Smart Contracts – The Secret Sauce of Blockchains

Smart contracts are the worker bees of blockchain technology. Most of the applications that run on blockchains – everything from financial exchanges to games – are decentralized applications (dapps) that are full of smart contracts, sometimes in the hundreds of thousands. These contracts automatically perform complex sets of transactions when certain conditions are met, allowing dapps to function.

You can think of them as cyber if/then statements. Some can be as simple as saying that if the price of a financial asset falls to a specified level, a decentralized lending protocol will liquidate a corresponding collateral position.

Here’s what investors need to know about smart contracts:

Smart contracts are not actually smart. While the name may bring to mind some type of AI-based sentient being, it is not accurate. Smart contracts cannot do anything on their own. They require external inputs, either from a person or data stream. Also, smart contracts do not have the ability to exercise discretion. Unlike a bank that performs a risk analysis before initiating a large wire transfer to see if an account might have been hacked, for example, a smart contract will just send it through, no questions asked. The contracts also cannot detect fat-finger mistakes that would be obvious to a human observer.

Many applications in industry. Smart contracts can often be associated with decentralized financial applications, but that is far from their only purpose. They can be found in applications as diverse as digital identity, real estate, pharmaceutical computing (such as for clinical trials), and metaverse and gaming.

An example in the healthcare system is the SAFE protocol, which gives medical professionals quick access to patient records. This project creates a unique identifier that is secured by the underlying blockchain, creating a traceable, instantly accessible and secure record, while preserving patient privacy. The owner of this identifier can use a smart contract to create a set of rules that govern who has access to the records, for how long and for what purpose.

As another example, the Rarible NFT marketplace uses smart contracts to help owners and creators of non-fungible tokens list assets, set prices, and execute the transactions when an asset is sold. For example, there is a specific contract that will prevent an asset from being transferred to the buyer’s wallet before payment is sent to the seller. With the multi-billion dollar NFT market projected to grow at nearly 10% a year from 2022-2026, this is making a real economic impact.

Smart contracts can be risky. There are many examples of these vulnerabilities being exploited in real life. A famous one is the 2015 DAO hack, where a single Austrian thief stole 3.6 million ether (worth $4.6 billion at today’s prices) from a venture investment platform built on top of EthereumETH
by manipulating smart contracts to siphon off funds. Recently, hackers stole $375 million worth of ether from a smart contract bridge, a type of platform used to transfer assets between blockchains.

Recovery can be difficult in such cases. Many times, aggrieved parties have little recourse but to plead with the attacker, sometimes via messages transmitted via blockchain, or rely on crypto-forensics firms to try to identify the bad guy.

Smart contracts are usually not legally enforceable. Despite the name, smart contracts do not have codified legal status on their own. This may change as they become more intertwined in traditional finance, new uses are developed in private versions of blockchains that are more comparable to today’s financial infrastructure (see below) and general industry knowledge of the technology grows. It is also important to note that in the United States there is no federal contract law. Instead, these issues are decided at the state level, which can lead to wide degrees of interpretation of how smart contracts apply. This is an area that needs further study.

Smart contracts can be public or private. While some blockchains are open to any developer or investor, others are permissioned – meaning access is restricted to certain parties. In other words, private firms continue to develop internal tools and smart contracts that can be customized depending on the use cases or needs of the customers. These private smart contracts enable the creation of proprietary tools for specific applications or clients.

Some uses for private smart contracts include 1) banks can share data with each other and between branches, 2) healthcare institutions that have access to a common (and trusted) record of patient data and 3) colleges and universities can document and share records with potential employers and other institutions for higher education. In all cases, the availability of reliable data benefits all participants.

Smart contracts allow blockchains to communicate with each other, enable blockchain firms to enter new businesses, and are set to play a key role in the maturation of the sector.