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What are smart contracts in simple terms? Let’s find out!

With the rapid spread and development of blockchain technology in society and the crypto sphere, there is a growing interest in smart contracts and the opportunities they provide. In this article, let’s look at what smart contracts are, their purpose, what impact they already have on our lives, and where they are heading.

What Is a Smart Contract?

A smart contract is a computer algorithm designed to implement and maintain self-executing contracts on a blockchain. After a smart contract is written and placed on the blockchain, it executes on its own. In other words, a smart contract is a means of exchanging value without the participation of intermediaries.

Smart contracts are typically used to automate the execution of an agreement so that all participants can be immediately certain of the outcome without an intermediary’s involvement or time loss. They can also automate a workflow, triggering the following action when conditions are met.

In 2015, the first notable smart contract platform, Ethereum, was launched, creating the foundation for an ecosystem of decentralized applications (dApps) to be developed and unleashing the potential use cases for the cryptocurrency ecosystem.

What is an example of a smart contract?

Examples of smart contract applications include financial purposes like trading, investing, lending, and borrowing. They can be used for gaming applications, healthcare, real estate, and even to configure entire corporate structures. Here are some of the real-world examples of smart contracts and dApps.

Decentralized financial applications (DeFi) dApps are a huge alternative to traditional financial services. Their popularity is growing due to the reliable, immutable, and transparent characteristics of blockchain technology and smart contracts. DeFi decentralized applications provide parallel services for the banking and financial services industry. These services include lending, borrowing, trading, and a host of other financial services, along with entirely new product types and decentralized business models that can offer significant benefits and utility to users. Furthermore, with the increased transparency, 24/7 functionality, and lower costs enabled by smart contracts, decentralized applications can lower barriers to entry into the financial services arena for people worldwide.

Non-fungible tokens (NFTs). Blockchain technology in the gaming industry is typically driven by non-fungible tokens or NFTs. They are unique digital assets that represent in-game content. These NFTs rely on smart contracts. These exclusive tokens are unique, rare, and indivisible, while the blockchain networks that underpin NFTs facilitate player ownership, provable scarcity, interoperability, and immutability. Together, these characteristics of blockchain in games can drive mainstream adoption and create a more equitable value model.

Real World Smart Contract Example

  • Legal industry.

One of the most promising applications of smart contracts in the real world is their ability to function as the legally binding contracts that are used in most modern business relationships. Technology is driving innovation in the legal industry, most recently with the advent of electronic signatures for binding legal agreements. Smart contracts represent another new development in this sphere. They might soon become an option for parties to legal agreements, potentially reducing the costs incurred from using lawyers and other intermediaries.

  • Real estate.

Through tokenization, smart contracts facilitate fractional ownership of assets and thus lower the entry barrier to investment for many by merging blockchain and real estate operations and transactions. In particular, several successful attempts have been made to tokenize real estate assets. In addition, smart contract technology can also redesign transaction processes and documentation by incorporating blockchain in real estate transactions.

  • Emerging technologies.

One of the most exciting applications of smart contract technology is the ability to facilitate complex computational tasks such as those associated with machine learning and artificial intelligence (AI). Combining AI’s data-intensive processing with the decentralized security and immutability of blockchain technology makes it possible to create smart contracts based on artificial intelligence. As smart contract applications are adopted across different industries, they will become more complex to fit these new emerging roles. While rudimentary use cases for smart contracts can be manually designed, AI-enabled smart contracts might allow the creation of very complex, more flexible, enterprise-grade smart contracts and dApps that can significantly enhance the capabilities of the technology.

Smart Contracts and Blockchain

Smart contracts are a kind of algorithm for specific actions integrated into the blockchain code. They are part of the blockchain code and work directly within the network. Smart contracts perform the function of paper contracts familiar to us, only in the digital field. The conditions are written not with a pen on paper but with the use of mathematical algorithms and programming languages.

The advantages of blockchain-based smart contracts

  • Speed. Smart contracts are executed through code without requiring manual document processing. As a result, they can process transactions very quickly. This speed can save time compared to many traditional business processes.
  • Transparency. To ensure transparency, every transaction on the chain is logged in databases so that all other users on the network can see it.
  • Security. Blockchain is a distributed digital ledger linked by cryptographic hashes. The registry is shared on a “peer-to-peer” network, with a copy of each node on the network replicated to all users’ computers.
  • Stability. The data processed on the blockchain network cannot be changed. Therefore, the party cannot dispute the conditions specified in the contract.

The Importance of Smart Contracts

Smart contracts proved to be able to revolutionize the way we do business online. They are faster and more cost-effective than traditional contract law as they do not require manual enforcement by third parties, which means fewer costs for businesses and consumers.

Moreover, smart contracts are secure because they are decentralized on the blockchain. It means there is no single point of failure or vulnerability to attacks and hacks. All parties have full access to their funds at all times, helping to reduce fraud and protect both buyers and sellers in the event of a dispute.

Smart contracts are useful tools in creating efficient financial, banking, supply chain, healthcare, government, insurance, real estate, energy, and gaming products.

Smart contracts vs. traditional contracts

Unlike traditional contracts, smart contracts do not require the authority of a third party to verify their authenticity. This allows the parties involved in the contract to save time and money on a particular transaction.

In addition, as we know, authenticity is undoubtedly an important advantage of smart contracts. Unfortunately, traditional contracts can be forged or altered if not properly secured or verified by a certified professional. Even minor changes in wording can have important implications for the final agreement. However, since smart contracts are stored on the blockchain, they are immutable.

Another traditional contract’s drawback is that they are signed on both sides by one party without the other party’s knowledge. When it comes to smart contracts, this cannot be done, as they require the use of a digital key signature, which is known only to the person who owns it.

Hence, smart contracts provide a fast, transparent, secure, and trustworthy agreement between the parties. However, they also have some disadvantages.

Problems with smart contracts

One major problem with smart contracts is that they are pseudonymous as they are stored on the blockchain. Indeed, transactions made on the blockchain use pseudonyms for the parties involved in the transaction. It’s not completely anonymous, but it still doesn’t require the parties to have a legal entity. Therefore, in the event of a dispute, smart contract cases are almost impossible to take to court, as the only known information about the parties is their wallet address, not their identity. Although there are several ways to work around this problem with the help of KYC requirements, not all cases can be prevented.

What Is a Smart Contract Audit?

A smart contract security audit examines and comments on a project’s smart contract code. The main aspect of understanding the process of auditing smart contracts is its definition. The smart contract audit process focuses on checking the code used to validate the terms of the smart contract. With such an audit, smart contract developers could easily identify vulnerabilities and bugs before deploying smart contracts.

As a rule, third parties audit smart contracts to ensure the code is thoroughly checked. On the other hand, enterprises can choose professional smart contract auditors to perform the audit.

Thorough code testing before deploying a smart contract is an essential thing. Once a smart contract is written to the blockchain, it is impossible to change the code. Therefore, deploying smart contracts without proper auditing can lead to adverse circumstances such as discrepancies in the desired performance of the contract. At the same time, inadequate audit processes can also lead to risks such as personal data loss or data theft.

Final Thoughts

Smart contracts are an up-and-coming technology and a tool for creating new solutions. Many organizations are already actively working on correcting the existing shortcomings of smart contract technology. Analysts say that shortly, this technology will get a full legal justification, which will increase people’s credibility.

In the coming years, smart contracts will be able to replace most of the paperwork in the field of finance, and not only. Many of the world’s leading banks are experimenting with blockchain technologies and transferring their routine activities to them.

In the not-so-distant future, smart contracts will be used at the state level to optimize the processes of reporting, documentation, and more.

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Disclaimer. This material should not be construed as a basis for making investment decisions or as a recommendation to participate in investment transactions. Trading digital assets may involve significant risks and can result in the loss of invested capital. Therefore, you must ensure that you fully understand the risk involved, consider your level of experience, investment objectives, and seek independent financial advice if necessary.