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NFT Smart Contract – A Digital Contract That No One Can Break!

“You know what – contracts are like heartsthey are made to be broken.”

Well, that’s certainly not the case with smart contracts, which are virtually impossible to break. But why are smart contracts impossible to breach, and how do they work, anyway? We’re going to learn all that in layman’s terms today. 

The Jargon Explained

Before everything, you need to familiarize yourself with these concepts first. If you already know about them, that’s great. But in case you still have some confusion, we strongly recommend you go over the definitions given below.

  • Blockchain: A blockchain is a digital ledger of transactions that are replicated and shared across the entire network of computers connected to the blockchain. Since each of them would have a copy of the data, any alterations or modifications to that are virtually impossible, making it highly secure.
  • Decentralization: In the blockchain world, decentralization means instead of all the data and information being stored on a central server, it would be stored on all computers connected to the network.
  • Fungibility: Fungibility denotes something’s ability to be swapped or exchanged for something else of equal value. For example, ten one-dollar bills can be swapped for a ten-dollar bill, as they have the same value. However, an original or unique painting is non-fungible as it has a distinctive value and can’t be interchanged with another painting.
  • Non-fungible Token (NFT): They’re unique digital tokens that cannot be replicated and act as proof of ownership of an asset. An NFT can represent virtual objects like in-game items or real-world things like art or music.
  • Oracle: Oracles act as data feeds and connect blockchains to the outside world, allowing smart contracts to execute their terms based on the data and information received from the real world.
  • Ethereum and Ether (ETH): Ethereum is an open-source, decentralized version of the blockchain that offers smart contract functionality. It’s popularly known for its cryptocurrency called Ether (ETH), the second only to Bitcoin in terms of market capitalization.

A Brief History of Smart Contracts

A smart contract may be one of the latest buzzwords in the NFT space, but it has been around for some time. The term was coined in the late 1990s by Nick Szabo, an American computer scientist, legal scholar, and cryptographer. The definition he used was:

A smart contract is a computerized transaction protocol that executes the terms of a contract. The general objectives of smart-contract design are to satisfy common contractual conditions (such as payment terms, liens, confidentiality, and even enforcement), minimize exceptions both malicious and accidental, and minimize the need for trusted intermediaries. Related economic goals include lowering fraud loss, arbitration and enforcement costs, and other transaction costs.

Now, let’s understand how it actually works with a real-world example. 

How Smart Contracts Works

Suppose you’ve rented out your room to someone else on the condition that they have to move out after six months. To ensure they abide by that, you also made the tenant sign a legal contract stating the terms.

Now, your tenant is refusing to move out after six months. So you have no option but to get in touch with your lawyer so the court can enforce the contract terms.

But what if, instead of the court, the contract could grow hands and enforce its terms itself? In that case, a third party wouldn’t need to be involved. That’s precisely what a smart contract does.

A Smart Contract Will Execute the Programmed Terms Itself

If you programmed a smart contract with the terms that your tenant would be evicted if they refuse to move out after six months, your smart contract would enforce it automatically if one of the parties breaches the contract. A smart contract might not be able to kick people out physically in the real world, but it can surely do that with ease in the metaverse.

How Does It Know When the Terms and Conditions Are Broken?

Smart contracts use oracles to know what’s going on in the real world. An oracle acts as a bridge between the smart contract and the real world. For example, you can set up an oracle to let the smart contract know if the tenant doesn’t move out after six months.

The Automatic Execution of Terms Goes Both Ways

Not only will your tenant be able to live in the room for more than six months, but you also won’t be able to evict them before six months passes either – unless your terms also say that you can evict them whenever you want.

Once a Smart Contract Is Programmed, It Can’t Be Changed

Smart contracts are tamper-proof; no one can alter or modify what has been programmed into them due to their decentralized nature. 

Traditional Contracts vs. Smart Contracts

T.C. – Transactions take a minimum of 1-3 days.

S.C. – Transactions take minutes.

T.C. – Manual remittance.

S.C. – Automatical remittance.

T.C. – Physical presence is needed for the wet signature.

S.C. – Can be signed digitally regardless of where you are.

T.C. – Lawyers must be involved.

S.C. – Lawyers may not be required.

T.C. – An escrow is necessary.

S.C. – No escrow needed.

T.C. – Transaction costs are high.

S.C. – Little transaction cost.

Why Are Smart Contracts So Important for NFTS?

Simply put, NFTs are useless without smart contracts. While NFTs are unique tokens that serve as the proof of ownership of specific digital assets, smart contracts are the backbone of the whole thing.

Suppose you’re an artist and you’ve put your NFT artwork up for sale on a marketplace. The deal is that every time your NFT gets re-sold, you’ll be receiving a royalty payment. That sounds good and all, but how do you make sure the marketplace holds its end of the bargain?

Yep, that’s where the smart contract comes in.

If the terms programmed in the smart contract say that you’ll be paid one ether for every sale, it would be executed automatically every time someone buys your artwork. No need to worry about the marketplace not paying your royalties. And if the marketplace takes a commission for every sale, that can also be automated by the smart contract.

To wrap things up: NFTs may allow you to prove your ownership of digital items, but smart contracts enable you to actually take action based on that. Owning a private swimming pool on paper means little if you can’t stop other people from using it, right?

How Do Smart Contracts and NFTS Work Together?

Integrating smart contracts with NFTs opens possibilities for a wide range of use cases. Not only does it enable users to create very complex contractual structures, but it also unlocks new directions for innovation in digital products and services.

Generally, NFTs and smart contracts interact with each other in two ways.

Depending on the purpose, either NFTs can be embedded in smart contracts or the other way around.

What Happens When NFTS Are Embedded in Smart Contracts

When someone says an NFT is embedded in a smart contract, what it means is the smart contract is in control of the NFT. Or in other words, the smart contract owns the NFT.

Based on the pre-programmed terms and conditions, the smart contract holds the authority to transfer the NFT to another user or even a smart contract.

Let’s assume a couple of your friends are playing a game. The winner gets to take the prize, a Mona Lisa NFT. To do that, a smart contract can be programmed to be the temporary owner of that artwork until the match is over. After that, it would transfer the NFT to the winner.

So, in this case, the Mona Lisa NFT was embedded in the smart contract o While we’ve used the analogy of a game here for the sake of simplicity, that’s how it works in other use cases as well.

What if It’s the Other Way Around: Smart Contracts Being Embedded in NFTS

When smart contracts are embedded in an NFT, it’s usually to control the access to assets within the NFT.

Let’s use the metaphor of the NFT of a music album for this. Suppose you’ve bought a Pink Floyd album with ten songs in total. However, two of them are special releases, so those two must be purchased separately. 

You try to play them anyway, but it doesn’t work.

What’s going on here is, there’s a smart contract embedded in the NFT that prevents you from accessing the special releases unless you’ve purchased them. If you can fulfill the pre-programmed terms and conditions (do you own the NFT and have you bought the special releases?), then, and only then, the smart contract would unlock the songs.

That’s how smart contracts embedded in NFTs can retain control over the digital assets even when the NFT has changed hands.

Applications of Smart Contracts

Flash Loan

A 10 million dollar loan with no collateral?

It’s pretty unlikely you can borrow that much money in the real world with no down payment. The reason is simple; there’s no reason for the lender to believe you wouldn’t be running away with the money.

Interestingly, it’s very much possible to borrow that much money without any collateral in decentralized finance (Defi), as long as it’s done through a smart contract. Because in that case, the borrower doesn’t have to trust you. The smart contract will make sure the money is returned. That’s what Flash loan means.

Now, picture this. You’ve got a flash loan of 10 million dollars, and according to the smart contract, you’re supposed to return it with five percent interest after two days. You use the money to buy a lot of Dogecoins at 30 cents. Then when the price has increased to 40 cents, you sell them off, and bam, you now have quite a bit more than what you originally borrowed. Pay the 10 million back with the 5% interest, keep the rest of the money to yourself.

That’s how flash loans can help day traders to create money essentially out of thin air. Did you know someone once made $360,000 following these exact steps?

Insurance

Every year, the insurance industry spends substantial money on processing claims. On top of that, it loses millions of dollars to fraudulent claims too.

However, the process can become far more efficient with the help of smart contracts. For example, smart contracts could inspect the damage and determine the payout amount based on the insurance policy terms. 

As it will minimize human intervention, the processing time, margin of error and, costs can be reduced dramatically.

Not to mention, it would be impossible to get away with fraudulent claims due to the amount of security smart contracts come with.

Voting Systems

Given how transparent and secure smart contracts can be, they can open up a whole new world for voting systems. The traditional electronic voting systems cost millions of dollars in some cases but still are not safe from manipulation. However, smart contracts are much simpler and cost-effective on top of the security they provide.

For instance, a smart contract can be programmed to verify voters’ identities and record their votes. When the voting is over, it can count the votes and show which candidate has got the most votes with zero human intervention.

Since the data stored in a blockchain is impossible to alter or modify once they’ve been recorded, it wouldn’t be possible to rig the election either.

Real-Estate Ownership and Management: Both Virtual and Real-World

Remember the example about your tenant breaching the contract that we used to understand how smart contracts work? The idea of a smart contract evicting tenants might seem a bit far-fetched, but it’s not as bizarre if we take the metaverse into account.

In the virtual world, real estate ownership is all about who owns the NFT. 

As we’ve seen already, an NFT can be embedded into a smart contract. So if you rent your virtual property to someone and they breach the contract, the smart contract would definitely be able to transfer the NFT and hence the ownership of the property back to you. The tenant wouldn’t have access to that real estate anymore, which is the same as evicting them. The best part is, no need to get any third party like lawyers or the court involved.

Similarly, smart contracts can be used for real-estate management and ownership in the real world. First off, instead of traditional contracts, you can use a smart contract to record your property ownership which is much faster and economical. 

Secondly, it eliminates the need for lawyers and real estate brokers, thus driving the cost down further.

Last but not least, using smart contracts for real estate would enable sellers to handle the transaction entirely by themselves for the first time in history. So they get to take all of the money (excluding tax, of course) home with them.

How Are Smart Contracts Created/Minted and Deployed in Ethereum? 

The creation process of smart contracts is permissionless. As in, anyone who knows how to code in a smart contract language and has enough ether (ETH) in their wallet can deploy a smart contract into the Ethereum blockchain.

Currently, two popular developer-friendly programming languages for writing smart contracts are Solidity and Vyper. After you’ve written your smart contract’s code, it needs to be compiled before deployment, so Ethereum’s virtual machine can “understand” and store the smart contract in the blockchain.

Since smart contract deployment is considered a transaction, you need to pay a gas fee. However, gas fees for smart contract deployment tend to be significantly higher than simple ETH transfers.

You can also look into tools like Remix and Hardhat. They provide a development environment to compile, deploy, test and debug your smart contracts for Ethereum.

What Makes Smart Contracts So Secure?

Smart contracts are based on blockchain technology, which is incredibly safe. Especially when it comes to smart contracts deployed on the Ethereum blockchain, they benefit from the additional security features the blockchain offers too.

Let’s take a look at the reasons as to why.

Secured by Cryptography

Since all transactions on the blockchain are secured by cryptography, it’s extremely tough to decode a smart contract once it’s been encrypted.

On top of that, every block on the “chain” has a unique, private key that can be verified with a public key. Even if someone does succeed in changing the data of one block, its unique key will become invalid automatically, and the block would be removed from the chain, effectively rendering it useless.

Decentralized and Distributed

Because of blockchain technology’s distributed and decentralized nature, there’s no single point of failure in the system. Even if one of the connected computers is compromised and attempts to alter the data stored on the blockchain, the rest would prevent it immediately as they each have a copy of the data.

And hence, it’s virtually impossible to hack the blockchain.

Consensus Mechanisms

Every transaction in blockchain technology is verified and legitimized by a consensus model to ensure no fraudulent transaction can occur. Most consensus mechanisms use protocols like Proof of Work, Proof of Authority, Proof of Stake, etc. However, both Ethereum and Bitcoin blockchain use Proof-of-work (PoW).

Are Smart Contracts Legal?

If you’re asking whether it’s illegal to use smart contracts – definitely not; they’re completely legal no matter where you live. However, if your question is whether they’re legally binding or not, well, that’s a totally different ball game.

While countries like the United Kingdom and Belarus have already legalized smart contracts making them legally enforceable, the others are yet to follow suit. It’s best to consult with a lawyer if you’re unsure whether a smart contract would hold up in court.

What Is the Contract Address in NFT?

The contract address represents where the smart contract is deployed on the Ethereum blockchain. In other words, it’s the unique address of where your NFTs are stored.

The contract address is usually generated when a new smart contract is deployed to the blockchain.

Are Smart Contracts Legally Binding in the U.K.?

They are. According to the U.K. Jurisdiction Taskforce’s (UKJT) 2019 Legal Statement on Crypto Assets and Smart Contracts, a smart contract is legally enforceable. A court will only hold the agreement to be uncertain as to the last resort.

Moreover, in November 2021, the Law Commission has published its advice to the Government on smart contracts concluding that “the current legal framework in England and Wales is clearly able to facilitate and support the use of smart legal contracts, without the need for statutory law reform.”

To summarize, smart contracts are perfectly legally binding in the United Kingdom.

Does Bitcoin Have Smart Contracts?

Yes, it does. In November 2021, Bitcoin got an upgrade called Taproot which, along with many other things, unlocks the potential for smart contracts. That being said, Ethereium is still considered the leader in smart contracts due to its superior functionalities and popularity in the NFT space.

Are There Auditing Entities for Smart Contracts?

Yes, quite a few. With the growing popularity of smart contracts, several companies have started providing smart contract auditing services to individuals and businesses. Generally, the audit firms comprise blockchain developers who go through the finished code of the smart contract, analyze the architecture manually, check for bugs to test the smart contract to ensure it’s working as intended.

The process is the same as a regular code audit, but the extra emphasis is put on finding security flaws and vulnerabilities in the smart contract before it’s deployed.

While consulting with companies like Certik and Least Authority would be a good idea for high-profile smart contracts, you can also use open-source tools like Echidna to test the smart contract yourself if you’re a developer.

The Bottom Line 

We’ve learned the history of smart contracts and how they work with real-world examples. We’ve looked at the benefits of smart contracts over traditional contracts. Then, we’ve learned why smart contracts are so important for NFTs and how they work together. Along with that, we’ve delved into some popular applications of smart contracts like flash loans and insurance. Finally, we’ve learned a bit about how smart contracts are created and what makes them so secure. 

We hope this guide has helped you get a better understanding of smart contracts. Wish you good luck on your journey in the NFT space! 

Henry Hicks
Henry Hickshttps://nonfungibletalk.com
NFT and Crypto Enthusiast. Loves Travelling and Exploring the Metaverse!
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