What Is a Smart Contract?

Even though smart contracts have only been around for about ten years, they’re already revolutionizing the way financial transactions are carried out online. By running on the blockchain, they cut out the middlemen and enable direct, automated deals between users. These contracts are secure, transparent, and immutable once they are created.

Even though smart contracts can be extraordinarily complex, the concept is actually rather simple. You don’t need to be a developer or coder to understand them. Let’s learn how smart contracts work.

A smart contract is basically a computer program stored on a blockchain. It runs automatically when certain predetermined conditions are met. When the contract is live, it cannot be changed (without completely taking over the entire blockchain), which makes it trustworthy and secure. However, they can still contain bugs that could make them vulnerable to hackers.

Ethereum is the most popular blockchain for smart contracts. Platforms like Uniswap (a crypto exchange) and OpenSea (an NFT marketplace) use this technology to run their services without a central authority.

Like any kind of sophisticated code, smart contracts are comprised of a handful of different components. Now let’s explore the conceptual elements of a smart contract, followed by the code-level components.

Conceptual Components of a Smart Contract

The conceptual, real-world elements explain how a smart contract works as a digital agreement. They are more architectural and not tied to specific lines of code.

Conceptual Component	Meaning
Agreement Terms	The business logic or rules that the contract follows (“if a buyer pays, release the item”)
Digital Signature	Proof of agreement using cryptographic signatures. Users sign transactions with their private keys, and the contract verifies them using their public addresses.
Contract Code	The logic behind the contract, written in a smart contract language like Solidity or Vyper.
Data Input (Oracles)	External data sources that feed off-chain information into the blockchain (e.g., stock prices, weather data)
Blockchain Ledger	The decentralized, tamper-proof database where the smart contract lives.
Trigger Events	Specific conditions that activate the contract’s logic.

Code-Level Components of a Smart Contract

Now that we’ve covered the big-picture concepts, it’s time to break down the actual code elements that make smart contracts work on platforms like Ethereum.

Variables (or Data Storage)

The variables are the contract’s building blocks. They store information like names, balances, and deadlines. For instance, a smart contract for crowdfunding can store how much money each person donated to the cause. A simplified version of a common Solidity pattern that’s used in smart contracts on Ethereum would look like this:

uint public goal = 100 ether;

mapping(address => uint) public contributions;

Functions

Functions are the actions that a smart contract can take. You can “call” a function to take an action, like sending money or updating a record. Let’s stick to the crowdfunding example. In it, there would be a function to accept donations and another one to check if the funding goal was reached:

function donate() public payable {

contributions[msg.sender] += msg.value; }

Events

Events in a smart contract act as signals. When something happens in the contract, like a donation in our example, the contract can trigger an event. The event will be logged on the blockchain and apps or websites can then show this activity in real time.

event DonationReceived(address donor, uint amount);

Modifiers

In a smart contract, the modifiers add the rules. They control how we can use certain functions. For instance, only the contract’s creator might be allowed to withdraw funds. A modifier works to enforce this rule. This is what it would look like:

modifier onlyOwner() {

require(msg.sender == owner); _; }

Constructors

The constructor runs only once when the contract is first deployed. It is usually used to set important values like the contract owner.

constructor() {

owner = msg.sender; }

Fallback Function

This special function is triggered when a contract is called with unknown data or functions. It helps the smart contract handle unexpected input.

fallback() external payable {

// Handle direct payments or unknown function calls }

Access Control

Smart contracts often include logic to restrict who can perform actions. This is usually paired with modifiers like onlyOwner.

require(msg.sender == owner);

Receive Function

The receive function is used specifically to receive Ether when no data is sent with the transaction.

receive() external payable {

// Accept ETH sent with no data }

Self-Destruct Function

Some contracts, but not all, include a selfdestruct() call that lets the contract delete itself from the blockchain. This can free up space and return any leftover Ether.

function kill() public {

require(msg.sender == owner);

selfdestruct(payable(owner)); }

How Do Smart Contracts Work?

Smart contracts run on a blockchain, like Ethereum. But, what does this actually mean? Let’s go through it step by step.

The contract is written in code

First, the developer writes the smart contract using a programming language like Solidity (used on Ethereum) or Rust (used on Solana). The code includes:

What the contract does
What conditions must be met
Who can interact with the contract
What happens when someone sends money or data

Think of this like writing down rules for a project, but in a form that a computer can read.

Note: Smart contracts aren’t perfect. Once they are deployed, they cannot be edited. If there is a bug in the code, it needs to be fixed before it is deployed to avoid compromising the smart contract. That’s why audits and testing are so important.

The contract is deployed on the blockchain

Once the code is ready, it gets uploaded to the blockchain. We call this deployment.

After it is deployed, the contract usually lives on the blockchain permanently. No one, not even the original creator, can change its code. It’s what makes smart contracts secure and tamper-proof.

However, contracts that include a special selfdestruct() function can delete themselves and return any leftover Ether. This makes them inaccessible, though they remain in the historical record of the network. Any contract without this specific function remains on the blockchain permanently.

When deployed, a smart contract will get its own address, just like users do. Anyone can interact with it by sending data or cryptocurrency to that address.

The contract listens for inputs

The smart contract won’t run constantly. It will wait for someone to trigger it by calling a function or sending a transaction. When this happens, it will check whether the pre-set conditions are right.

For instance, if the contract is for a lottery, it might check if the entry fee has been paid. If it’s for a sale, it might wait for a buyer to send the correct amount.

The contract is executed automatically

If all the necessary conditions are met in the previous step, the contract will be automatically executed.

Let’s say a freelancer finishes a gig. The client’s payment is already locked in the smart contract. Once the job is marked as complete, the contract will release the payment without the need for a bank or an accountant.

The result is being stored on the blockchain

When a smart contract runs, the outcome is automatically recorded on the blockchain. This means that anyone can see what happened. Anyone can see how much money was sent, which wallets interacted with the contract, and when it all happened.

This type of transparency is the core of blockchain technology. It helps build trust, especially for things like online marketplaces, voting systems, games, and financial apps.

Smart Contract Examples

Nick Szabo, the cryptographer who first proposed the idea of smart contracts in the 1990s, explained them as a vending machine where you put in your money, press the button, and the machine gives you a snack in return. A smart contract does essentially the same thing, but digitally.

To show how this idea works in practice, Ethereum has provided a sample smart contract written in Solidity, its main programming language. It simulates a digital vending machine that sells cupcakes. Here is what it looks like:

pragma solidity 0.8.7;

contract VendingMachine {

// Declare state variables of the contract

address public owner;

mapping (address => uint) public cupcakeBalances;

// When ‘VendingMachine’ contract is deployed:

// 1. set the deploying address as the owner of the contract

// 2. set the deployed smart contract’s cupcake balance to 100

constructor() {

owner = msg.sender;

cupcakeBalances[address(this)] = 100;

}

// Allow the owner to increase the smart contract’s cupcake balance

function refill(uint amount) public {

require(msg.sender == owner, “Only the owner can refill.”);

cupcakeBalances[address(this)] += amount;

}

// Allow anyone to purchase cupcakes

function purchase(uint amount) public payable {

require(msg.value >= amount * 1 ether, “You must pay at least 1 ETH per cupcake”);

require(cupcakeBalances[address(this)] >= amount, “Not enough cupcakes in stock to complete this purchase”);

cupcakeBalances[address(this)] -= amount;

cupcakeBalances[msg.sender] += amount;

}

Let’s break this down:

The contract starts with 100 cupcakes
Only the owner (the person who deployed the smart contract) can add more cupcakes
Anyone can buy cupcakes by sending 1 ETH per cupcake
Once paid, the contract will update the balances, just like the vending machine hands you the snack

This example is basic and a bit silly, but it shows how rules are enforced by the smart contract’s code, not people. There is no room for negotiations or delay.

Now, let’s look at something much bigger and more real.

A real-world example of how smart contracts work is Uniswap, a popular decentralized crypto exchange. Uniswap uses smart contracts to let people trade crypto tokens directly without a central exchange. When you swap the exchange, you are interacting with a smart contract that checks prices, moves tokens, and updates records. This all happens within seconds.

Here is how it works:

You connect your personal crypto wallet
You choose which token to trade
Behind the scenes, the smart contract calculates the exchange rate using its internal formula
You approve the trade, and the contract automatically swaps the tokens

All of this happens within seconds, and it is not just trading. The contract also handles liquidity pools (where the users deposit tokens and earn fees), price tracking, and transaction records, all saved directly to the blockchain.

Smart contracts are now being used in many industries, including:

NFT platforms like OpenSea use smart contracts to mint, list, and transfer digital assets like art.
Decentralized lending platforms like Aave and Compound allow users to lend and borrow crypto automatically, with the interest being handled by the contract.
Gaming platforms like Axie Infinity use them to power in-game economies and ownership of digital assets.
Insurance projects like Etherisc use them to automatically pay out claims, such as flight delays.

Benefits and Drawbacks of Smart Contracts

Smart contracts offer incredible functionality and security, but they are not perfect. That being said, let’s look at the major benefits and drawbacks.

Benefits of Smart Contracts

Efficiency

Since there is no middleman, tasks that once took days can now be done in seconds. Whether you want to transfer assets or execute legal contracts, this technology automates the process with minimal delay.

Trustless and transparent

There is no need to include a trusted third party or even the contract’s creator. As long as the conditions are met, the contract will execute automatically. Also, since Ethereum smart contracts live on a public blockchain, everyone can see and verify them.

Accuracy and automation

Smart contracts can eliminate a lot of human error. When the logic is set, it is followed precisely and consistently, which makes the outcomes more predictable and fair. However, there can still be errors in the code that could cause problems.

Immutability and security

A smart contract cannot be altered once it is deployed. This makes them secure from tampering. This is a big reason behind the growing smart contract adoption in industries like finance and supply chain.

However, developers can design upgradeable contracts using proxy patterns. By doing this, they can update the logic while keeping the data consistent. This is common in bigger DeFi projects.

upgrading a smart contract via proxy from Alchemy — Upgradeable smart contract diagram | Source: Alchemy

Drawbacks of Smart Contracts

Permanence

Immutability is a strength, but it is comes with some major downsides. If the contract has a bug in it, it is locked in. Some developers use proxy patterns to upgrade contracts, but this makes smart contract development more complex and many bugs simply can’t be fixed this way. Developers often have to fix the code and redeploy the contract.

To avoid costly mistakes, smart contracts should undergo thorough security audits. Well-known exploits like the DAO hack and reentrancy attacks show just how dangerous insecure smart contracts can be. A reentrancy vulnerability in DAO’s smart contract allowed an attacker to call the withdraw() function before the balance was updated and siphon off 3.6 million ETH (worth roughly $60 million at the time).

This incident ultimately led to Ethereum’s hard fork, splitting the chain into Ethereum (ETH) and Ethereum Classic (ETC).

Exploits can be costly

A smart contract is only as safe as the code it’s built on. Faulty logic or loopholes can sometimes be easily exploited. This can lead to losses in the millions, as has been seen in several DeFi attacks. For instance, in April 2023, Euler Finance, a DeFi lending protocol, lost nearly $200 million after an attacker exploited a vulnerability in its smart contract using a flash loan attack.

Legal and regulatory gaps

The gap between blockchain technology and traditional legal systems remains significant. Some see smart contracts as legally binding agreements, but they aren’t always recognized as such in court.

Gas fees

Every time a smart contract runs, users must pay a gas fee, which is a small amount of crypto that goes to network validators. Complex contracts can be expensive to use, especially during network congestion.

Not GDPR-friendly

Data stored in a smart contract cannot be deleted. This makes it problematic in jurisdictions like the European Union, where GDPR gives users the “right to be forgotten.”

The issue has already raised concerns among regulators. The European Parliament’s Blockchain and DLT Working Group has flagged this as a serious obstacle to blockchain adoption in Europe.

The Data Protection Authority for France (CNIL) issued guidance in 2018 stating that blockchain solutions aren’t fully GDPR-compliant unless they are carefully designed. They recommended minimizing personal data stored on-chain and using encryption or off-chain alternatives.

The Uniform Electronic Transactions Act (UETA) adds another major legal layer to consider. While it doesn’t address privacy, it gives electronic signatures and records like the ones in smart contracts the same legal standing as paper ones in most U.S. states. This helps smart contracts function without traditional legal frameworks, but it doesn’t resolve conflicts with regulations like GDPR.

The E-SIGN Act is a U.S. federal law passed in 2000. Like the UETA, it ensures that electronic signatures and records are legally valid and enforceable. E-SIGN applies across all U.S. states, even where UETA hasn’t been adopted yet.

The History of Smart Contracts Explained

The idea of smart contracts dates back to before blockchain technology even existed. The first person who came up with the idea to create smart contracts was Nick Szabo. The cryptographer came up with the term in 1994. He imagined contracts that could automatically execute rules without human input, much like a vending machine.

Szabo was fascinated by how law and technology intersect. He believed that if you could translate the logic of legal contracts into computer code, you could create self-executing agreements that cannot be tampered with.

“A smart contract is a set of promises, specified in digital form, including protocols within which the parties perform on these promises,” he wrote in his paper “Smart Contracts: Building Blocks for Digital Markets.”

In his papers, Szabo proposed many different potential use cases for smart contracts like digital cash, derivatives, and property rights. Little did he know, he was decades ahead of his time. Soon after, he developed the concept of BitGold, a decentralized digital currency system that many believe was a precursor to Bitcoin.

It’s important to note that while Szabo laid the theoretical foundation for Ethereum smart contracts and other programmable blockchains, he didn’t invent blockchain technology (unless he is secretly Satoshi Nakamoto). In the following video, you can hear Nick Szabo talk at the Smart Contract Symposium in 2016:

Even though his idea came early, it wasn’t until 2015, when Ethereum was launched, that it became a reality. Ethereum smart contracts introduced a platform where anyone could write and deploy code that automatically handled value and ownership.

The invention of smart contracts sparked a revolution in finance that few experts saw coming. For the first time ever, developers could create smart contracts that acted like decentralized apps, governing everything from lending platforms to digital art sales.

Over time, smart contracts evolved from simple coin swaps to complex systems that run entire protocols. Today, they are used for governance, managing billion-dollar treasuries, and much more. Such growth has powered a wave of innovation across sectors, laying the foundation for what we call “Web3.”

Most Important Use Cases of Smart Contracts

Smart contracts have countless applications these days. They are already reshaping many different industries, but especially finance. Here are some of the most popular smart contract applications these days:

Decentralized Finance (DeFi)

DeFi apps use smart contracts to let users borrow, lend, and trade assets without requiring centralized third parties like banks or other financial institutions. Platforms like Uniswap and Aave are powered entirely by smart contracts. The contracts replace banks and brokers. When users interact with a DeFi protocol, they are engaging with a smart contract’s terms, which means no paperwork and no approval delays. Once the conditions are met, the transaction is executed.

Since the logic is coded into the blockchain, smart contracts remove the need for trust between two parties. For instance, when you deposit collateral into a lending platform, a simple smart contract automatically determines your borrowing limit and interest rate based on the predetermined rules.

NFTs and Digital Ownership

Smart contracts are the backbone of non-fungible tokens (NFTs). An NFT is a digital token that proves ownership of a unique item like digital artwork, a music file, or even a domain name.

When you buy an NFT, the smart contract will verify ownership and record it permanently on the blockchain. This has transformed art, gaming, and collectibles, making digital ownership provable and easy to transfer.

Supply Chain and Logistics

Modern supply chains are extremely complex, global systems, but smart contracts are already starting to help. Smart contracts can be used to track goods from factory to shelf. They automatically confirm when items are being shipped, arrive, or meet the conditions at the storage. This improves transparency in the industry and reduces errors and delays.

For example, IBM and Maersk have used blockchain technology to log the journey of cargo in real-time. Smart contracts trigger updates or payments automatically when the goods reach their desination.

This is especially useful in industries like food and pharmaceuticals, where traceability is critical. The smart contract’s terms can include anything from quality checks or temperature data, and automatically reject shipments that don’t meet the criteria.

Clinical Trials and Healthcare

In healthcare, smart contracts are being used to manage clinical trial data, consent forms, and even insurance forms. Since the data in a smart contract is time-stamped, it is immutable and easier to audit.

Real Estate and Mortgages

Right now, most property deals are full of friction. They include lawyers, agents, and escrow services, all of which are often necessary to finalize a transaction and confirm ownership of the property. With smart contracts, these steps can all be automated. They can handle everything from escrow arrangements to ownership transfers once certain provisions like payment received or inspection passed are met.

Property sales and mortgage agreements can be turned into smart legal contracts, removing costly paperwork and ensuring fast transactions. This is still in early development, but some platforms are already tokenizing real estate, allowing users to invest in property through digital shares.

Insurance and Claims

Insurance companies have already begun testing smart contracts for auto and travel policies. For instance, a smart contract could pay out compensation automatically when a flight is delayed by more than 3 hours without the need for lengthy claim forms and processes.

Conclusion

Smart contracts are one of the most exciting inventions in blockchain and technology in general. They have completely changed how we trade, invest, and build applications on the blockchain.

They are not magic, though. Smart contracts are lines of code that follow their predetermined rules. As their adoption continues to grow, so does the need for better tools and safer practices, as well as clearer legal guidance.

FAQs

How do smart contracts function?

Smart contracts are programs that run when certain conditions are met. No one can stop or change them once they start.

Can smart contracts be changed after they are deployed?

Most of them cannot be changed once deployed. This is why, when you create a smart contract, you must make sure it is free of bugs and mistakes before you launch it. Some advanced smart contracts use patterns that allow upgrades, but they are more complex.

Are smart contracts legally binding?

This depends on the jurisdiction. Some countries consider smart legal contracts enforceable, especially if the terms are clear. Others still prioritize traditional legal contracts.

What's the best platform for smart contracts?

Ethereum is the most well-known platform for smart contract development at the moment. Other options include Solana, Polygon, and Avalanche.

Do I need to code to use a smart contract?

No. Many apps will allow you to use smart contracts with just your wallet and a few clicks. However, if you want to create a smart contract, you'll need to learn a language like Solidity.

What Is a Smart Contract?