Smart Contracts 101: History, Technology, Use Cases, and Risks

Our world runs on the backs of intermediaries, including agents, brokers, notaries, and escrow companies. Together, they help conduct legal deals and connect clients to the world of finance and law. Just imagine being able to complete all your transactions without the need for intermediaries: no additional fees and work, but in a much quicker and legal way.

Fortunately, we have technology today that makes such a future possible. There are smart contracts between two parties with predefined terms outlined in code. When both parties fulfill the terms, the deal is executed.

Blockchain-based smart contracts are transparent, irreversible (unless otherwise stated), and auditable. Today, smart contracts mostly power digital tokens and asset exchanges on Ethereum and other public chains, but they have the potential to expand offline and replace intermediaries by bringing dedicated technology instead of people. This would enable users to control their deals more effectively and save money.

A brief history of the technology

Smart contracts were invented by Nick Szabo, a co-founder of Ethereum who some believe to be Satoshi Nakamoto. The idea was to create a protocol to execute deals without an intermediary, but rather by using mathematical algorithms. Think of it as a vending machine: the machine ensures there are drinks, you choose one and pay money, and if both conditions are met, you automatically get the item you need.

The concept was first introduced in 1994, but there was no suitable environment to deploy it: smart contracts require a trustless, decentralized peer-to-peer network to function, without which they would be useless. With the invention of Bitcoin in 2009, the idea was possible to implement, but the network of the first cryptocurrency was too cumbersome for this goal. In 2015, Vitalik Buterin launched Ethereum with support for smart contracts — and that has changed the crypto market forever.

How can smart contracts be used?

Vending machines don’t really need smart contracts to run, but let’s consider an example of how the technology could assist us in real life. Suppose you want to rent out your apartment: you need to do a lot of paperwork and interact with people you don’t know. Alternatively, you can hire a realtor who will take care of this for you, but will also charge a commission.

Smart contracts eliminate the need to work with a third party: they automate the entire money flow. Once a potential tenant pays you money, they get the right to rent your apartment — not any time earlier. With this kind of condition, you don’t need to rely on a blind trust to find tenants. In addition, your smart contract allows you to set several additional rules, such as charging a penalty fee if the tenant pays you late or terminating the contract if they don’t pay on time.

Smart contracts have potentially limitless functionality. In real estate, they can help make deals when many people are involved — say, if you want to rent out a house with your friend, a smart contract would send you the profits according to your share. Beyond real estate rentals, smart contracts can be used in any sphere that involves value transfer, including mortgages, e-commerce, insurance, and voting.

How do smart contracts work?

Smart contracts depend on three elements to work: participants, the subject of the agreement, and the terms under which it will operate. Since the technology works on public-key cryptography and requires a trustless P2P network, blockchain is the only proper environment for smart contracts so far. The biggest blockchains that support smart contracts are Ethereum, Binance Smart Chain, Solana, Avalanche, and others.

In Ethereum, smart contracts are coded in the Solidity language that is compatible with many computational instructions. Every smart contract in the network has its own address that can be used to investigate or track activity in this contract. For instance, here is the address of the USDC-ETH liquidity pool on the Uniswap decentralized crypto exchange:

0x8ad599c3A0ff1De082011EFDDc58f1908eb6e6D8

According to this smart contract, if you send ETH to this pool, it will send you a certain amount of USDC tokens in return, and all of this will be handled automatically. This smart contract’s data can be seen on Uniswap or Etherscan.

This is how it should work in real life

In our example above, we showed how a smart contract can work in an offline context with real estate. Now, let’s look at how this should operate from the perspective of technology.

Suppose Bob wants to rent out his house to Alice. They write a smart contract that says “If Alice transfers $1k to Bob, she can move into the house next Monday.” Since the smart contract is written in an irreversible and immutable blockchain, no one can change these rules once they are agreed upon.

Using public keys, the blockchain confirms the identities of Alice and Bob. Once Alice sends the funds, the smart contract is activated, and Bob receives his money. Bob doesn’t have to remind Alice that she should pay, and Alice will know for sure that Bob won’t ask her to pay extra (and if he does, she’ll be able to prove with the public blockchain data that he is acting dishonestly). Transparency is the key advantage of smart contracts, besides the fact that both parties don’t have to pay fees to middlemen.

Smart contracts and blockchain-based DApps

One of the main Ethereum use cases today is decentralized applications — apps that look like any other ones but run on the blockchain via smart contracts. The top DApps today include decentralized exchanges where you can swap Ethereum-based tokens (Uniswap), borrowing and lending protocols (Aave, Compound), NFT marketplaces (OpenSea), and games (Illuvium, Sandbox).

Top Ethereum-based DApps according to DApp Radar

The critical difference of DApps compared to regular applications is that they run in a decentralized environment, not on centralized servers. Hence, they are not controlled by a single entity, and no party can arbitrarily change the rules upon which the app functions. Additionally, DApps allow users to own their tokens and game items, enabling them to execute irreversible transactions, ensuring greater control and involvement. All this is powered by smart contracts, and DApps remain their core use case to date.

Weaknesses of smart contracts

Smart contracts sound like the technology of the future that should be adopted right now, but there are a few drawbacks to be aware of.

First and foremost, smart contracts are known to be vulnerable. In 2020–2021, we’ve experienced a boom in decentralized finance with new protocols emerging every day. Each service is based on its own contract, but many of them were developed in a hurry and haven’t gone through an audit, which means there are critical vulnerabilities in some of the contracts that hackers use to compromise them and steal users’ funds.

Anyone can deploy a smart contract and attract millions of dollars — and such freedom is misused by many. Lack of regulation and rules make smart contracts some sort of today’s Wild West. The situation gets even trickier if we’re talking about technology used in the offline world — if an apartment is rented, you can control the money flow through the contract, but how do you ensure the keys are transferred and the apartment is in good condition? You won’t be able to settle case discrepancies in court until there is a legal framework for smart contracts.

The irreversibility of smart contract transactions is another potential risk. It’s good in terms of contract execution, but if funds are transferred by mistake, it will be harder than usual to return them.

Final word

A smart contract enables an intermediary-free, trustless value exchange between two or more parties: once the pre-set conditions are met by both parties, the deal is automatically executed without any human intervention. Today’s main use case of smart contracts is blockchain-based applications on Ethereum and other networks, but there is a potential to implement the technology in real life (for real estate, insurance, voting, and other domains). However, smart contracts remain vulnerable and poorly regulated, and these downsides need to be addressed so that this technology can be widely adopted.