How Do Ethereum Smart Contracts Work?

Unveiling the Powerhouse of Decentralized Applications: Ethereum Smart Contracts

With Ethereum, blockchain now has a smart contract functionality

Bitcoin was a marvelous innovation in itself. The transparent, distributed digital ledger system propounded with its invention is known as blockchain. But, when it was conceptualized, the major challenges were to create a secure payments system that was uncheatable, unhackable and yet — did not need any trusted third party to conduct its operations.

Also, it was the first time the problem of double-spend was successfully solved. Now, with blockchain technology, people like you and me, connecting over an internet supported peer-to-peer network could transact among themselves.

Quickly, this technology found many fans. Among them was Vitalik Butarin — the then editor of Bitcoin Magazine. He quickly realized that blockchain is a much stronger technology and can have much wider applications than just recording transactions like what bitcoin blockchain does.

Being a talented developer himself, he tried to diversify the use case of bitcoin without compromising with the original code. But the bitcoin system just would not allow that to happen. So, Vitalik thought of starting to develop another blockchain with smart contract functionalities — Blockchain 2.0 also called Ethereum.

With Ethereum, blockchain now has a smart contract functionality possible where people can write codes representing real-world contracts. Business processes with complex transactions could now be done over the blockchain.

And these contracts came with an in-built escrow mechanism which ensured that the contract will execute only and only if both the parties to the contract fulfill their obligations. So, in a way — it mitigated the counterparty risk involved in the real world.

This feature enabled various applications, mostly financial applications to be developed on the Ethereum platform. These applications can emulate the functioning of a bank, a financial intermediary, an issuer. It could be used to lock real assets and issue digital tokens against them, it could be used to tokenize rare art and other collectibles and store / transact over the digital medium.

These applications which are built over Ethereum blockchain are called Decentralized Applications or DApps. So, much so that — entire organizational functions can be coded into conditional smart contracts and entire organizations can be hosted on the decentralized ecosystem — these are known as Decentralized Autonomous Organizations or DAOs.

The financial applications have proliferated to various financial activities like borrowing & lending, yield farming, insurance, tokenization of assets, issuance, capital management, derivatives contracts, decentralized exchanges with order matching systems, liquidity pools and automated market makers and even yield farming. This entire gamut of financial applications over the decentralized platform is now popularly known as Decentralized Finance of DeFi.

The Ethereum network can be considered as a great world computer where millions of transactions are processed by the nodes or the validators. It is called the Ethereum Virtual Machine or EVM. It uses a State Transition Model to maintain the distributed digital ledger as the basis for verification and validation of submitted transactions. The transaction validation cost of Ethereum is known as Gas and it is exchanged against only the native coin Ether.

The prolific useability of Ethereum has made it one of the most popular blockchains and it is being used for enterprise applications in existing business models. But it has given rise to one problem. The transaction fee or the gas fees has increased manifold as the supply of validators in the chain has not increased proportionate to the applications and transactions using these various applications.

This has provided the opportunity for other innovative projects like Layer 2 solutions for Ethereum to achieve scalability at low cost or even the new blockchain layer 1 projects with similar smart contract facilities as ethereum to gain prominence. The ethereum development team has also been upgrading the ethereum system to a more efficient validator model and more efficient database storage solution involving techniques like staking and sharding respectively.

The second most popular Cryptocurrency is expected to grow several times larger in the coming days.

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