What Are Smart Contracts and Why Are They Important for Ethereum?

Smart contracts on Ethereum are self-executing programmes that enable trustless and decentralised agreements. Here’s how they work.

What Are Smart Contracts?

A good metaphor of smart contracts is a vending machine — it functions according to preset rules and can automatically complete transactions. A smart contract is a computer programme that lives on a blockchain, like Ethereum, and automatically executes an agreement when certain predefined conditions are met. It’s like a digital agreement that enforces itself without needing a middleman monitoring the transaction.

Key characteristics of smart contracts include:

• Automated: No human intervention needed once they’re set up.
  
• Immutable: Smart contracts cannot be altered once set.
  
• Transparent: Anyone can see a smart contract’s code and rules.
  
• Decentralised: They are used and monitored by nodes that collectively verify transactions.
   
• Secure: Smart contracts run on a blockchain, which makes them very difficult to tamper with.
  
• Instant: They execute transactions immediately when conditions are met.

Did Ethereum Invent Smart Contracts?

Though the Ethereum Foundation did not invent smart contracts, Ethereum was developed to use smart contracts on a blockchain network. ​​The concept of smart contracts was originally proposed by Nick Szabo, a computer scientist and cryptographer, back in 1994 — well before blockchain technology even existed.

Szabo described smart contracts as computerised transaction protocols that execute the terms of a contract. His vision was to create a way to digitally facilitate, verify, or enforce the negotiation or performance of a contract without centralised intermediaries like lawyers or banks. He used the simple example of a vending machine that we mentioned above to illustrate the concept: the machine automatically checks if enough money has been inserted, and if so, releases the selected product. 

Szabo already conceptualised smart contracts in the 1990s, but it wasn’t until the creation of Ethereum in 2015 by Vitalik Buterin that helped revolutionise smart contracts. Ethereum was specifically designed to support complex, programmable smart contracts, turning Szabo’s theoretical concept into a working technological innovation.

Some people have speculated that Szabo might be Satoshi Nakamoto, the anonymous creator of Bitcoin, which he has consistently denied. He is, however, widely recognised as the original visionary of smart contracts for decades.

How Do Smart Contracts Work on Ethereum?

A smart contract on Ethereum is basically a piece of code written in programming languages like Solidity. Imagine Ethereum as a giant, decentralised computer that’s running on thousands of computers around the world. Each of these computers, called nodes, keeps a complete copy of the blockchain data and a current ledger of transactions that run on each contract. This is the essence of decentralisation — no single person controls the contract: It runs based on its code, verified by the entire Ethereum network.

There are two steps in the smart contract process: creation and execution. Developers create smart contracts by writing the contract’s code to define what it should do and paying gas (a transaction fee in ETH) to deploy the contract. Anyone can then interact with the contract by sending a transaction. If we stick with the digital vending machine example originally used by Szabo, the smart contract could:

• Know the price of each item
• Check if enough money was sent
• Automatically dispense the item if payment is correct
• Return change if too much money was sent
• Prevent selling items if they’re out of stock

How Are Smart Contracts Used?

Smart contracts are being used across numerous industries to automate and secure complex transactions, including DeFi, insurance, and real estate. 

DeFi

In DeFi, smart contracts power lending platforms like Aave, where users can borrow and lend cryptocurrencies without banks, and interest rates and collateral requirements are enforced by code. 

Supply Chain Management

In supply chain management, companies like Walmart use smart contracts to track food products from farm to store, automatically verifying each step of the journey and instantly recording provenance data. 

Insurance

Insurance companies are implementing smart contracts to automatically process claims when predefined conditions are met, such as flight delays or natural disaster damages, reducing paperwork and claim-processing time. 

Real Estate

Real estate platforms are using smart contracts to facilitate fractional property ownership, allowing investors to buy and trade tokens representing partial ownership of physical properties. 

Gaming and NFTs

In gaming and digital collectibles, smart contracts are used to manage the creation, ownership, and trading of unique digital assets, including NFTs, ensuring authenticity and scarcity. 

Governance

Voting systems in blockchain governance are also exploring smart contracts to create tamper-proof, transparent election processes, where each vote can be independently verified without compromising voter anonymity.

Use Case: Real-World Assets (RWAs) and Smart Contracts

One prominent example of smart contract use for real-world assets (RWAs) is Centrifuge, a blockchain platform specialising in tokenising RWAs. Another notable company is Securitize, which has tokenised venture capital and private equity funds using Ethereum-based smart contracts. They’ve helped convert millions of dollars in traditional assets into blockchain-based tokens that can be traded more efficiently.

Conclusion: The Future of Smart Contracts on Ethereum

Smart contracts are a transformative innovation that has elevated Ethereum beyond a simple cryptocurrency platform into a robust, programmable blockchain ecosystem. By enabling trustless, automated, and decentralised agreements, smart contracts are reshaping industries, from finance and supply chains to real estate and gaming. Their versatility and security have made them a cornerstone of blockchain technology, enabling the tokenisation of real-world assets and fostering a new era of efficiency and transparency.

However, as with any technology, smart contracts come with challenges, including immutability and governance complexities. Developers and communities continue to innovate solutions to enhance flexibility while maintaining security and decentralisation.

As Ethereum evolves, the potential applications of smart contracts will only grow, unlocking new possibilities for businesses and individuals alike. Understanding the role and functionality of smart contracts is key to grasping the transformative power of blockchain technology.

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