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Smart contracts are the worker bees of blockchain technology. Most of the programs that run on blockchains–ranging from financial exchanges to games–are decentralized applications (dapps) that are full of smart contracts, sometimes numbering in the hundreds of thousands. These contracts automatically execute complex sets of transactions when certain conditions are met, allowing the dapps to function.
You can think of them as cyber if/then statements. Some can be as simple as saying that if the price of a financial asset drops to a specified level, then a decentralized lending protocol will liquidate a corresponding collateral position.
Here is what investors need to know about smart contracts:
Smart Contracts Are Not Actually Smart. Although the name might bring to mind some type of A.I.-based sentient being, that is not accurate. Smart contracts cannot do anything on their own. They require external inputs, either from a person or data feed. What is more, smart contracts do not have the ability to exercise discretion. Unlike a bank that performs a risk analysis before initiating a large wire transfer to see if an account may have been hacked, for instance, a smart contract will just send it through, no questions asked. The contracts also cannot detect fat-fingered errors that would be obvious to a human observer.
Numerous Industry Uses. Smart contracts might be commonly associated with decentralized finance applications, but that is far from their only purpose. They can be found in applications as diverse as digital identity, real estate, pharmaceutical data management (such as for clinical trials), and the metaverse and gaming.
One example in healthcare is the SAFE protocol, which allows medical professionals rapid access to patient healthcare records. This project creates a unique identifier that is secured by the underlying blockchain, creating a traceable, instantaneously accessible and secure record, while also preserving patient privacy. The owner of that identifier can use a smart contract to create a set of rules governing who can access the records, for how long and for what purpose.
As another example, the Rarible NFT marketplace uses smart contracts to help non-fungible-token owners and creators list assets, set prices and carry out the transactions when an asset is sold. For instance, there is a specific contract that will prevent an asset from being transferred to the purchaser’s wallet before payment is sent to the seller. With the multi-billion dollar NFT market forecasted to grow by nearly 10% a year from 2022-26, this translates into real economic impact.
Smart Contracts Can Be Risky. There are plenty of examples of these vulnerabilities being taken advantage of in real life. A famous one is the 2015 DAO hack, where a single Austrian thief stole 3.6 million ether (worth $4.6 billion at today’s prices) from an venture investment platform built on top of Ethereum
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Recovery can be difficult in such cases. Many times,aggrieved parties have little recourse beyond pleading with the attacker, sometimes via messages transmitted via blockchain, or relying on crypto forensics firms to try to identify the miscreant.
Smart Contracts Are Usually Not Legally Enforceable. Despite the name, smart contracts do not have codified legal standing by themselves. This could change as they become more intertwined in traditional finance, new uses develop in private versions of blockchains that are more comparable to today’s financial infrastructure (see below) and general industry knowledge of the technology grows. It is also important to note that in the U.S. there is no federal contract law. Instead these issues are decided at the state level, which can lead to wide degrees of interpretation regarding how smart contracts apply. This is an area in need of further study.
Smart Contracts Can Be Public Or Private. While some blockchains are open to any developer or investor, others are permissioned–meaning that access is restricted to certain parties. In other words, private firms continue to develop in-house tools and smart contracts that can be customized depending on the use cases or needs of clients. Those private smart contracts allow for the creation of proprietary tools for specific uses or clients.
Some uses for private smart contracts include 1) banks being able to share data with each other and between branches, 2) healthcare institutions having access to a common (and trustworthy) record of patient data and 3) colleges and universities being able to document and share records with potential employers and other institutions of higher education. In every instance, the availability of trustworthy data delivers benefits to all participants.
Smart contracts allow blockchains to communicate with each other, enable blockchain firms to enter into new businesses, and are set to play a key role in the maturation of the sector.