A smart contract is a programmable contract written in computer code instead of legal language that executes automatically when predefined conditions are met. Smart contracts are deployed and run on blockchain networks like Ethereum to enable decentralized, transparent agreement execution without intermediaries.

The term was coined in 1994 by cryptographer Nick Szabo who hypothesized about vending machines executing contractual conditions autonomously. With the invention of blockchain technology, this concept is now practically implemented through smart contracts.

Ethereum enables developers to code applications and logic into smart contracts using languages like Solidity. Users can then interact securely with these smart contracts to exchange assets and execute agreements trustlessly on the blockchain.

How Do Smart Contracts Work?

Smart contracts contain executable computer code and are submitted as transactions to the Ethereum blockchain.

Once deployed, users can trigger the smart contract by sending transactions that satisfy conditions defined in the contract’s code. The smart contract will execute automatically based on the programmed logic.

For example, an ERC-20 smart contract may contain code to transfer token balances between addresses. Users triggering this function by submitting transactions with the correct data will have their balances altered accordingly.

No manual oversight is required once the smart contract is active on Ethereum. The network’s nodes automatically validate interactions and execute the code as long as predefined rules and conditions coded into the smart contract are satisfied.

Key Capabilities and Usage of Smart Contracts

Some major capabilities and usage cases of Ethereum smart contracts include:

Token Creation – The popular ERC-20 token standard utilizes smart contracts to create and manage fungible tokens. Projects create tokens like Shiba Inu (SHIB) as ERC-20 contracts.

Decentralized Exchange – Platforms like Uniswap use smart contracts to enable trustless token trading. Liquidity pools and market making are handled programmatically.

Loan/Lending – DeFi lending protocols like Aave and Compound use smart contracts to automate collateralized loans and earning yield.

Insurance – Decentralized insurance projects code coverages and premiums into smart contracts automatically paying covered claims without manual intervention.

Gaming/NFTs – Smart contracts enable digitally scarce gaming assets and NFTs with programmatic ownership and royalties.

These examples demonstrate how smart contracts introduce programmable rules, assets, and agreements into Ethereum’s deterministic execution environment.

Key Limitations and Considerations of Smart Contracts

However, smart contracts also come with limitations users should consider:

• Difficult to change - Code deployed to Ethereum is largely immutable, making smart contracts difficult to upgrade or fix if issues arise.
• Transaction costs - Sending transactions to trigger smart contract execution requires payment of Ethereum gas fees.
• Potential bugs - Code errors can lead to disastrous outcomes like funds being lost or locked. Rigorous auditing is required.
• Data connectivity - Smart contracts can’t natively connect to external data sources (i.e. market prices) which must be routed in.

Understanding these limitations helps set reasonable expectations when working with smart contract powered dApps. As Ethereum scales and programming languages mature, capabilities will expand over time.

Conclusion

Smart contracts enable programmatic agreements that execute deterministically on Ethereum without intermediaries. They provide the automation and flexibility that powers decentralized finance and applications.

However, smart contracts require rigorous programming to avoid bugs and accommodate upgradability. When designed well, smart contracts will continue revolutionizing finance and agreements by replacing costly intermediaries with trustless blockchain-based automation.

Future blockchain innovation will likely focus on interoperability between contract ecosystems and increased functionality around external data manipulation. But Ethereum’s vibrant smart contract ecosystem shows the profound potential of this technology when combined with secure public blockchains.