cardano, and many other platforms each offer their own approach to smart contracts, with different trade-offs in security, decentralization, and performance.
Layer 2 solutions like Arbitrum and Optimism run on top of Ethereum, offering faster and cheaper transactions while inheriting Ethereum's security. Many developers are building on these platforms to avoid Ethereum's high mainnet fees.
### Smart Contract Security
The irreversible nature of blockchain creates unique security challenges for smart contracts. Once deployed, a contract cannot be changed. If there is a bug in the code, the bug is there forever, and attackers may exploit it.
[WARNING] Smart contract vulnerabilities have resulted in losses of hundreds of millions of dollars. Before interacting with any smart contract, especially with significant funds, research whether the contract has been audited by reputable security firms. Even audited contracts are not guaranteed to be bug-free.
Common vulnerabilities include reentrancy attacks, where a contract is tricked into calling itself repeatedly before completing previous operations. Integer overflows occur when mathematical operations produce results outside the range the contract can handle. Access control issues arise when functions that should be restricted can be called by anyone.
Auditing is the process of having security experts review smart contract code for vulnerabilities. While auditing reduces risk, it does not eliminate it. New attack vectors are discovered regularly, and even audited contracts have been exploited.
Many protocols use bug bounty programs, offering rewards to hackers who responsibly disclose vulnerabilities instead of exploiting them. This creates an economic incentive for white-hat hackers to help secure the ecosystem.
### Real-World Applications
Smart contracts have enabled entirely new categories of applications that were not possible before.
Decentralized exchanges allow users to trade tokens directly with each other without trusting a centralized intermediary. Smart contracts manage the order books, match trades, and handle the transfer of assets.
Lending protocols enable users to borrow and lend cryptocurrency with interest rates determined algorithmically. Collateral is held by smart contracts, which automatically liquidate positions if they become undercollateralized.
[EXAMPLE] Consider how a decentralized lending protocol works. You deposit cryptocurrency into a smart contract as collateral. The contract allows you to borrow other assets up to a certain percentage of your collateral value. If the value of your collateral drops too low, the contract automatically sells it to repay your loan. All of this happens without any human intervention.
Non-fungible tokens use smart contracts to establish provenance and ownership of unique digital assets. The contract maintains a record of who owns each token and handles transfers between buyers and sellers.
Insurance protocols are being built that pay out automatically when certain conditions are met, such as flight delays or crop failures reported by trusted data feeds.
### Interacting with Smart Contracts
For users, interacting with smart contracts typically happens through web interfaces or mobile applications. You connect your wallet, which allows you to sign transactions that interact with the contract.
When you interact with a smart contract, you are sending a transaction to the blockchain. You will need to pay a transaction fee, which covers the cost of executing the contract code. The fee varies based on network congestion and the complexity of the operation.
[KEY] Always understand what a smart contract does before interacting with it. Read the documentation, understand the risks, and start with small amounts until you are confident in your understanding. The irreversibility of blockchain means mistakes cannot be easily fixed.
Many smart contracts require you to grant them permission to access tokens in your wallet. Be cautious about these approvals, as a malicious or compromised contract could drain approved tokens. Consider using limited approvals rather than unlimited ones when possible.
As you continue through this course, you will learn more about specific applications built on smart contracts, including decentralized finance and NFTs. The foundation you build here will help you understand and evaluate these more complex applications.
Knowledge Check
What is a key aspect of what is a smart contract??
- It's only for advanced users
- Understanding the fundamentals is essential for making informed decisions (Correct)
- It doesn't apply to cryptocurrency
- It requires expensive equipment
Explanation: Understanding the fundamentals of what is a smart contract? is essential for anyone participating in the cryptocurrency ecosystem. This knowledge helps you make better decisions and avoid common mistakes.