How smart contracts work with blockchain: A step-by-step guide

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You may have heard about smart contracts, but what are they, exactly, and how do they work? If you’re a crypto enthusiast, you may remember that smart contracts used to be an Ethereum network thing (versus a Bitcoin thing). Now that the Bitcoin network supports smart contracts—a major leap forward for the original blockchain—you may be curious to learn more about smart contracts.

Imagine a world in which contracts execute themselves and trust is established and maintained only by lines of tamper-proof code. That’s the world of smart contracts—blockchain-based computer programs or transaction protocols that function as digital contracts. So how do smart contracts work, and how can they be used?

A smart contract—like any contract—is an agreement between two parties. Smart contracts use code to leverage the benefits of blockchain technology, including efficiency, transparency, and security. The results can be innovative, but using smart contracts also carries risk.

The digital nature of smart contracts means they can be programmed to execute automatically in a six-step process.

The creation of a smart contract starts with an agreement. The parties wishing to transact or exchange goods or services must agree on the terms and conditions of the arrangement. The parties involved must also decide how the smart contract will work, including what conditions must be met for the contract to execute and whether it will execute automatically.

The transacting parties have multiple options to create a smart contract, ranging from coding it themselves to working with a smart contract developer. The terms of the agreement are translated into a programming language to create the smart contract, which specifies rules and consequences just as a traditional legal contract would.

Creating a smart contract can be simple, but it’s important to note that a poorly designed smart contract is a major security risk. It’s critical to fully verify the smart contract’s security during this step.

Once the securely designed smart contract is ready, the next step is to deploy it to a blockchain. The smart contract is broadcast to the blockchain just like any other crypto transaction, with the code of the smart contract included in the transaction’s data field. The smart contract is live on the blockchain once the transaction is confirmed, and it cannot be revoked or changed.

That last part is important. Deploying a smart contract to a blockchain is like buying an item and intentionally throwing away the receipt. There are no returns, no refunds, and no exchanges—no exceptions.

A smart contract works by monitoring the blockchain or other credible information source for certain conditions or triggers. These triggers can include almost anything that can be verified digitally—a date reached, a payment completed, a monthly bill received, or any other verifiable event. Trigger conditions may also be met when one or more parties to the contract perform a specific action.

When the trigger conditions are satisfied, the smart contract executes. A smart contract that executes automatically may perform one or several actions, such as transferring funds to a seller or registering a buyer’s ownership of an asset.

The smart contract’s execution is immediately broadcast to the blockchain. The blockchain network verifies the actions performed by the smart contract, records its execution as a transaction, and stores the completed smart contract on the blockchain. The record of the smart contract is generally available for review by anyone at any time.

At this point, smart contracts may feel abstract, so let’s take a look at some specific ways that smart contracts can be used. You may be surprised at how smart contracts can aid in transactions and other money decisions:

Smart contracts can also be used for a wide range of functions that are native to blockchains, like peer-to-peer lending and other forms of decentralized finance. But in the grand scheme of things, these examples barely touch on the vast variety of use cases that smart contracts may someday offer.

Smart contracts can potentially replace trust in humans with trust in code. But are these digital contracts secure?

Smart contract developers can take steps to maximize and verify the security of their contracts, but the physical, technological, and regulatory environments in which a smart contract operates may make it vulnerable to outside risks. For example:

These are just a few of the primary risks to which smart contracts may be exposed.

Evaluating the security of smart contracts is an important part of understanding how they work. Smart contracts can be most secure when development includes:

Smart contracts self-execute agreements based on predefined protocols. Their capacity to perform this function in an automated and tamper-proof environment makes them one of the most innovative and promising technologies in development. By replacing trust in centralized institutions (such as banks, attorneys, and financial advisors) with trust in blockchain-compatible computer code, smart contracts could usher in an era of automated “trustless systems.”

Relying on computer code alone for important tasks can be efficient, but it’s also risky. Most of us aren’t ready to sell a home or other large asset via an irreversible electronic smart contract. Plus, smart contracts are evolving, with basic legal and regulatory frameworks still taking shape. But as smart contracts and other crypto use cases inch toward mainstream adoption, we can see hints of their potentially significant, if not disruptive, role in the future of our economy and society.