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Smart Contracts: What They Are and How They Operate

How smart are smart contracts? Very. Here's a short explainer of what they are and what they do.

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Key Takeaways:
  • Smart contracts establish the terms of an agreement and are executed as code that runs on a blockchain network.
  • As the execution of the contract is recorded on a blockchain, there is an immutable, permanent record of the transaction.
  • Now, anyone can create and deploy a smart contract on a network, and with the code being publicly verifiable, anyone can look behind the curtain of the contract to see how it operates.
  • These contracts help to drive protocols that power everything from DeFi services to NFT deployment and gaming protocol.

What is a Smart Contract?

Here is an easy way to explain smart contracts: a smart contract is to the digital world what a paper contract is to the physical world – It establishes the terms of an agreement. The major difference is that with smart contracts, the terms are executed as code that runs on a blockchain network

Smart contracts are what enable developers to create decentralized applications (dApps) that are able to utilize the security, reliability, and accessibility of blockchain technology while at the same time offering expansive peer-to-peer functionality that spans multiple sectors from finance and insurance to gaming.  

Expanding upon the original premise of Bitcoin - the ability to send and receive money without a “trusted intermediary” - smart contracts make it possible to securely automate and decentralize practically any kind of deal or transaction, no matter the complexity. To top it off, the entire process is recorded on the blockchain, providing an immutable, permanent record of the transaction. 

Why are Smart Contracts Important?

Prior to smart contracts, blockchains mainly served as money transfer networks but didn’t really offer much in the way of additional functionality. Thanks to the integration of smart contracts, the cryptocurrency community has expanded into a thriving ecosystem of interconnected blockchains that host a multitude of different dApps that serve a variety of functions. 

So, what are smart contracts used for?  Smart contracts power everything from decentralized finance (DeFi) and supply chain tracking to non-fungible tokens and gaming protocols. As with any token that is transferred on the blockchain, all smart contract transactions are recorded on the blockchain and, in general, are unable to be reversed or changed.  

DeFi has perhaps been one of the most significant developments to arise from smart contract technology as it aims to transform the banking and financial industries, helping to bring banking to the masses and cut out the high-fee middlemen. 

Decentralized exchanges, lending and borrowing platforms, and stablecoin protocols all owe their existence to smart contract technology, which allows users to access these services from anywhere in the world without the need for a financial institution. 

How do Smart Contracts Work?

First proposed in the 1990s by a computer scientist and legal scholar named Nick Szabo, smart contracts were designed to automate virtually any type of exchange within the need for a human intermediary. 

Fast forward thirty years, and smart contracts now power some of the most popular cryptocurrency blockchain networks, including Ethereum – currently the dominant smart contract platform – Polkadot, Algorand, Tezos, BNB Smart Chain, and Solana. 

So, what are the benefits of smart contracts? The advancement of blockchain technology has made it so that virtually anyone can create and deploy a smart contract on a network with its code publicly verifiable. This helps to bring a new level of trust to the process as any interested party can look behind the curtain to see what exactly makes a smart contract tick. 

Some of the popular programming languages used to write smart contracts include Solidity, Web Assembly, and Michelson, and new ones are created with each passing year as the blockchain ecosystem advances in its development. 

Every ledger or node on a blockchain network stores a copy of all existing smart contracts and their current state alongside the blockchain and transaction data that gets recorded in each newly minted block.

Engaging with and executing smart contracts typically involves a transaction fee typically referred to as “gas,” which is commonly paid using the native currency of the blockchain that the smart contract is operating on. 

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