What are smart contacts? Smart contracts are self-executing agreements based on predetermined conditions written in code. Programming languages like Plutus or Solidity are used to write the code. Many of the decentralized applications, or dApps, that we utilize, such as the Genius DEX or Uniswap, are essentially smart contracts. Smart contract execution and transaction details are recorded on public blockchains like Cardano or Ethereum.
Bitcoin only allowed for the transfer of value, or bitcoin, between parties. This functionality makes bitcoin useful but limits complex financial transactions. Smart contract platforms go much further because of the ability to code conditions into the transaction. The benefits of smart contracts on public blockchains like Cardano is that you can create many of the financial services products available today in traditional finance. DEXs, lending, financial derivatives, and insurance all become possible with smart contracts. Let’s discuss the benefits and risks of smart contracts.
- Decentralization — A key benefit of using smart contracts is that those on a public blockchain like Cardano are decentralized and don’t need an intermediary to confirm the transaction. Eliminating a centralized intermediary makes the dApp permissionless, allowing anyone to use it.
- Transparency — Due to transactions being recorded on the blockchain, anyone can verify or confirm the transaction details. This transparency is one of the major benefits of smart contracts, allowing people to interact with others they don’t trust, because each user only must trust the code. If giving a loan out, how do you trust that the other person will pay? If exchanging ADA for GENS on a DEX, how are you sure the other person will send their agreed upon amount? Smart contracts code these conditions into the transaction, ensuring each party fulfills the conditions before a transaction is executed.
- Storage back-up — Transaction details are stored on the blockchain, which is a distributed ledger of transactions. An individual or company doesn’t have to individually store all transactions. With details stored on the blockchain, companies or individuals can reduce the cost of having and securing their own private data storage.
- Lower costs — Decentralized applications (dApps) that utilize smart contracts eliminate intermediaries, replacing them with code. DEXs eliminate clearinghouses and their staff and lending/borrowing protocols eliminate banks. The cost of employees, brick and mortar locations, and even the cost of regulatory oversight is eliminated by code. The benefits of lower costs are passed onto the user, who can get more profit or pay less expenses to utilize dApps.
- Security — While public blockchains like Cardano and Ethereum may be secure, that doesn’t mean the code of smart contracts written by thousands of developers are without bugs or vulnerabilities. As blockchains are decentralized, anyone can publish their dApp, regardless of their skill or qualifications as developers. There is no gatekeeper like the Securities Exchange Commission in the United States, which regulates the issuance, marketing, and trading of all securities within its domain. While the lack of gatekeepers allows more participants, there will also be more nefarious actors. Anonymous entities with ill intentions can create and market coins or tokens with false information and put them on a DEX like Uniswap. When investors bid up the price of the digital asset, the entity could dump all their holdings for a quick profit, leaving investors with massive losses. Developers can also create dApps with vulnerabilities that hackers take advantage of to steal user funds. To mitigate this risk, many projects open source their code, allowing anyone, including independent third party auditors, to review the code.
- Regulation — Building on security, the number of hacks from smart contract bugs or vulnerabilities has been increasing. Blockchain security firm CertiK reported that 44 DeFi hacks stole $1.3 billion in user funds in 2021, which is up 160% from $500 million lost in 2020. A main cause of hacks was centralization, caused by projects having one set of private keys instead of multi-signature wallets or a DAO. When hackers obtained the private keys, they gained complete control over the smart contracts. Other projects were hacked due to vulnerabilities or bugs in their smart contract code. Most DeFi platforms exploited were unaudited. In these cases, most users never recover their funds. As more hacks happen and more money is stolen, this will heighten the risk of regulation on smart contracts as regulators seek to protect consumers from financial loss. Overly strict regulation could potentially eliminate decentralization for some dApps and stunt innovation.
- Interoperability — Millions of users are using dApps spread across blockchains like Ethereum, Solana, Polkadot, and Cardano. Since many of these blockchains use different consensus mechanisms and programming languages, dApps on one platform can’t be easily ported to another blockchain. Smart contracts that offer interoperability are going to be needed to increase the functionality for all users, regardless of what blockchain they primarily use.
- Scalability — Smart contracts take up more computing resources and memory on the blockchain. Many blockchains have limitations on the size of a transaction that’s included in each block. With some blockchains adding new blocks of transactions every 15 seconds up to a few minutes, the ability of smart contracts to be used by millions of people daily is implausible. Many blockchains, such as Cardano, are spending tremendous resources on initiatives such as Hydra to increase the scalability of their platforms.
While the benefits of smart contracts such as decentralization and disintermediation are well-known, the risks of smart contracts such as security and overreaching regulation must not be ignored. Over time as the standards of quality code and security audits develop, and features such as scalability expand, we could potentially see less drawbacks to smart contracts.