A contract is a legal agreement between two or more parties whereas smart contracts are digital contracts stored on a blockchain. These are automatically executed when predetermined terms and conditions are met. These automated processes are necessary for a blockchain transaction. Once the process is completed, the transactions are trackable and irreversible.
This contract enables secure transactions and agreements to be executed between diverse and anonymous parties. This will require a central authority, a legal system, or an external enforcement mechanism.
The necessity of a smart contract arises when transactions occur between parties that do not trust each other. Smart contracts are introduced to remove the need for a trusted third party to interfere with any actions between them.
Smart contracts have four major components:
- State variable (data)
- Functions (what can be done)
- Events (messages in and out)
- Modifiers (special rules for specific users)
A transaction between a consumer and a business serves as the most straightforward and traditional example of a smart contract.
How Do Smart Contracts Work on a Blockchain?
Smart contracts are self-executing contracts that are stored on a blockchain. They are written in code and are triggered when certain conditions are met. They are secure, transparent, and immutable, which means they cannot be changed or tampered with.
This contract enables users to exchange money, property, or anything of value in a transparent, conflict-free way while avoiding the services of a middleman.
Benefits of Smart Contracts
While talking about the benefits of smart contracts, benefits are somewhat similar to the benefits of blockchain technology. Both are intended to remove the need for third parties. Some other benefits included in this technology are;
- Efficiency: They speed up contract execution
- Accuracy: Free from human error
- Immutability: The programming cannot be altered
Let’s go a little more deep into the benefits of smart contracts
As above mentioned, the contract is executed immediately after the condition is met. All these processes are performed digitally and automatically without any need for paperwork. This ensures no time is spent to examine the error that might happen in manually completed documents. This could potentially boost the speed, efficiency, and accuracy.
Since the process does not involve a third party, there is no need to worry about the information transacted has been altered for personal benefit.
All the transactions made via blockchain are encrypted so it is hard for a third person/party to hack. This is made possible by linking each record with a previous and successive record on a distributed ledger, so even to change a single record, hackers need to alter the entire chain. So there is no need to question about the security.
Smart contracts will remove the need for intermediaries to handle transactions and, by exOf course their associated time delays and fees.
Of course, you need to know about the drawbacks of smart contracts and they are listed below:
- Permanent: Since it is permanent, you cannot change it even if there are mistakes human man factor: They completely rely on the programmer to make sure the code is programmed correctly to execute the planned actions
- Loopholes: Codings might have loopholes, and it allows for contracts to be executed in bad faith.
Risks That Are Associated With Smart Contracts
The risks associated with smart contracts include security, regulation, interoperability, and scalability. A small description of this is given below:
Security: Even though blockchains like Cardano and Ethereum are secure, that doesn’t imply that the code of smart contracts written by thousands of developers is free from bugs and vulnerabilities. dApps can be published by anyone, with the skill, and qualification as developer is not a barrier, since blockchains are decentralized.
Here you will not find any gatekeeper like you have in the United States (Securities Exchange Commission), that is facilitated to regulate the issuance, marketing, and trading of all securities within its domain.
Regulation: The count of hacks from smart contract bugs or vulnerabilities is indeed increasing. The report states that 44 DeFi hacks stole $1.3 billion in user funds in 2021, which is up 160% from $500 million lost in 2020. The major reason for hacking is obviously centralization, which is caused by projects having one set of private keys instead of multi-signature wallets or DAOs.
Interoperability: On average, millions of users are using dApps. Most of the blockchains employ different consensus mechanisms and programming languages, and dApps on one platform can’t be easily ported to another blockchain. Despite the blockchain use, smart contracts that offer interoperability are going to be needed to increase the functionality for all users.
Scalability: Smart contracts require more computing resources and memory on the blockchain. Most blockchains limit the size of a transaction included in each block.
Role of Smart Contracts in DeFi (Decentralized Finance)
Several types of smart contracts serve different financial services and applications. The key types of smart contracts in DeFi include:
- Lending and borrowing contracts
- Decentralized exchange (DEX) contracts
- Yield farming contracts
- Insurance contracts
Smart contracts perform several roles in DeFi. A brief description of the roles are listed below. Check it out!
1. Enhanced security and trust
Smart contracts in DeFi can enhance the security and trust in financial interactions. Conventional financial systems often rely on centralized authorities and it is prone to fraud, censorship, or manipulation. Smart contracts are performed on a decentralized blockchain network, here all the transactions are transparent and cannot be changed. The immutable ensures that agreements are honored, considerable reduction of fraud, and providing a higher level of security for users.
2. Automated and efficient transactions
Manual interventions are removed and reducing the associated costs and delays, will result in the automation of complex financial transactions. This automation permits faster and more efficient processes, reducing paperwork, and streamlining operations in the DeFi ecosystem.
3. Eliminating counterparty risk
Counterparty risk is defined as the risk that one party in a transaction may default or act dishonestly. This was one of the concerns in traditional finance. Smart contract follows predetermined rules, transactions are made if and only if the specific conditions are met. Through this, the need to rely on trust between parties is eliminated. Thereby reducing the counterparty risk and ensuring a higher level of security and peace of mind for the participants.
4. Programmable and flexible financial instruments
Programmable financial instruments can be created with the support of smart contracts thereby offering a broad spectrum of possibilities for DeFi applications. Decentralized applications (dApps) can perform various activities such as lending, borrowing, decentralized exchanges, yield farming, derivatives, and others. Customization of programmable financial instruments can be done to cater to specific needs.
5. Decentralized governance and transparency
Using smart contracts token holders or community members can automate the decision-making process. Transparency is provided, and decentralized governance ensures that no single entity has excessive control.
6. Interoperability and composability
Interoperability and composability between different DeFi protocols and applications are enabled by smart contracts, which means, several decentralized applications can seamlessly interact with each other and permit the creation of complex financial systems and innovative use cases.