Blockchain, the technology that makes most cryptocurrencies possible, enables so much more than just simple transactions. Decentralized finance (DeFi), decentralized applications (dApps), Web 3.0, non-fungible tokens (NFTs)—it all requires blockchain to function and exist.
More specifically, they rely on smart contracts—a distinct feature of blockchain—to exist.
Below we take a closer look at what a smart contract is, how they work, and the history of the concept. We also walk through a couple of smart contract examples and discuss why smart contract capabilities are so important.
What is a smart contract?
A smart contract is a program or line of code that exists on a blockchain, and which automatically executes once predetermined conditions are met.
Just like a traditional contract, written and signed on paper, a smart contract establishes the terms of a deal or transaction, which outline what conditions must be met for each party to agree to the deal. At the moment that those conditions are met, the program automatically executes.
Because smart contracts execute without needing a third-party intermediary such as a bank or lawyer to take action, they are often called “automated, self-executing, and trustless contracts.”
History of Smart Contracts
While smart contracts are considered an integral piece of cryptocurrencies, they were theorized all the way back in 1994 by a cryptographer and computer scientist named Nick Szabo.
Back then, he defined smart contracts as “a computerized transaction protocol that executes the terms of a contract” and compared smart contracts to a sort of vending machine, allowing transactions to take place without an intermediary required to accept payment.
Smart contracts as a concept truly began to gain steam after the launch of Ethereum in 2015, as they were a key piece of the blockchain’s technology at launch. In the years that followed, additional blockchains with smart contract functionality would continue to be developed and released.
How do smart contracts work?
A smart contract works like this:
First, two parties must reach an agreement as to the terms of a transaction. These terms are then written into the contract using a programming language. On the Ethereum network, this is typically done with the Solidity language, though other languages also exist. Once the contract has been written, the code is encrypted and stored on the blockchain network, where it awaits the conditions that will cause it to self execute.
Once uploaded to the blockchain, the terms of the smart contract cannot be tampered with or changed.
When the terms of the smart contract are met, the contract executes and is considered to be complete. At that point, the transaction is recorded on the blockchain. This transaction record propagates across the different nodes of the blockchain until consensus has been reached.
In order to execute a transaction, users must typically pay a gas fee which can be thought of as being similar to a toll that you pay to access the underlying network. How much gas is required will depend on the complexity of the transaction, the required speed of the transaction, and the overall demand for the network’s resources.
Gas fees are generally paid in the cryptocurrency or token native to the underlying blockchain network. For example, a smart contract built on the Ethereum blockchain would require a gas fee paid in ETH in order to execute.
Benefits of Smart Contracts
Proponents of the use of smart contracts tout their many benefits, which may include:
Speed: Once the terms of a contract are met, the program executes itself immediately. This is much faster than is possible with traditional contracts, which can require significant amounts of time to process, verify, and approve.
Trust: Smart contracts are stored on a blockchain, which is itself distributed across multiple nodes of a network. This makes it extremely difficult (if not impossible) for the terms of the contract to be altered once they are uploaded. This removes the need to question whether or not the contract has been altered to benefit one party at the expense of the other.
Security: Because smart contracts are stored on a blockchain, they are necessarily encrypted and therefore highly secure.
Cost reduction: Smart contracts by nature remove the need for intermediaries (such as lawyers, banks, or brokers) to verify that the terms of the agreement have been met and to execute the transaction. This can significantly reduce costs associated with such transactions.
Smart Contracts & Blockchain: Which blockchains support smart contracts?
In theory, any blockchain can facilitate smart contracts.
That being said, the Ethereum network is currently the leader in the world of smart contracts. This can be seen in the fact that the network has the most number of decentralized applications (dApps) running on top of it—more than 3,000 as of May 2022.
Of course, recent years have seen the emergence of a new cohort of blockchains that exist to directly compete with Ethereum for dominance over the smart contract market. Dubbed “Ethereum Killers” by some, they include Solana (SOL), Cardano (ADA), Tezos (XTZ), Avalanche (AVAX), and Polkadot (DOT), among others.
A good way to understand the difference in scale between these networks is to compare their Total Value Locked (TVL), a metric which communicates the total value of the money that users have deposited into DeFi projects on each network. According to DeFi Llama, a TVL aggregator, each network has the following amount locked on it as of April 23, 2022:
Polkadot: $3.89 million
What makes smart contracts so important?
Smart contracts introduce a whole new layer of functionality to the world of cryptocurrency. Without them, blockchain-based cryptocurrencies would be primarily limited to playing a role as a payments platform. The additional functionality enabled by smart contracts has given rise to a burgeoning industry and ecosystem of decentralized applications (dApps) and decentralized finance (DeFi).
Smart Contracts and Decentralized Applications (dApps)
A decentralized application (dApp) is a software application much like one you would find on a website, laptop, or smartphone. The primary difference between dApps and conventional applications is that dApps integrate with a blockchain—bringing all of the potential benefits offered by the blockchain (such as increased transparency, security, and speed) to the end user.
Decentralized applications rely on smart contracts to exist. That’s because smart contracts essentially act as a sort of API connector that allows a dApp to connect with the underlying blockchain. This connection is what allows transactions to occur between the dApp developer and the end user. Without smart contracts and the connection to the blockchain that they provide, an dApp would simply be a traditional application.
Just as conventional applications can be created to serve a wide variety of purposes, so too can dApps be developed for a wide variety of use cases. There are, for example, dApps related to gaming, social networking, entertainment, productivity, and much more.
One area of dApp development that has received a lot of attention of late is that of decentralized finance (DeFi), a nascent industry that allows financial transactions to take place without the infrastructure or governance of a central authority such as a bank.
All of the services provided by traditional financial institutions—such as banking, spending, lending, trading, and borrowing—can theoretically be achieved through various DeFi applications as well, thanks to the functionality offered by smart contracts.
Investing in Smart Contracts
Because of the benefits that they offer, many people have theorized that smart contracts may one day serve as a means of disrupting vast industries, in much the same way that the invention of the internet allowed ecommerce companies such as Amazon to disrupt brick-and-mortar retailers like Barnes & Noble.
With this in mind, it’s only natural that you might be interested in investing in smart contracts technology in order to take advantage of these trends.
But just as there was no way of investing directly in the internet during its early days, there is no way of investing directly in smart contracts. Instead, investors who believe in the power of smart contracts must find indirect ways of investing in the technology.
One way that you might achieve this is by investing in cryptocurrencies that facilitate smart contracts, such as Ethereum and its competitors. Additionally, you may decide to invest in publicly-traded companies that are developing smart contract-based products and services.
Here at Allio, we believe that cryptocurrency has exciting potential to help build the infrastructure of tomorrow’s technological and financial ecosystem but currently as an asset, doesn’t have the regime in place to drive its price up. Bitcoin, due to its limited supply could come into high demand if the global financial system ever experienced hyperinflation. Rather than have our clients purchase a wallet or trade on a messy exchange with hidden fees to purchase coins, we prefer to seek this upside via the use of an ETF which includes the added benefit of not being directly exposed to the speculative underlying asset. That said, they are still volatile and investors should only purchase them if they’re willing to lose that entire portion of their portfolio. For that reason, we offer our clients the choice for whether they’d prefer to have crypto exposure, alongside traditional asset classes—like stocks, bonds, commodities, and real estate— for a truly diversified macro investment strategy.