Smart Contracts in DeFi Simplified For Beginners

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Last updated on April 22nd, 2023 at 09:16 pm

The concept of smart contracts has recently gained wide recognition and is described as the pillar of blockchain technology and the bedrock of Decentralized Finance (DeFi). Their widespread use in almost all well-known decentralized applications contributes to this.

However, to be able to operate and utilize smart contracts, it is essential to understand how exactly they work, how secure they are, and the important utilities they provide to the DeFi community.

Therefore, this article aims to introduce beginners to the concept of smart contracts while also adding to the knowledge of DeFi experts.

To get started, we must define key terminologies.

Contracts

A contract is simply an agreement between two parties on terms they both agree to and binding on them.

A contract, in modern times, has now gone beyond being a mere agreement between two people due to the introduction of new laws and systems. It includes other features like warranties and clauses primarily designed to protect both parties from unexpected events during the transaction.

DeFi

Decentralized Finance (DeFi) is a financial technology based on cryptocurrencies and the Blockchain. Unlike traditional financial institutions, it eliminates the need for third parties and centralized institutions from financial transactions.

As the name implies, it involves creating finance systems independent of centralized platforms like banks and the baggages attached to them. It is pushing for systems that give financial power back to the individual. (In a previous DeFi Planet article, we explained and gave a proper introduction for a beginner.)

Undergirding a successful financial transaction is a contract between the parties involved. DeFi obviously does with the traditional methods and therefore uses different kinds of contracts. It uses smart contracts.

What makes contracts in DeFi smart?

Smart contracts are an advanced type of contract that utilizes blockchain technology. The term “smart” refers to how efficiently they improve the traditional contracting process and how they can self-execute in real-life situations.

Essentially, a smart contract is an agreement between two parties that occurs and is recorded on a blockchain. The most appealing aspect of these contracts is their ability to be self-executing, secure, and free from the need for intermediaries such as lawyers or banks.

Moreover, they are able to eliminate counterparty risk by enabling users to check their balances at any time and ensure that no changes have been made to their balances without mutual consent.

Nature of Smart Contracts

Smart contracts are computer protocols composed of software code that verify and enforce actions related to the terms agreed upon by a user. They are designed to execute the agreed-upon terms automatically on the Blockchain.

Smart contracts enable trustlessness and provide credibility in the transactions performed on the Blockchain by removing the need for third parties. Additionally, smart contract transactions are irreversible and easily trackable.

Smart contract software code is typically written in various programming languages, with Solidity being the most widely used. Solidity is the programming language used by Ethereum, the platform that invented smart contracts.

A Brief History and How Smart Contracts Work With Blockchain

Smart contracts were first introduced by Nick Szabo, a computer scientist also known as the “Father of Smart Contracts,” in 1994. Szabo created a virtual currency called “Bit Gold” in 1998, long before Bitcoin was introduced. He defined smart contracts as “computerized transaction protocols that execute terms of a contract.” He aimed to improve the functionality of electronic transaction methods like point of sale (POS) in the digital space.

In modern times, smart contracts operate on the Blockchain, where every node (i.e., computer or device attached to the network) can validate actions using consensus mechanisms like Proof of Work or Proof of Stake. The contracts are deterministic, making them more trustworthy, safe, and accurate. They provide proof of validity without the need for trust and ensure transparency on the publicly distributed ledger of the Blockchain.

A great example of how smart contracts work with the Blockchain is the sale of non-fungible tokens (NFTs). NFTs are essentially smart contracts between two parties. They allow artists to sell digital representations of their work to collectors. The NFTs provide the creator’s “signature of authenticity” to the buyer.

Traditionally, it may be challenging for artists to prove ownership of their artworks, as copies (and exact replicas) of their work may be in circulation. However, with the Blockchain, the entire sales history of the NFT can be recorded digitally and published on public ledgers, making ownership of the art clear and indisputable. Even though the art may still be copied, the owner of the NFT will always be the actual owner, as a public record available on the Blockchain lends to their claim.

How Individuals Can Use Smart Contracts

Smart contracts have become increasingly popular in recent years, as they offer a highly secure and self-executing way to automate transactions. This trustless execution of coded agreements makes them a valuable tool in a range of use cases.

Complete Transactions Without Intermediaries

One important use case is the creation of Decentralized Autonomous Organizations (DAOs). DAOs operate without the need for a central authority and allow individuals to automate transactions with one another, ensuring that all parties involved fulfill their agreed-upon terms, such as sending the correct amount of money at the appropriate time.

Thus, the need for intermediaries like lawyers or banks, who typically handle these processes in the traditional finance system, is eliminated.

Disrupt The Traditional Finance Systems

In the traditional finance system, banks and related industries derive revenue from contract agreements facilitated by two parties. For example, opening a bank account requires customers to sign up for specific terms presented by the bank and pay service fees. Also, banks have the power to refuse banking services to individuals and, thus, prevent innovative business ideas from coming to fruition. For example, a bank might deny small-scale business owners access to funds because they don’t meet all their requirements or can’t pay their high service fee.

DeFi, enabled by smart contracts, aims to disrupt this traditional finance system by taking this power away from banks and allowing individuals to finance their business decisions personally. This major utility of DeFi will enable individuals to pursue their business goals without relying on traditional financial institutions.

Problems/Vulnerabilities of Smart Contracts

Smart Contracts are not immune to security issues and can be vulnerable to hacking attempts by malicious actors. These attacks can result in the attacker gaining control over code execution, allowing them to steal funds, delete data, or change the rules of a contract.

Two common types of attacks on smart contracts are replay attacks and re-entrancy attacks:

Replay attacks occur when a malicious actor broadcasts a transaction to the network and then repeats it after it has been mined into a block.
Re-entrancy attacks involve an attacker gaining control over a user’s code and using that access to run further actions and potentially access other accounts controlled by the user.

Future Prospects of Smart Contracts in Technology

Smart contracts offer numerous possibilities for enhancing various sectors by removing administrative barriers and enabling self-executing systems. In the future, smart contracts have the potential to:

Revolutionize other sectors such as real estate, gaming, and government/voting
Enable programmable conditional payments, where transactions are executed only after specific conditions are met
Support features like margin trading, derivatives, stablecoins, and basic lending and borrowing in DeFi apps
Improve market prediction using data oracles to transmit real-world and open-internet data to the Blockchain

The goal in all of these is to make life significantly easier and more trustworthy. Thus, the future is promising for DeFi and the businesses that operate in this market as it continues to garner institutional adoption on a broader scale.

In Conclusion,

Smart contract technology is here to stay!

As the Web3 and DeFi industries continue to grow at an incredible pace, it’s becoming increasingly evident that blockchain technology has long-term benefits that cannot be ignored. Smart contracts are a big part of this growth. They are transforming how individuals and organizations connect, conduct financial transactions, and exchange information efficiently and transparently online.

Given these advantages, it’s safe to say that smart contracts will become even more widely adopted in the future and revolutionize traditional industries across various business sectors by streamlining their contractual operations.

Disclaimer: This piece is intended solely for informational purposes and should not be considered trading or investment advice. Nothing herein should be construed as financial, legal, or tax advice. Trading or investing in cryptocurrencies carries a considerable risk of financial loss. Always conduct due diligence.

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