What is a Smart Contract and How Does It Work?

Like all other contracts, a smart contract establishes the terms of an agreement.
Its main difference with a traditional contract is that the terms get executed as per the code running on the Ethereum blockchain. It allows developers to build apps that take advantage of blockchain security, reliability and accessibility and offer sophisticated peer-to-peer functionality at the same time.
And like all other traditional contracts, smart contracts also lay out their terms of deal or agreement. But rather than being created on paper sitting on a lawyer’s desk, smart contract terms get established and executed as codes running on the Ethereum Blockchain. And this is what makes them ‘smart’.
They use the basic idea behind Bitcoin – trading money without any middleman (such as a bank) to automate and decentralise any complex transaction. And since smart contracts run on the Ethereum blockchain, features like reliability and borderless accessibility are a given.

Why are smart contracts so important?

Developers can build a variety of decentralised applications and tokens with the help of smart contracts. Stored in a crypto blockchain like any other crypto transaction, they get used for everything, ranging from new financial tools to logistics and game experiences. And once any smart contract application gets added to the blockchain, it becomes difficult to reverse or change it.
Applications powered by smart contracts get referred to as ‘dapps’ or ‘decentralised applications. These include DeFi technology that aims to change the banking industry.
Cryptocurrency holders can engage in complex financial transactions via DeFi apps to take loans or insurance from anywhere in the world without banks taking any cut.

Here are some popular applications powered by smart contracts:


It is a decentralised exchange that enables users to trade a few types of cryptocurrencies, via smart contract, without any central authority setting the rates.


It is a platform that helps investors earn interest and borrowers to get a loan instantly via smart contracts without any middleman such as a bank.


It is a cryptocurrency pegged to the US dollar via smart contracts and is part of a new category of digital money known as stablecoins.

So how can you use these smart-contract powered tools?

For instance, you have some Ethereum that you would like to trade for USDC. You can begin the process by putting some of the Ethereum into a Uniswap wallet which automatically will find you the best interest rate using smart contracts and make the trade for you.
After that, you can put some of that USDC into, say, Compound, to lend to others and receive an algorithmically determined rate of interest. The best part is that you can do all of this without any middleman such as a bank.
But swapping currencies in traditional finance is not as easy. Most of the time, it is expensive and cumbersome. It is also pretty unsafe to loan out liquid assets to strangers across the globe. That is where smart contracts come in and simplify things. They make both the above scenarios doable without any risk and security concerns.

How do smart contracts work?

A computer scientist and lawyer called Nick Szabo proposed the concept of smart contracts in the 1990s by simply comparing a smart contract to a vending machine.
For instance, a vending machine that sells a soda can for a quarter will produce a drink and 75 cents in change if you put a dollar in it. Or it will prompt you to make another selection and get your dollar back if your selected drink is not available.
A smart contract is similar to this. A smart contract can automate any transaction virtually, similar to a soda machine that can automate sales without a human intermediary.
The most popular smart contract platform currently is Ethereum. But other cryptocurrency blockchains such as EOS, Neo, Tezos, Tron, Polkadot and Algorand can also run smart contracts. Another advantage of a smart contract is that anyone can create and deploy them to a blockchain.
Since the code is also transparent and verifiable by the public, the interested party can see the exact logic followed by the smart contract when it receives digital assets.
The code of every smart contract gets stored on the Ethereum Blockchain. That allows any interested party to inspect the contract’s code and verify its functionality.
A copy of all existing smart contracts and their current state is stored on each computer network on the blockchain with the transaction data.
When a user sends funds, the smart contract’s code gets executed by all the nodes in the network to reach a consensus about the outcome and the resulting flow of value.
That is how smart contracts run securely and enable users to make complex financial transactions with unknown entities without the involvement of any central authority. And to execute smart contracts on an Ethereum network, users have to pay a charge known as Gas fees.
It is not usually possible to alter smart contracts once they get deployed onto a blockchain. So even the person who creates them cannot bring about changes later on. However, there are exceptions to this rule.

Advantages of smart contracts

Using smart contracts can give you a lot of business advantages. Some of these are –

Cost efficiency

Smart contracts can eliminate several operational expenses and save a lot of resources, including the personnel needed to monitor the progress of a complex process.

Processing speed

The speed of business processes that run across multiple enterprises can be sped up and improved using smart contracts.


Smart contracts are performed automatically and reduce the need for a third party to manage transactions between businesses.


Smart contracts take advantage of Blockchain and other distributed ledger technologies to maintain a verifiable record of all the activities related to a complex process that cannot get changed later. That ensures that any potential for human error gets eliminated, and there is accuracy while executing the contracts.

Limitations of smart contracts

Since smart contracts cannot send HTTP requests, they cannot get information about real-world events. And relying on external information can jeopardise consensus (crucial for decentralisation and security). However, there are ways to get around this problem.
The maximum size of a smart contract should be 24KB, or it can run out of gas. This limit to its contract size is another disadvantage or limitation of a smart contract. But this issue can also get circumnavigated by using The Diamond Pattern.

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