What is a smart contract?
Home > What is a smart contract?
Killian Bell
Oct 05, 2022 7 mins read

What is a smart contract?

Smart contracts are automated computer programs that run on the blockchain, and they are fundamental to the entire cryptocurrency industry. They are made up of computer code and data, and they not only facilitate transactions without the need for a centralized entity or third- party, but they also enable a growing library of decentralized applications (DApps).

Since smart contracts are entirely automated based on their input, there’s nothing you need to do as a user to get them working, so most traders and investors never really think about them. However, if you’re curious, this AAG Academy guide will teach you the basics of smart contracts, including how they work and why they’re so important.

How does a smart contract work?

Smart contracts have been around a lot longer than cryptocurrency itself. They were first introduced in 1994 by Nick Szabo, the American computer scientist behind the “Bit Gold” digital currency that launched in 1998 — ten years before the invention of Bitcoin. Szabo had a great way of explaining how smart contracts work by likening them to a vending machine.

A vending machine removes the middleman from the process of buying goods by automating it. A customer inserts their money, enters the code for the product they want to buy, and then the vending machine works its magic to fetch the product and dispense it. It’s entirely clear to the customer before they’ve even handed over their cash, what the outcome will be.

A smart contract, which is essentially a piece of self-executing code that runs on a blockchain, works in much the same way. You feed it some data — such as the wallet address of someone you want to send cryptocurrency to and the number of tokens you want to send — and then the smart contract automatically takes care of the rest.

Smart contracts don’t need a centralized server or any other middleman to operate, and they are completely transparent, which means anyone can examine their code on the blockchain. Furthermore, once a smart contract has been launched, it is live forever and cannot be altered. This ensures their security and reliability and prevents any nefarious activities.

Are smart contracts secure?

One of the biggest advantages of smart contracts is that they’re incredibly secure. They run on a blockchain, so there is no centralized server that can be attacked or compromised, and once they are published, smart contracts cannot be altered or tampered with in any way — not even by those who wrote and created them.

However, this statement only applies to smart contracts that are well-written and free from bugs and vulnerabilities. If a smart contract contains errors and other flaws, then there is a possibility that they could be exploited, and that the smart contract could be compromised. Bugs can also lead to unintended outputs, which could result in cryptocurrency losses.

With that being the case, you should always stick to using trusted DApps and projects, which are more likely to be using stable and reliable code that’s free from bugs and security flaws. If in doubt, find out whether the project has been audited. This is when an independent third-party examines a project and its smart contract to ensure it is safe and trustworthy.

What are the benefits of smart contracts?

As we’ve established above, security is one of the biggest benefits of smart contracts — assuming they are free from flaws — and we’ve already touched upon lots of others. These include:

Distributed
Smart contracts are distributed among blockchain nodes and participants, which means they do not reside in a single place like other computer programs powered by centralized servers. This makes smart contracts more secure since they are less susceptible to targetted attacks, and it ensures that smart contracts are always live.

Transparent
Smart contracts are viewable on the blockchain, so anyone can examine their code to find out exactly how they work. This prevents someone from creating a smart contract for nefarious uses — like stealing cryptocurrency tokens — since their functions are impossible to conceal.

Immutable
In addition to being transparent, smart contracts are immutable, so they cannot be edited or altered in any way once they are published. This prevents someone from launching a safe smart contract and then changing its code later to perform unsafe operations.

Autonomous
Smart contracts are entirely autonomous, which means that when certain conditions are met (or when they are fed the right data), they carry out their functions automatically.

Flexible
A smart contract can be used for an incredibly wide range of functions, which is why they have become so critical to the cryptocurrency industry and decentralized applications. It is also possible to combine multiple smart contracts to perform more complex tasks.

What are the limitations of smart contracts?

Although smart contracts can be incredibly flexible, they do have limitations, such as:

Immutable
Immutability is both a benefit and a limitation of smart contracts, and although it can make them safer, it also means that a smart contract cannot be “fixed” or improved if bugs and other instabilities are discovered after it is published. The only real fix is to create a new smart contract, which can be an incredibly complex task for a project that’s already live.

Legal status
Don’t be fooled by its name; a smart contract doesn’t actually constitute a legally binding agreement in most countries. Contracts, in the majority of nations, usually demand that both parties are identifiable and over the age of 18, whereas smart contracts are open to anyone. Furthermore, there is no legal liability when a smart contract goes wrong.

Support
The decentralized nature of smart contracts means that in most cases, it is incredibly difficult for users to get support if something goes wrong.

What are some examples of smart contracts?

Smart contracts have a wide range of uses today, and they do more than just facilitate cryptocurrency transfers between two people. They also play an important role in the decentralized finance (DeFi) industry to enable lending and borrowing, and even in play-to-earn games that give players the opportunity to earn cryptocurrency tokens and NFTs.

So, whether you’re buying, selling, mining, spending, or trading cryptocurrency; collecting digital assets you’ve been awarded inside a game, or buying digital goods inside the Metaverse, smart contracts are involved in the process. Ethereum is by far the most popular platform for smart contracts, with more than 2 million currently running on its blockchain.

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Frequently Asked Questions

It is important to distinguish between smart contracts and smart legal contracts, since they are very different to one another. A smart legal contract is defined as “a legally binding agreement that is digital and able to connect its terms and the performance of its obligations to external sources of data and software systems.” A smart contract (those that run on a blockchain) is not legally binding.

Smart contracts were invented in 1994 by Nick Szabo, an American computer scientist and the creator of “Bit Gold.”

Ethereum is the biggest cryptocurrency that has a smart contract blockchain, but it’s not the only one. Others include Cardano, Solana, Polkadot, and Ergo.

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About the author

Killian Bell
Senior content writer
United Kingdom
Senior copywriter for AAG Marketing team with the focus of educating our community on all things web3, blockchain and Metaverse.

Disclaimer

This article is intended to provide generalized information designed to educate a broad segment of the public; it does not give personalized investment, legal, or other business and professional advice. Before taking any action, you should always consult with your own financial, legal, tax, investment, or other professional for advice on matters that affect you and/or your business.

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