Learn about crypto
Smart contracts: real-world uses and limitations
Smart contracts can be simple, like a Bitcoin payment layer. Or they can be complex, like a decentralized app running on the Ethereum blockchain. In their most basic form, they are programmed contracts that trigger automatically when their outlined conditions are met.
Smart contracts are designed to take the traditional intermediaries that help us form binding agreements in the real world and replace them with code. The concept of a smart contract predates Bitcoin. They were first outlined by cryptographer Nick Szabo back in 1996, in an article titled Smart Contracts: Building Blocks for Digital Markets.
Per his definition, a smart contract is a “set of promises, specified in digital form, including protocols within which the parties perform on these promises.” Or, as Szabo referred to them in simpler terms, think of a vending machine where “money + snack selection = snack dispensed”.
How clever should a smart contract be?
The Ethereum blockchain tends to be most commonly associated with smart contracts. It is also home to ERC-20: a technical standard that allows new tokens to easily be created on the Ethereum chain. Many other blockchains, however, are also attempting to position themselves as leading platforms for creating smart contracts.
Even Bitcoin, designed to primarily serve as a decentralized platform for handling financial transactions, can host smart contracts — albeit fairly simple ones. Smart contracts on the Bitcoin blockchain typically use programming languages like Script to carry out specific conditional actions. One well-known example is the Lightning Network, a second-layer payment network that leverages smart contracts to trigger settlement on-chain. Smart contracts built on Bitcoin are generally characterized by simplicity, which tends to make them robust yet slower to develop.
Ethereum, however, was specifically designed to enable decentralized applications (dApps) and smart contracts. Its use of flexible programming languages, such as Solidity, has made it an extremely popular choice for developers who are looking to create applications that operate directly on the Ethereum network.
How are smart contracts being used today?
Today, some of the largest digital assets by market cap are built around ERC-20 token contracts. Sites like Etherscan.io allow you to view all digital tokens that leverage this standard.
Smart contracts enable decentralized finance (DeFi), which currently accounts for its most significant and widespread use cases. These projects allow users access to the types of financial services that you would typically expect a bank or trading platform to provide — without relying on the financial institutions themselves.
In many of these projects, users and institutions intentionally lock away their assets to provide liquidity or serve as a collateral. They are rewarded with the ability to receive interest on their holdings or take out loans. As of press time, a total of more than $62 billion USD worth of digital assets is purportedly locked away in DeFi projects that facilitate services such as decentralized lending and trading.
Decentralized exchanges are currently one of the strongest practical uses for smart contracts. Most cryptocurrencies are still purchased from exchanges owned by companies that place fees and limits on investor behaviors. On a decentralized exchange, however, smart contracts are instead used to automatically allow people to purchase and trade digital assets. Their liquidity is often sourced from users who willingly lock away some of their own holdings in order to receive interest.
Behind the scenes, decentralized exchanges often comprise two smart contracts and a front-end user interface. They allow users to swap specific coins or tokens without the involvement of any third party. Essentially, they operate as peer-to-peer ‘vending machines’ that enable users to convert digital assets without needing to rely on a centralized provider such as an exchange or trading desk.
Smart contracts are also currently being used to try and redefine how we measure audience attention and user data. For instance, one token built on the Ethereum blockchain makes use of smart contracts in order to pay users for watching ads and provides revenue directly to publishers. This type of application shows how smart contracts may help undermine intrusive centralized platforms such as Facebook Ads and Google Adsense.
Other tokens are attempting to use smart contracts to coordinate decentralized data storage and file sharing. They aim to serve as alternatives to centralized file storage solutions that are often criticized for a lack of transparency and inability to match the changing needs of consumers. At the current point in time, however, none of these projects have yet succeeded at creating a widely-adopted solution.
Overcoming the limitations of smart contracts
Smart contracts are often praised as one of the defining features of the cryptocurrency movement, but placing them in real world contexts can be challenging. They are currently most often used to handle on-chain events and enable decentralized finance services.
However, the emergence of decentralized “oracle networks” allows blockchains to interact with off-chain information. This means projects could feed blockchains data from the real world such as financial information, APIs, Internet of things (IoT) data, and more. This could, in theory, allow smart contracts to expand beyond the cryptocurrency industry.
An initial use of oracles can be found in peer-to-peer betting markets. Since oracles are able to fetch information from outside the blockchain, users have been able to bet on the outcome of a football game, the weather, or just about anything else through decentralized gambling apps. As this technology reaches maturity, smart contracts could enable agreements between peers in the real world as well, and even register the delivery of physical goods using RFID sensors.
Smart contracts are becoming more refined
As for the development of smart contracts, new blockchains are frequently emerging in an attempt to overcome current limitations such as high resource demands. With the rising popularity of some of these chains, we are also seeing an increasing number of projects become blockchain-agnostic. This means that some leading tokens are compatible with other blockchains in addition to the Ethereum network, and are essentially hedging their bets should new chains prove more secure and less resource exhaustive.
When it comes to Bitcoin, its OP_Return feature has long been one of the easiest ways to create and fulfill a contract for the average user, and peer-to-peer exchanges are able to apply Bitcoin’s native multisignature capabilities to secure traded funds. These contracts are robust, but extremely limited. The types of complex DeFi projects seen on chains designed to host smart contracts, like Ethereum, are currently out of reach. In the future, Bitcoin’s contracts on the Lightning Network using RGB could be one way to expand its smart contract capabilities without compromising the network’s resilience.
Where do we go from here?
Significant hurdles currently stand in the way of true smart contract adoption. Despite drumming up a lot of hype, poorly-coded contracts and overzealous promises have previously resulted in multi-million dollar losses for users. Smart contracts programmed on Ethereum and similar chains are able to be much more ambitious than their Bitcoin counterparts. However, this can come at the cost of projects being heavily centralized or negatively impacting the network’s performance as a consequence of reaching the market long before they are ready.
Overall, the ability to extend smart contracts beyond the context of cryptocurrencies could challenge the need for intermediaries in a wide variety of other industries. Trust can often prove to be a scarce resource in the world today, and having a way to replace intermediaries with reliable and transparent programs would be extremely lucrative. For now, however, smart contracts are most equipped for use in the multi-billion dollar world of decentralized finance.
