Blockchain was originally associated mainly with transferring digital value. Bitcoin showed that it is possible to send money over the internet without a bank or another central institution having to confirm every transaction. But blockchain can do more than just record who sent what to whom. It can also store and execute pre-programmed rules.

This is exactly where smart contracts come in: programs that run directly on a blockchain and carry out a defined action once pre-set conditions are met. They can, for example, transfer a token, swap digital assets, manage collateral for a loan or issue an NFT.

Thanks to smart contracts, blockchain grew from a technology designed mainly for transferring cryptocurrencies into an environment where entire applications can run. They are behind decentralized exchanges, DeFi, stablecoins, NFTs and tokenized assets.

What is a smart contract

The name smart contract can be a little misleading. It is not necessarily a contract in the legal sense, and it certainly is not a program that would be "smart" in the way artificial intelligence is.

At its core, a smart contract is a program stored on a blockchain that contains pre-defined rules and performs certain operations according to them.

On Ethereum, a smart contract has its own blockchain address, contains its code and also data representing its current state. It can, for example, hold cryptocurrencies or tokens, and users can interact with it through blockchain transactions. The contract then executes the function programmed into its code.

If condition A occurs → perform action B.

For example:

• If the user sends the required amount → issue them a token.
• If the value of the collateral falls below a set threshold → trigger liquidation.

A smart contract therefore does not try to understand the user's intent. It merely executes the rules it has been programmed with.

A smart contract as a vending machine

One of the simplest analogies for a smart contract is a vending machine. When we walk up to it, we do not have to negotiate with a shop assistant. We insert the right amount, choose a product, and the machine dispenses the goods according to its rules.

money + product selection = product dispensed

If we insert too little money, the condition is not met and the machine will not perform the requested operation. If the conditions are met, nobody else needs to manually decide whether we should get the goods.

A smart contract works in a similar way. The difference is that instead of a physical machine we have a program stored on a blockchain, and instead of a can of soda the result may be a cryptocurrency transfer, the issuance of a token or the execution of a financial operation.

A smart contract does not decide. It executes.

What smart contracts solve

In the traditional financial or commercial system we often need some form of intermediary.

Imagine a trade between two people who do not know each other. One is supposed to pay money and the other is then supposed to hand over a certain asset. A simple trust problem arises.

Who should fulfil their side of the deal first?

That is precisely why the conventional world has banks, exchanges, custodians, payment companies and other institutions that enforce the rules, hold funds and ensure that transactions are settled.

A smart contract makes it possible to move part of this role into a program.

Imagine, for instance, a swap of a digital asset for 1,000 USDC. The buyer deposits 1,000 USDC into the smart contract. The seller deposits the required digital asset. The smart contract verifies whether both conditions have been met. If they have, it sends the asset to the buyer and the USDC to the seller.

In such a case, neither side has to blindly trust that the other will actually honour its obligation after receiving the funds. The settlement rules are part of the program.

Of course, this does not mean that smart contracts have removed intermediaries entirely. But they can automate some activities that previously required a separate administrator or institution.

Ethereum and the programmable blockchain

Bitcoin supports a certain amount of programmable logic, but its main function remains the secure transfer and storage of digital value.

Ethereum expanded this idea considerably. Its blockchain was designed so that more general programs could run on it. Smart contracts on Ethereum can today be written in programming languages such as Solidity or Vyper, and once deployed they are executed by the Ethereum network.

For example, a user deposits ETH into a lending protocol, the smart contract calculates the value of the collateral, allows a stablecoin to be borrowed against it and then continuously checks whether the collateral still meets the required conditions.

It is precisely this programmability that created the foundation for a large part of today's ecosystem of decentralized applications.

Using smart contracts costs something

While a smart contract can automate part of a process, running it is not free.

Every operation performed by a blockchain requires a certain amount of computing resources. On Ethereum, the cost of this work is called gas.

So a user does not pay only for a plain ETH transfer. A fee is also paid when interacting with smart contracts. Deploying a new smart contract is itself a blockchain transaction and usually requires more gas than a simple cryptocurrency transfer.

That is why the cost of different operations can vary significantly. A simple token transfer may require less computational work than a complex operation in a decentralized finance application that interacts with several different smart contracts within a single transaction.

Higher costs and the limited capacity of the main network are among the reasons for the rise of Layer 2 networks, which allow many operations to be processed more efficiently and more cheaply.

What smart contracts made possible

Decentralized exchanges

On a conventional cryptocurrency exchange, the trading system is operated by a specific company. A decentralized exchange, or DEX, can manage part of this process through smart contracts.

A user connects their wallet, selects the token they want to swap and confirms the transaction. The smart contract then carries out the swap according to its rules and determines, for example:

• how the price is calculated,
• how many tokens the user receives,
• how high the fee is,
• how liquidity is handled,
• where the funds will be sent.

The swap itself therefore does not have to take place inside a database operated by a single exchange, but through rules recorded on the blockchain.

DeFi

The role of smart contracts is even more pronounced in decentralized finance, or DeFi. Here smart contracts can manage, for example:

• loans,
• crypto collateral,
• asset swaps,
• liquidity management,
• derivatives,
• reward payouts,
• some forms of staking.

With a crypto-backed loan, a smart contract can set the minimum value of the collateral and automatically begin liquidation if it falls below the set threshold. The rules therefore do not have to be checked manually by an employee of an institution.

Stablecoins

Smart contracts are also important for stablecoins. A token can be created via a smart contract, transferred between addresses or removed from circulation again.

In some more decentralized stablecoin systems, smart contracts additionally manage the crypto collateral and automatically check whether its value remains sufficient.

A stablecoin is an asset. A smart contract is one of the tools that can govern the rules of how it works.

NFT

NFTs are typically based on smart contracts too. The contract can define:

• how many NFTs exist,
• who owns a particular token,
• how it can be transferred,
• what identifying data is associated with it,
• what rules apply to it.

The image, music or other media itself does not have to be stored in full inside the smart contract. But the contract can serve as the blockchain record of ownership of the given token and of the rules for transferring it.

Asset tokenization

Smart contracts also matter for tokenization. Under certain conditions, a blockchain token can represent a share in another asset or a particular economic right. This could be, for example:

• a bond,
• a fund,
• a commodity,
• real estate,
• another financial instrument.

The smart contract can then govern things like token transfers, the permissions of individual users or how certain payments are distributed.

Here, however, it is important to distinguish between the blockchain token itself and the right it is supposed to represent. A smart contract can govern the token, but the legal relationship to the real-world asset still depends on how the specific product is structured and on the applicable rules.

Smart contracts are not only about cryptocurrencies

The principle of a smart contract can also be used outside purely cryptocurrency applications.

IBM describes smart contracts as a way of automating processes based on the logic of "if or when a certain condition occurs, perform a specific action". As possible uses it mentions, for example, releasing funds, registering events or triggering the next step in a workflow.

A similar principle can be applied in a supply chain, for instance. Imagine the shipment of certain goods. A system can record information about the individual stages of transport. Once delivery is confirmed, another process can start automatically, such as releasing a payment or changing the status of an order.

IBM gives examples of blockchain systems used to track pharmaceutical goods, manage relationships between suppliers and buyers, or in the field of international trade.

Smart contracts as digital LEGO

One of the most interesting properties of smart contracts is their ability to work together.

On a public blockchain, applications and smart contracts can interact with already deployed contracts and use their functions much like open software interfaces. This principle is known as composability.

The easiest way to picture it is to think of individual smart contracts as LEGO bricks. Each brick can perform a certain function. One manages a stablecoin. Another runs a decentralized exchange. A third provides loans. A fourth obtains price data.

The developer of a new application does not have to build all of these functions from scratch. They can use some existing smart contracts as building blocks.

Imagine, for example, an application for automated cryptocurrency portfolio management. It might:

• use a stablecoin created by another protocol,
• obtain an asset price from an oracle,
• swap a token via a decentralized exchange,
• then deposit the funds into another DeFi protocol.

All of this can happen through several interconnected smart contracts.

Composability is one of the reasons why the ecosystem of decentralized applications can grow so quickly.

But it has another side. If one application depends on several other smart contracts, a problem in one of them can spread further. The advantage of interconnectedness thus also becomes a new type of risk.

A smart contract cannot see into the real world

A smart contract is very good at working with information that exists directly on the blockchain. It can, for example, find out:

• how many tokens a given address owns,
• whether a particular transaction took place,
• how much money is held in another contract,
• what state a given blockchain application is in.

By default, however, it cannot find out what is happening off-chain. It does not know, for example:

• what the current price of gold is,
• whether it is raining today,
• who won a sports match,
• what the EUR/USD exchange rate is,
• whether a shipment actually arrived,
• whether a company fulfilled a certain obligation.

If a smart contract needs to work with data from outside the blockchain, it must obtain that data through other systems. This is exactly where oracles come in.

Oracles: the bridge between the blockchain and the outside world

An oracle supplies a smart contract with information that originates outside the blockchain.

Let us return to the lending application. A user deposits ETH worth 10,000 dollars as collateral and borrows a stablecoin against it. The smart contract knows how much ETH is stored in the system. But it does not automatically know how much one ETH is currently worth in dollars.

If it is to monitor the value of the collateral, it needs an external price feed. An oracle can provide it. Thanks to this, a smart contract can work with things like the prices of financial assets, the outcomes of events or other data originating outside the blockchain.

But this creates a new problem.

What if the oracle supplies an incorrect value?

A smart contract can be programmed perfectly and still perform the wrong action if it receives incorrect input data.

For example, an incorrect asset price may cause a lending system to liquidate a position that would not have been liquidated under normal circumstances.

This is often referred to as the oracle problem. The security of a system therefore depends not only on the smart contract itself, but also on the quality and reliability of the data it uses.

A smart contract does what is in the code

One of the biggest advantages of smart contracts is predictability: if a contract has firmly defined rules, it executes them without making decisions of its own. At the same time, this is one of their greatest weaknesses. The program does not know what the developer intended, only what they actually programmed.

That is why security is extremely important when developing smart contracts. These programs often manage real digital assets and a mistake can have immediate financial consequences. Testing, security review and an audit before the contract is deployed to the main network therefore play an important role.

The history of cryptocurrencies shows that a bug in a smart contract is not merely a theoretical problem.

One of the best-known cases was the The DAO project in 2016. A flaw in its smart contract was exploited to drain approximately 3.6 million ETH. The event then triggered a very difficult debate about whether and how Ethereum should respond to the incident, and ultimately contributed to the split of the network into Ethereum and Ethereum Classic.

This case demonstrated a very important principle. A blockchain can execute the rules of a smart contract correctly, but if the flaw is in the rules themselves, decentralization will not automatically fix it.

The technology can therefore remove part of the operational trust placed in an intermediary, but at the same time it increases the importance of the program being correct.

Immutability, upgrades and control

It is often said that once a smart contract has been deployed, it can no longer be changed.

The basic principle really is that code stored at a specific blockchain address is immutable by default. This helps build confidence that nobody can rewrite the rules without notice.

But it also has a downside. If a critical bug appears in a contract, it would not be possible to simply fix it the way we update an ordinary mobile app.

That is why various mechanisms for upgrading applications have emerged. The so-called proxy model, for instance, separates the part of the system the user interacts with from the program containing the current logic. Under certain conditions, developers can then deploy a new version of the logic without changing the main address used by users.

But this creates another trade-off. If someone can update the rules of the system, we need to know:

Who holds that authority?

• a single company,
• a single person,
• a group of developers,
• a DAO,
• a multisig.

A smart contract can therefore be technically built on a decentralized blockchain, yet some of its important parts may still depend on a relatively small group of people.

One way to reduce dependence on a single person or a single private key is multisig.

Multisig, short for multiple signature, requires several independent signatures to carry out a given action.

For example, a 3-of-5 configuration means that there are five authorized keys, but at least three must agree for an operation to go through.

Multisig is used, for instance, in managing funds or certain parts of a DAO. The advantage is that the loss or compromise of one key does not automatically mean losing control of the entire system.

At the same time, multisig is not a synonym for decentralization. If an important change is decided by, say, three people out of five, that is still a fairly small group.

With smart contracts it therefore makes sense to look not only at whether they use a blockchain, but also at who actually has the authority to change how they work.

This is one of the most common misconceptions.

An application can run on a decentralized blockchain and still contain a number of centralized elements:

• the web interface is operated by a single company,
• contract updates are controlled by a handful of administrators,
• data is supplied by a limited number of oracle services,
• the operator can pause certain functions,
• a particular key can change some parameters of the system.

It is therefore not accurate to say:

"It uses a smart contract, so it is decentralized."

The better question is:

"Which parts of the system are decentralized and which still require trust in specific people or infrastructure?"

The same principle applies to stablecoins, Layer 2 networks and other areas of the cryptocurrency market.

A smart contract is not automatically a legal contract

The word "contract" can create the impression that this is a legally binding agreement. But a smart contract is first and foremost a program.

It can carry out the terms of a particular agreement, but on its own it does not necessarily constitute a contract in the classic legal sense.

Advantages of smart contracts

Automation: Once the defined conditions are met, the program can carry out the next step without manual intervention.

Transparency: On public blockchains it is often possible to follow a smart contract's transactions and, in many cases, its published source code as well. Public code alone, however, does not mean that it is easy to assess whether it is correct.

Programmability: Smart contracts make it possible to create far more complex rules than an ordinary cryptocurrency transfer.

Composability: Individual contracts can be combined and used as building blocks for other applications.

Global availability: A public blockchain application can be accessible to users with a compatible wallet regardless of where they connect to the network from. In practice, however, access may be affected by the specific user interface, regulation or other services built around the smart contract itself.

What risks smart contracts carry

Risk of a bug in the code: If a contract manages real assets, even a minor programming error can have very serious financial consequences.

Oracle risk: A smart contract may be correct yet work with faulty external data.

Administrator risk: If a system can be upgraded or paused, it matters who controls those powers.

Risk from other smart contracts: Composability means applications can be interconnected. A problem in one protocol can affect a system that depends on it.

Blockchain risk: A smart contract also depends on the blockchain network it runs on, including its fees, availability and security properties.

User risk: Blockchain transactions tend to be difficult to reverse. A user may interact with a fraudulent contract, approve a dangerous transaction, grant a contract overly broad permission to handle their tokens or use a fake user interface.

The security of a smart contract therefore does not automatically mean the security of the entire path from the user all the way to the blockchain.

What to check before using a smart contract

An ordinary user will obviously not study the Solidity programming language before every transaction. Even so, there are a few simple questions that help to better understand an application's risk.

Who built the application? Is the development team known and does the project have a traceable history?

How long has the system been running? New technology can be interesting, but it also has a shorter track record of real-world operation behind it.

Have the smart contracts been audited? A security audit is no guarantee that there is no bug in the program, but it can uncover some significant risks.

Can the contract be updated? If so, who can make the change?

Is there an administrator key or a multisig? It is important to know who has the ability to change important parts of the system.

Does the application use an oracle? If so, how does it obtain external data?

What other protocols does it depend on? Connections to other smart contracts can bring benefits as well as additional dependencies.

What happens if something goes wrong? Does the system have a way to halt certain functions or to carry out a security update?

The more complex an application is, the more important it is to understand that its security is not determined by a single smart contract, but by the entire architecture around it.

Conclusion

At its core, a smart contract is a simple concept: a program stored on a blockchain receives a certain input, checks pre-defined rules and performs a specific action. It is precisely this idea that allowed blockchain to expand from transferring cryptocurrencies to financial applications, digital assets and automated processes.

At the same time, smart contracts do not mean that the need for trust or the presence of risk has disappeared from the digital world. Trust has only partly shifted. Instead of asking only "Can I trust the intermediary?", we also have to ask "Can I trust the code, the data it uses and the people who may be able to change how it works?"

So it is not enough to know that a given service "uses smart contracts". What matters more is understanding what the contract actually does, where it gets its information, who has control over it and what it depends on. Smart contracts are not automatically safe or decentralized, but they are one of the main building blocks of today's blockchain applications.

This text is for informational and educational purposes only and does not constitute investment advice. Crypto assets are volatile and you may lose the entire amount you invest.