The world of crypto has been on a wild ride as of late, and that’s likely to continue for the foreseeable future. Of course, cryptocurrencies aren’t on their own here. The stock market has seen similar volatility, but all of this has made a lot of investors want to learn more about the underlying elements of crypto.
When you learn about cryptocurrency and the underlying technology, it puts you in a better position to assess the risks of your investments and make informed decisions.
Smart contracts are relevant to cryptocurrency, but they have potential other implications as well.
The following is a guide to smart contracts and how they work, in general, and in terms of crypto.
A smart contract is a set of programming codes that are stored on a blockchain. The codes are meant to carry out particular tasks only when predetermined conditions are met. Smart contracts are a way to automate the execution of agreements that are already established.
In this sense, smart contracts let all participants know about the eventual outcome of said agreement, but they eliminate the need for a third party.
All decentralized finance loan protocols utilize smart contracts for the execution of financial products.
Smart contracts are one of the foundational pieces of technology in the blockchain. The contracts are autonomous, transparent, and decentralized. They’re also not able to be changed or reversed once they’re deployed.
As is the case with traditional contracts, smart contracts are an agreement between two or possibly more parties. One party is offering something that has value to the other party, and then the offer is accepted.
Smart contracts are only different in that they’re self-executing code that carries out the agreement terms.
The code goes to an address on a blockchain as a transaction. Then, it’s verified by the consensus mechanism of the blockchain. When the transaction is included in a block, the smart contract isn’t reversible, and it’s initiated.
With smart contracts, there’s no need for intermediaries, and this reduces the expenses and simplifies negotiations.
The code is what defines the transaction mechanisms, and it’s the final arbiter for the terms.
How Do They Work?
A smart contract can be written in different program languages, which include Michelson, Solidarity, and Web Assembly. On the Ethereum network, a smart contract code is stored on the blockchain. Anyone who wants to can look at the code and current state for verification of functionality.
Every computer or node on the network stores a copy of the existing smart contracts, and their state, along with transaction and blockchain data.
When a user funds a smart contract, the code is then executed by all the nodes on the network to reach a consensus of outcomes.
Again, once a smart contract is deployed onto a blockchain, it can’t be altered even by the creator except in some rare situations.
What is DeFi?
A big part of understanding smart contracts comes down to understanding Decentralized Finance, also known as DeFi, which is a term for financial services that are on public blockchains, especially Ethereum.
DeFi allows you to do most of the things traditionally supported by a bank. For example, DeFi includes the ability to earn interest, borrow, buy insurance, trade assets, and lend. It doesn’t require paperwork, though, and it’s faster. As mentioned, it also doesn’t need a third party to be involved.
DeFi is peer-to-peer, which means between two people directly rather than being routed through a system that’s centralized.
DeFi takes the general concept of digital money like Bitcoin and then expands on it from there. It’s like a digital alternative to all of Wall Street without the costs that would otherwise be associated with it.
The hope or objective of DeFi is the provision of a free and open financial market with accessibility available to anyone who has a connection to the internet.
You don’t have to provide your name or personally identifiable information, and it’s flexible. You can move assets whenever you want without waiting for long transfers or paying fees.
Particular ways people are currently using DeFi include:
- Lending—when you lend your crypto, you can earn rewards and interests every minute as opposed to once a month.
- Loans—you can get a loan without filling out paperwork. This includes flash loans that are very short-term and aren’t offered by traditional banks and financial institutions.
- Trading—you can make peer-to-peer trades of assets like buying and selling stocks without the need for a brokerage.
- Savings—with DeFi, you have the opportunity to put your crypto into savings accounts that earn higher interest rates than what’s available from banks.
- Buying derivatives—You can make bets both short and long-term on assets, which is kind of like the cryptocurrency version of futures contracts or stock options.
The entire building block of DeFi is the smart contract.
Benefits of DeFi
Benefits of DeFi for individuals can include more security, lower costs, more service offerings, and the option to earn higher income on your crypto holdings.
For crypto investors, one of the most popular benefits right now is the ability to generate income.
Crypto staking is an example of earning income on your holdings. With crypto staking, coin owners can help validate transactions as part of what’s known as yield farming. With bank interest rates still low, there’s an appeal here.
If you have crypto assets, no matter who you are, you can provide them as liquidity or loans through yield farming. Then, you are paid with fees and interest, earning you passive income.
As a crypto owner, you can farm yield by providing liquidity in a coin exchange, lending peer-to-peer to borrowers through smart contracts or borrowing against holdings, and then farming the borrowed coins. You can also stake in a proof-of-stake coin like Ethereum.
Downsides of DeFi
While DeFi has some pretty compelling benefits, it’s not without risks and downsides, which is true of anything in finance or technology. Downsides of DeFi can include:
- DeFi is more complex to navigate for people who are new to it. There are so many applications and opportunities, and it can be confusing to figure out how to make sense of all of it initially. For example, to even begin participating in DeFi, you would have to move your money from an exchange into a noncustodial wallet.
- There are scams. If you see something advertising a yield that appears too good to be true, it might be.
- Crypto coins can be stolen, particularly when there are coding vulnerabilities in dApps. Your funds can be lost, and then the team behind the project has to decide how or even if they’ll compensate someone who loses funds.
- There’s a gas fee that has to be paid when you interact with smart contracts. A gas fee is like a token that makes machines run. There are steps along the way that can increase the costs, and that means you could end up paying hundreds in gas fees.
- Yield farming can reduce some of the downsides in cryptocurrency, which is highly volatile, but still, as we’ve seen recently, there can be massive fluctuations.
The Importance of Smart Contracts
Smart contracts let developers build apps and tokens used in so many ways, from not only financial tools but also games and logistics.
Particular implications include USDC. USDC is a cryptocurrency that’s pegged by a smart contract to the US dollar. This means that one USD is worth one dollar. This is part of a category of digital money that’s relatively new, known as stablecoins.
The real importance of smart contracts is in the ability to eliminate the need for expensive, time-consuming methods of swapping currencies or making other financial transactions.
Another potential implication for smart contracts in the future would be voting. Using blockchain as part of the voting process could help with some of the major problems that can otherwise occur. With smart contracts, there are certain terms and conditions that are set in the contract. No voter would have the ability to vote from a digital identity that wasn’t their own.
Every vote would be registered on a blockchain network, and then the counts would be tallied without a third party or the need for any manual process. Every ID gets one vote, and the validation is from the blockchain network users.
With a smart contract, there would be the ability to add and remove members and change voting rules.
A somewhat new concept within crypto is insurance policies. The use of insurance can help users protect digital assets.
Most decentralized financial insurance protocols use what’s called a Decentralized Autonomous Organization structure. That means that insurance companies utilize a pool of decentralized coverage providers that offer insurance for custodial and collateral services.
When there’s insurance coverage from crypto lending firms, it protects against security breaches and other similar outcomes.
Overall, there are likely to be ever-increasing implications and uses for smart contracts and DeFi in general as we go forward.