You’ve probably heard the term smart contract tossed around in crypto conversations. But what does it actually mean? Despite the name, smart contracts aren’t traditional contracts, and they’re not exactly “smart” in the AI sense either. They’re simply programs that run on the blockchain and automatically do what they’re coded to do — whether that’s transferring cryptocurrencies, issuing a token, or executing a trade.
In this guide, we’ll explain smart contracts in plain English: what they are, how they work, and why they’ve become a key part of the blockchain ecosystem. Plus, we’ll look at real-world examples to help you see how they’re used today.
Key Takeaways about Smart Contracts
- Smart contracts are self-executing programs that run on the blockchain and follow predefined rules.
- They remove intermediaries, making transactions faster, cheaper, and more secure.
- Smart contracts are widely used in DeFi, NFTs, DAOs, and supply chain management.
- Smart contracts continue to evolve, supporting cross-chain operations, tokenized assets, and automated compliance.
What are Smart Contracts?
Smart contracts are among the core innovations of blockchain technology. But despite the name, they’re neither traditional legal contracts nor powered by artificial intelligence. Instead, they’re bits of code that automatically carry out actions once certain conditions are met.
Definition of Smart Contracts
A smart contract is a self-executing program that automatically performs predefined actions once certain conditions are met. These contracts run on blockchain networks like Ethereum, making them secure, transparent and globally accessible.
Here’s a simple example: Imagine you and a stranger bet on the outcome of a football match. Instead of trusting each other or involving a third party, you use a smart contract. The contract holds both of your crypto deposits and checks the final score from a trusted source. As soon as the match ends, the contract automatically releases the winnings to the right person - no delays, no disputes, no middlemen.
In short: A smart contract is code that enforces agreements automatically, based on “if this, then that” logic.
How Do Smart Contracts Work?
Smart contracts follow a simple principle: “If X happens, then do Y.” This logic is written in code and, once deployed on a blockchain, becomes immutable (can’t be changed) and publicly verifiable.
Here’s how a smart contract works in simplified steps:
- Contract Creation – Writing code and specifying the automated actions to be executed.
- Deploy – Deploying the contract on the blockchain.
- Execute – When predefined conditions are met (e.g. a payment is made or a date is reached), the contract executes the corresponding action.
- Validation – The blockchain validates the action and updates the network without the need for approval from any central authority.
Because the contract runs on a blockchain, no one can tamper with it, and everyone can verify its function. That makes smart contracts ideal for trustless environments where strangers interact, like DeFi protocols, NFT platforms or automated payouts.
New to DeFi or NFTs? Learn more in our articles: What is DeFi and What is a NFT.
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Examples and Use Cases of Smart Contracts
Smart contracts are used in a wide range of applications across the blockchain space. Here are some of the most common and innovative use cases:
Decentralized Finance (DeFi)
Smart contracts power lending platforms, decentralized exchanges (DEXs), and yield farms. They automate interest payments, token swaps, and liquidity rewards - all without banks or brokers.
Using DeFi platforms? Then you’re likely creating tax-relevant transactions. Check out our Tax Guides for 2025 to learn how DeFi activities are taxed in your country.
NFTs and Digital Ownership
When you mint or sell an NFT, a smart contract automatically handles the transfer of ownership and transparent royalty payments.
DAOs (Decentralized Autonomous Organizations)
DAOs use smart contracts to manage community rules, proposals, and treasury funds - allowing users to vote and participate without centralized authority.
Supply Chain Management
Smart contracts enable real-time tracking of goods across borders, confirm delivery milestones, and automatically trigger payments once conditions are met.
Insurance
Parametric insurance platforms use smart contracts to automate payouts - for example, releasing funds automatically if a flight is delayed or a predefined weather event occurs.
Types of Smart Contracts
Not all smart contracts are equal. Their purpose and behavior can vary significantly depending on how they’re designed and where they’re deployed. Today, three main types of smart contracts are commonly used:
Smart Legal Contracts
These are the closest equivalent to traditional contracts. They combine legal language with code to automate certain terms of a contract - such as rental payments, service delivery, or sales conditions. These types of contracts are especially useful in industries where formal agreements still matter but automation adds value.
Decentralized Autonomous Organizations (DAOs)
DAOs are governed entirely by smart contracts. Instead of a CEO or board making decisions, DAOs use on-chain voting and predefined rules to manage everything from budgets to proposals. Members use governance tokens to participate and shape the future of the organization.
Application Logic Contracts
These contracts are used to run decentralized applications (dApps). They contain the core logic that defines how an app works — from executing trades on a DEX to distributing rewards in a staking protocol.
Earning rewards through staking or lending in a dApp? These activities often count as taxable events. Read our tax guides on Staking and Lending to stay compliant.
Smart Contracts: Pros and Cons
Smart contracts offer powerful benefits, but also a few important limitations. Here's a quick comparison:
How To Create a Smart Contract?
Creating smart contracts is a complex task that requires coding knowledge — but modern tools and test environments make the process much easier. Below, we break it down into a few simple main steps:
- Choose a Blockchain: Most smart contracts are built on Ethereum, but networks like Solana, Avalanche, or Polygon are also popular alternatives.
- Write the Code: Use a smart contract language like Solidity (for Ethereum). You define the conditions and actions.
- Test the Contract: Before going live, test your contract on a testnet (like Goerli or Sepolia) to make sure everything works as expected.
- Deploy to the Blockchain: Once you’re confident in the code, deploy the contract using a tool like Remix, Hardhat, or Truffle.
- Interact with the Contract: After deployment, you can interact with your smart contract through a web app, wallet, or directly via a blockchain explorer.
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FAQ about Smart Contracts
How Secure are Blockchains and Smart Contracts?
Blockchains are generally considered very secure due to their decentralized structure. However, smart contracts are only as secure as their code. Bugs, logic errors, or vulnerabilities can be exploited. Audits and thorough testing are essential before deployment.
Who Uses Smart Contracts?
Smart contracts are used by a wide range of individuals and organizations. Businesses use them to automate transactions, manage logistics, or enforce agreements. Crypto investors rely on smart contracts to interact with DeFi platforms, while online communities use them to govern DAOs. And in the NFT world, smart contracts manage everything from minting to royalty payouts.
What Types of Smart Contracts Exist?
There are several types of smart contracts, but the most common include smart legal contracts (which combine legal language with code), contracts to power DAOs, and application logic contracts that define how decentralized apps operate.
How do you create a Smart Contract?
To create a smart contract, you’ll typically write code in a language like Solidity, test it on a blockchain testnet to verify its functionality, and then deploy it using tools like Remix or Hardhat. It does require technical skills, but many platforms now offer templates and streamlined workflows to make the process more accessible.
What are the Pros and Cons of Smart Contracts in Blockchain?
Smart contracts offer benefits such as automation, cost efficiency, and in many cases public transparency. They execute exactly as programmed, which reduces the need for intermediaries. On the downside, they can be rigid. Once deployed, they can't be changed. Errors in the code can cause unintended outcomes, and their legal status is still evolving in many jurisdictions.
Conclusion - What are Smart Contracts?
Smart contracts automate agreements on the blockchain — securely, transparently, and without middlemen. They power everything from DeFi and NFTs to DAOs and digital payments. If you're using DeFi applications or engage in any other cryptocurrency transactions, it's important to stay organized and remain compliant. CoinTracking helps you do just that by offering automatic transaction imports from wallets and exchanges, plus country-specific tax report generation for accurate and hassle-free reporting to tax authorities.
Disclaimer: All the information provided above is for informational purposes only and should not be considered as professional investment, legal, or tax advice. You should conduct your own research or consult with a professional financial advisor when investing.
