How do smart contracts work and why do they matter?

When Ethereum went live for the first time in 2015, everybody in the crypto space celebrated its creation. Ethereum single-handedly popularized the concept of smart contracts among the crypto community. Unlike previous generation blockchain platforms where they were only used for cross-border transactions, Ethereum has native capabilities to process smart contracts. It was deemed revolutionary, and it has changed the world of cryptocurrency forever. 

But what are smart contracts, actually? And why do they matter? To understand how Ethereum and newer blockchain platforms work, one must really understand the mechanism of smart contracts.

The Automation Of Contract

In layman terms, a smart contract is basically a contract that’s enforced purely through codes. Everything is fully automated, and there’s no central entity that can reverse the execution. Once it’s deployed, the rules are hardcoded and the parties involved in the smart contract are forced to honor the outcome.

Think of it like this. Let’s use an example where John attempts to buy Ken’s house. In a traditional contract, there are a lot of things that can happen in the process. Ken can change his mind, Ken might not honor the agreement, and there might be some hidden fees that the real estate agent charges. There are too many uncertainties just for a single transaction.

But, with a smart contract agreement, it can be as simple as this “when John pays Ken a certain amount of ETH, John will receive the ownership of Ken’s house.” Once John makes the deposit to the smart contract, and it matches the conditions executed by the codes inside that smart contract, John will receive the ownership token of Ken’s house (assuming that ownership token is legally approved, of course).

There’s no manual approval, no hidden fees, no hidden terms, and conditions. Everything is straightforward and very direct. This is why smart contracts matter. When you get into a smart contract, you are forced to honor the conditions inside that smart contract. 

Here you cannot just sign the paper and walk away. You have to make a deposit before you trigger the conditions provided by the contract. Once you interact with the smart contract, you will get what you want instantly.

What Makes Smart Contracts Possible?

Smart contracts are processed by decentralized virtual machines. Let’s use Ethereum as our example since it’s the most popular smart contract platform at the moment. With Ethereum, the virtual machine is called Ethereum Virtual Machine (EVM). This EVM has one job, which is to execute scripts by using a worldwide network of public nodes. The EVM is Turing-complete.

Smart contract executions inside EVM require gas. The fees for the gas are paid by ETH, the native cryptocurrency of Ethereum blockchain. These smart contracts accomplish the written conditions as soon as the requirements are met. The whole mechanism is trustless as these smart contract executions are automatically picked and confirmed by the blockchain miners.

Smart contracts are publicly auditable and immutable. Once they are deployed to the blockchain, you can verify the scripts inside the contract by yourself. The conditions cannot be edited by the creator anymore. So, once you interact with a particular smart contract address, you already know the “what if” conditions and what you expect.

Nowadays, there are also other smart contract blockchain platforms. Apart from Ethereum, there are Tron, EOS, Cosmos Network, NEO, Cardano, Polkadot-based Edgeware, and others. Smart contracts can be written in different programming languages, such as Solidity or WebAssembly.

The Use Cases

You might be wondering, “but what are smart contracts actually used for?”, and this is where we need to talk about use cases. The biggest use case of smart contracts at the moment is still to exchange tokens.

For example, let’s say a company called XYZ wants to issue its own token called XYZ token. They issue this XYZ token on the Ethereum blockchain. They create a smart contract where you can deposit ETH to get their XYZ tokens. For the sake of example, 1 ETH = 10 XYZ token.

So, when you send 1 ETH to a particular smart contract address provided by this company, you will instantly receive 10 XYZ token as soon as your transaction is confirmed on the blockchain. The company does not need to manually send your XYZ token; the transactions are automatically honored.

Many companies use this token exchange feature for various occasions, such as Initial Coin Offering (ICO), Initial Exchange Offering (IEO), or even for DeFi protocol tokens. 

The true potential here is when there are more and more tokenized real-life assets on the blockchain. Nowadays, we already have some tokens that represent physical gold, real estate, or even company equity with 1-to-1 valuation and with legal support from some governments.

Imagine the potential when traders actually put these types of tokens into smart contracts. We can easily replicate traditional financial transactions without the need of any middle man, and everything will be publicly auditable. The potential is enormous.