What is a smart contract?

Think of a vending machine: you insert the right amount, pick a product and the machine delivers it, with no cashier needed. A smart contract works in a similar way, except that instead of soft drinks it can handle tokens, swaps or digital collateral.

A developer writes the rules and deploys the program to a blockchain that supports smart contracts, such as Ethereum. When a user sends a transaction to it, the network executes the instructions and records the result. Execution usually has a cost, known as gas.

For example, a token swap contract can check whether you have the required balance and the necessary transfer approval. If its rules are met, it completes the swap. If not, the transaction fails, although you may still be charged gas for the computation that was done.

Why it matters

Smart contracts power many decentralized apps (dApps): exchanges, lending services, NFTs and voting systems. They let different apps work together, with one using the functions of another.

If you hold crypto, this means an action in your wallet can be more than just sending money. It can give a program permission to transfer specific tokens. We find this capability useful, but the simplicity of the screen often hides the complexity behind it.

What to watch out for

“Smart” doesn’t mean it thinks or judges whether a deal is fair. It executes code, bugs and all. A security audit is no guarantee that a hack or loss of funds is ruled out.

Also, it doesn’t trigger magically because a date has passed: a transaction has to call the relevant function. For information from outside the blockchain, such as a market price, it usually relies on an external data feed, the oracle.

Some contracts allow admins to upgrade or pause them. So check who holds these permissions and which approvals the app asks for. Finally, being called a “contract” doesn’t automatically make it a legally binding agreement.