The world of DeFi works effectively by eliminating bureaucracy and central authority in finance. To effectively do this, smart contracts are essential. Smart contracts automate DeFi transactions such that no party is required to trust the other party while ensuring that they won’t be cheated.
In traditional finance, when you have a large sum of money to deal with, you're likely to involve a third party to act as an escrow – banks, legal firms, etc. Once all parties have met the contract terms, the funds and valuables are released. Similarly, with DeFi, a smart contract acts as a digital escrow. Instead of being manually executed, smart contracts run contract conditions in a computerized manner.
Now that you have a picture of what a smart contract is let us discuss its significance in the world of decentralized finance and its importance in transaction automation with blockchain.
What is a Smart Contract?
Before going into what a smart contract is, we must first remember the traditional meaning of a contract. A contract is an agreement between two or more parties, natural or legal, to give details on what should be done, how it should be done, and what happens if not done. Traditional contracts have been verbal or an expensive written piece that requires time and a third party.
In contrast, smart contracts are typically used to automate the execution of an agreement so that all participants can be sure of the outcome immediately, without the intervention of an intermediary or the loss of time.
Smart contracts are self-executing protocols that include a set of instructions –irrevocable computer codes– and also terms and conditions that are deployed and executed on the blockchain platform, which is decentralized. The contract's terms are simple instructions and commands that the program follows.
Any smart contract's terms and conditions are similar to traditional contracts. In addition, they contain various rules, regulations, and requirements that must be followed and executed when specific actions must be taken. However, no one or institution is responsible for maintaining these smart contracts, as they are simply deployed to the blockchain network and executed as planned.
How does a Smart Contract Work?
The smart contract is a computerized version of the paper contract. All validation steps are recorded in the blockchain during the execution of the smart contract, and all data are irrevocably secured by preventing its deletion or modification.
First, both contracting parties agree on the terms, conditions, and regulations. Once these are agreed upon, all instructions are coded and programmed.
This code comprises conditional statements – operates based on a simple if/when...then.. information – that describes all possible future scenarios for a specific transaction. The smart contracts code is written to perform specific actions when a particular criterion is met. These actions may include transferring funds to the appropriate parties, sending notifications, or issuing a ticket. When the transaction is executed, the blockchain is updated. Once validated on the blockchain, the transaction cannot be changed, and the results are publicly available to all.
Smart contracts, like paper contracts, are mostly standardized, with the option of using templates. ERC-20 is the most well-known smart contract standard, and its primary function is to allow the creation of tokens (digital assets, cryptocurrencies) on the Ethereum network.
Importance of Smart Contracts on Blockchain:
Smart contracts help accelerate transactions while also increasing the credibility of blockchain technology. To begin, trades are automatically executed when certain conditions are met. Once the contract is signed, smart contracts enable the verification process to be completed in a brief period.
In practice, smart contracts are primarily used to automate value exchanges in the form of crypto assets. The blockchain records all accounting entries relating to these digital value exchanges systematically. All asset transfers are thus made public, predictable, and irreversible. Furthermore, anyone can verify the smart contract's correct execution on the blockchain and determine who owns which asset.
A variable permission structure is supported by smart contracts, particularly Ethereum smart contracts. As a result, regulators will be able to view the contract's terms and can recognize the components on their own. This helps regulators sort out any suspicious activity or fraud while not violating any policy.
Smart contracts are encrypted and stored on a shared blockchain so that parties can execute them on their own. As a result, there is no need to use a third party to facilitate transactions.
Several blockchains support the deployment of smart contracts, the most well-known of which is Ethereum, which already includes a large number of decentralized applications programmed using smart contracts. However, smart contracts can also be programmed using other promising protocols like EOS, Tezos, or Cosmos. The Cardano blockchain, which is currently in development, also allows for this, ensuring a level of security suitable for the most critical systems.
Benefits of Smart Contract
Trust and transparency: All encrypted records of transactions are shared with blockchain participants in smart contracts. As a result, there are no issues with trust because everything is transparent to the participants. Furthermore, because there are no third parties involved and encrypted records of transactions are shared among participants, the issue of modifying information for personal purposes is avoided.
Enhanced security: The blockchain's transaction records are encrypted, making them nearly impossible to hijack. All processes are carried out securely, and smart contracts only function as intended. Because the data in smart contracts is immutable, it cannot be changed. Therefore, all data contained in smart contracts is entirely secure.
Autonomous: The network is entirely autonomous because it handles the transfer and contract terms. This is the most significant advantage of smart contracts. There is no need for human intervention, and no third parties can change the smart contract. As a result, businesses can use smart contracts to automate various aspects of their operations.
Accuracy and assured results: The best thing about smart contracts is that they follow the rules specified in the code. Once a condition is met, the contract is immediately executed. As a result, there is no possibility of fraud or any other scenario.
The smart contract economy is still in its infancy, but it appears to have a promising future. Many decentralized applications are currently being developed in the health, insurance, and supply chain sectors.
In recent years, the growth has been rapid, driven primarily by upcoming speculations on cryptocurrencies such as Bitcoin, Ethereum, and many others. The adoption of blockchain-based smart contracts has been slower, but there have been early success stories. We may see better development and broader adoption with new, easier-to-use platforms and networks.
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