Since the release of Ethereum in 2015, smart contracts have been used as a decentralised way for two parties to automate deals and agreements.
Using smart contracts rather than having traditional brokers, lawyers or intermediary third parties has many benefits, but since it’s still a relatively recent technology, many people are still unaware of their existence, let alone their benefits.
What are Smart Contracts?
A smart contract is an agreement that has its terms and conditions written in code, with no need for a third party intermediary. Once certain conditions have been met, the contract is executed. This decentralised, self executing contract exists on a blockchain.
They are also used to build dApps (Decentralised Apps) and tokens. Through the use of these dApps and tokens, smart contracts are helping to transform and decentralise the finance industry. For example they can facilitate an exchange between two parties (like the Decentralised Exchange Uniswap does) without requiring a broker.
Benefits of trading with Smart Contracts
Smart contracts have proven themselves invaluable in the push to make finances more decentralised. Some of the benefits that they bring include the fact that they are:
- Secure – since contracts are stored on the blockchain, it’s virtually impossible for them to be altered after a transaction has occured.
- Traceable – a copy of all contracts are stored on each node of a blockchain network.
- Anonymous – users don’t have to give up any personal information.
- Irreversible – once on the blockchain, contracts generally can’t be changed or cancelled.
- Accessible – anyone with an internet connection can interact with them.
Layer 1 and Layer 2
A blockchain has different potential functionality and processing speeds, depending on whether it’s a layer 1 or layer 2 blockchain. This will affect what smart contracts it can support.
Layer 1 is the main blockchain architecture. This is the base underlying blockchain.
Layer 1 blockchains are quite often slow and inefficient, mainly due to prioritising security over speed. As a result, processing times and costs have increased as the use cases of these blockchains have grown.
Layer 2 are built on top of the base architecture of Layer 1. The purpose of these secondary blockchains is to improve the efficiency and scalability issues faced by Layer 1.
Layer 2 transactions are periodically verified by the Layer 1 blockchain. To compare their efficiency, every Layer 1 authentication approves up to hundreds of thousands of Layer 2 transactions.
Smart Contracts and NFTs
Smart contracts can be used with NFTs in a variety of ways. While there are several ways that they can be combined, there are two primary methods:
- By embedding a smart contract into an NFT, you can call certain assets within the NFT. For example, two parties could agree on conditions that would allow the user to access a game or song within that NFT.
- Conversely, NFTs can be embedded within a smart contract. This would mean that NFTs were transferred once the contract terms and conditions had been met.
Through these methods, there are many possible applications. While many are still in their early days of exploration and testing, some have already been established as both practical and useful:
- Digital Identity – using smart contracts to provide digital identity can help solve a global issue, since many people don’t own physical ID. It also removes the need to trust 3rd parties with your ID and personal details.
- International payments – removes and legal or financial barriers of trading with people abroad.
- Insurance – with access to the relevant information, smart contracts can be used to facilitate policies.
- Loans – parties can be easily connected with no need for an intermediary, resulting in an effortless and transparent loan.
As we’ve seen, Smart Contracts have many applications in DeFi, and offer many benefits. By removing any intermediaries through the use of blockchain, Smart Contracts are often considered as the foundational basis of DeFi.
Disclaimer: Nothing within this article should be misconstrued as financial advice. The financial techniques described herein are for educational purposes only. Any financial positions you take on the market are at your own risk and own reward. If you need financial advice or further advice in general, it is recommended that you identify a relevantly qualified individual in your Jurisdiction who can advise you accordingly.