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Here’s what a crypto smart contract is and how it works

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One of the most interesting — and potentially most useful — benefits of many cryptocurrencies is the ability to have smart contracts built into them. A smart contract automatically executes once its conditions have been met. The potential uses for smart contracts could be immense, and they offer another interesting use case for blockchain technology.

What are crypto smart contracts and how do they work?

Smart contracts, also known as digital contracts, use blockchain technology across a network of computers to fulfill a preprogrammed contract. When the contract’s conditions have been met, the smart contract executes, sending a payment to one of the parties to the contract, as an example.

Smart contracts are appealing for a variety of reasons:

  • Trustless. Because the smart contract and its terms have been agreed to upfront, the smart contract can be executed via the blockchain without a third party.
  • Immutable. “For any contract to work, trust has to be established between the people [involved],” says David Pedrini, CEO at Flashloans, which uses decentralized finance, or DeFi, to offer loans. “But with smart contracts, the rules are enforced by mathematics and data, and cannot be altered by any of the participants.”
  • Saves time. Without the need for intermediaries, smart contracts can execute more quickly and with less human intervention.

Developers code these contracts, and then the contracts live on a blockchain. In many cases, the contracts are publicly visible, providing greater transparency into the contract’s contents.

To use a smart contract or interact with the blockchain, you’ll need to pay a fee using a native token. “Native tokens are the root cryptocurrency or asset that is then bought and sold,” says Nick Donarski, co-founder and chief technology officer of Ore System, which specializes in blockchain gaming.

Most smart contracts are written in a programming language called Solidity, according to Ryan Boder, core team lead at API3, a crypto technology company. “Solidity was created for Ethereum, the largest and most widely used blockchain for smart contracts.”

What smart contracts can be used for

Smart contracts can be used in a variety of different contexts, but the most straightforward usage may be one that you’re already familiar with: cryptocurrency.

“What we often think of as cryptocurrency is actually the most simple form of a smart contract,” Boder says. “Cryptocurrency is a smart contract where the use case is to send and receive money or, more accurately, tokens. In that sense, smart contracts are a generalization of cryptocurrency that enable more use cases than just sending tokens back and forth.”

Some other popular use cases for smart contracts include:

  • Enable transfer of digital assets. Those transferring ownership of digital assets such as NFTs are a natural use of smart contracts. “In this case, the right of a specific digital art piece is transferred under specific conditions or rules from one party to another,” says Felix Honigwachs, CEO of Xchange Monster, a Web3 platform for gamers.
  • Decentralized finance. Smart contracts enable developers to build financial applications that allow users to lend and borrow or trade securities, among other things.
  • Gaming. Developers can use smart contracts to provide access to their games, while users can trade in-game digital content to other users, among other examples.
  • Transfer and sale of real estate. Smart contracts could assist in streamlining the transfer of real estate from one party to another and even in fractionalizing real estate for investment.

“If you want to do more in a trustless environment than just send money back and forth, you need smart contracts,” API3’s Boder says.

Disadvantages of smart contracts

Despite the benefits, crypto-based smart contracts do present some downsides to be aware of:

  • Unalterable after purchase. “People need to understand that the underlying conditions of the smart contract will always be followed and cannot be altered after the purchase,” Honigwachs says. Though a contract being unalterable may be good most times, it can be a downside, too.
  • Security issues. “Smart contracts are like any other computer program, they are susceptible to security vulnerabilities that can impact users,” says Donarski, who points out that users may suffer financial losses as a result. “Malicious users and attackers have increased their targeting of crypto smart contracts because of the high payoff in the event a security vulnerability is exploitable.”
  • Limited powers. “People think that smart contracts are superpowers that can fix anything with ease,” says Dion Guillaume, global head of public relations and communication at Gate.io, a crypto-trading platform. He calls them “slow and not that smart” and says, “They are only good when dealing with situations that require a strictly objective answer.”
  • Potentially expensive. The price to create a smart contract depends a lot on the market environment and the cost to operate on a blockchain such as Ethereum. That price can fluctuate due to demand and the price of the underlying cryptocurrency itself.
  • Bad code. Smart contracts depend heavily on the person coding them, making that person a potential point of failure. “Should the programmer make a mistake when coding, he or she could leave contracts exposed to bugs that hackers can exploit,” Pedrini says.
  • May be publicly available. Smart contracts are available on a public blockchain, a fact that may not always be attractive to a contract’s parties. Users may not always want that contract to be public, depending on what’s being exchanged.
  • Not always trustworthy. Though smart contracts permit trustless transactions, that doesn’t mean you should always trust the contract. “As a user, you must determine which smart contracts you will use, and using the wrong one can be costly,” Boder says.

“Smart contracts are a game changer,” Boder says. “But the user experience and guardrails around smart contracts have a lot of room for improvement in order to be used by the masses. Today, they are mostly used by the web- and tech-savvy.”

Bottom line

Smart contracts that use the blockchain are in the early innings, but they should continue to grow in their capabilities, offering new functionality and greater security over time.

“As of now, we are just at the tip of the iceberg,” Guillaume says. “The base blockchains will get faster and better. As such, smart contracts will be more efficient and powerful than ever before.”

Written by
James Royal
Senior investing and wealth management reporter
Bankrate senior reporter James F. Royal, Ph.D., covers investing and wealth management. His work has been cited by CNBC, the Washington Post, The New York Times and more.
Edited by
Senior wealth editor