Smart Contracts Explained: What They Can and Can’t Do

Smart contracts explained in simple terms reveal one of blockchain technology’s most revolutionary innovations—self-executing digital agreements that automatically enforce and execute terms without requiring intermediaries, potentially transforming how we conduct business, transfer assets, and establish trust in the digital age. Since Ethereum introduced programmable smart contracts in 2015, these autonomous code-based agreements have evolved from theoretical concepts into practical tools processing billions of dollars in transactions across decentralized finance (DeFi), supply chain management, real estate, insurance, and countless other sectors seeking to eliminate middlemen, reduce costs, and increase transaction speed and transparency.

Yet despite the considerable hype surrounding smart contract technology, significant misconceptions persist about what these digital agreements can realistically accomplish versus their actual limitations in today’s technological and regulatory landscape. Many enthusiasts present smart contracts as silver bullets solving all problems of trust, fraud, and inefficiency, while critics dismiss them as impractical experiments unlikely to achieve mainstream adoption. The reality lies somewhere between these extremes—smart contracts excel at specific use cases where predetermined rules govern transactions, transparency benefits all parties, and automation provides clear advantages, while simultaneously struggling with adaptability, real-world data integration, legal uncertainty, and scalability challenges that prevent universal application.

Understanding what smart contracts can and can’t do requires moving beyond surface-level explanations to examine the technical architecture enabling their functionality, the specific problem domains where they provide genuine value, the practical limitations constraining their use, the evolving regulatory landscape shaping their future, and the realistic expectations businesses and individuals should maintain when considering smart contract implementation. The technology’s potential remains substantial, but successful adoption demandsa clear-eyed assessment of both capabilities and constraints.

This comprehensive guide demystifies smart contracts, explaining how they function at a technical level, exploring proven real-world applications delivering measurable value, honestly addressing their significant limitations and challenges, examining the regulatory uncertainties surrounding their use, and providing practical guidance for determining when smart contracts represent appropriate solutions versus when traditional agreements remain superior choices.

What Are Smart Contracts?

Smart contracts represent self-executing digital agreements with terms written directly into code that automatically execute when predetermined conditions are met.

Basic Definition and Concept

A smart contract is essentially a computer program stored on a blockchain that runs automatically when specific conditions are satisfied.

Core characteristics:

Self-executing: Once deployed, smart contracts execute automatically without requiring manual intervention when triggering conditions occur.

Immutable: After deployment on a blockchain, smart contract code cannot be altered, ensuring terms remain consistent and predictable.

Transparent: All parties can view smart contract code and execution, creating accountability and trust through visibility.

Deterministic: Smart contracts produce identical results when given the same inputs, eliminating ambiguity in agreement interpretation.

Distributed: Smart contracts run on blockchain networks across multiple computers, preventing single points of failure or control.

The term “smart contract” can be misleading—these programs aren’t necessarily legally binding contracts in traditional legal senses, and they’re not inherently “smart” in artificial intelligence terms. They’re simply automated programs executing predefined logic.

How Smart Contracts Work

Smart contract execution follows a straightforward process on blockchain networks.

Basic workflow:

1. Creation: Developer writes contract code defining rules, conditions, and actions
2. Deployment: Contract is deployed to a blockchain network, receiving a unique address
3. Triggering: External event or transaction meets predefined conditions
4. Execution: Contract automatically executes programmed actions (transfer assets, record data, trigger other contracts)
5. Recording: Execution results are permanently recorded on the blockchain

Example scenario: A smart contract for an escrow arrangement might hold funds until both the buyer confirms receipt of goods AND the seller provides tracking information, then automatically release payment to the seller while recording the transaction immutably.

Technical Foundation

Smart contracts rely on blockchain infrastructure for their unique properties.

Key technical components:

Blockchain: A distributed ledger providing immutability, transparency, and a decentralized execution environment.

Programming languages: Solidity (Ethereum), Rust (Solana), Michelson (Tezos), and others enable writing smart contract logic.

Virtual machines: EVM (Ethereum Virtual Machine) and similar systems execute smart contract code in sandboxed environments.

Gas fees: Transaction fees compensating network nodes for computational resources used in contract execution.

Oracles: Third-party services providing external data to smart contracts (price feeds, weather data, event outcomes).

According to research from the MIT Technology Review, smart contracts represent a fundamental shift in how agreements can be structured and enforced, though practical implementation faces significant technical and social challenges.

Smart Contracts vs. Traditional Contracts

Comparing approaches highlights distinct advantages and disadvantages.

Traditional contracts:

• Written in natural language
• Require legal interpretation
• Enforced through the legal system and courts
• Can be amended through negotiation
• Flexible in handling ambiguous situations
• Require trusted intermediaries (lawyers, courts, escrow agents)
• Slow and expensive enforcement

Smart contracts:

• Written in computer code
• Execute automatically based on code logic
• Self-enforcing without legal intervention
• Immutable once deployed
• Struggle with ambiguity or unforeseen circumstances
• Eliminate many intermediaries
• Fast, inexpensive automated execution

Neither approach is universally superior—the optimal choice depends on agreement complexity, relationship duration, need for flexibility, and specific use case requirements.

What Smart Contracts Can Do: Capabilities and Use Cases

Smart contract applications span numerous industries where automation, transparency, and disintermediation provide clear advantages.

Decentralized Finance (DeFi)

DeFi applications represent the most mature and successful smart contract use cases.

Lending and borrowing: Smart contracts automatically manage collateralized loans—users deposit cryptocurrency as collateral, and contracts automatically liquidate positions if collateral value drops below thresholds. Platforms like Aave and Compound process billions in loans without traditional bank infrastructure.

Decentralized exchanges (DEXs): Smart contracts facilitate peer-to-peer cryptocurrency trading without centralized intermediaries. Uniswap and similar platforms use automated market maker (AMM) smart contracts to enable instant token swaps.

Yield farming and liquidity provision: Smart contracts reward users for providing liquidity to DeFi protocols, automatically calculating and distributing yields based on predefined formulas.

Synthetic assets: Smart contracts create derivative tokens tracking real-world asset prices (stocks, commodities, currencies) without requiring actual ownership of underlying assets.

Stablecoins: Algorithmic stablecoins use smart contracts to maintain price pegs through automated supply adjustments and collateral management.

DeFi advantages: 24/7 operation, global accessibility, transparency, composability (contracts interacting with other contracts), and elimination of traditional financial gatekeepers.

Supply Chain Management

Supply chain tracking benefits significantly from smart contract automation and transparency.

Provenance tracking: Smart contracts record each step as products move through supply chains—from raw material sourcing through manufacturing, distribution, and retail. This creates immutable audit trails proving authenticity and ethical sourcing.

Automated payments: Smart contracts release payments automatically when shipment tracking confirms delivery, reducing payment delays and disputes.

Quality assurance: Integration with IoT sensors allows smart contracts to verify temperature maintenance for perishables or other quality metrics, automatically flagging violations.

Counterfeit prevention: Luxury goods manufacturers use smart contracts to create unforgeable digital certificates of authenticity.

Real-world examples: Walmart tracks food safety through blockchain smart contracts, reducing contamination outbreak trace time from weeks to seconds. De Beers tracks diamonds from mine to retail, ensuring conflict-free sourcing.

Digital Identity and Credentials

Identity verification becomes more secure and user-controlled through smart contracts.

Self-sovereign identity: Smart contracts enable individuals to control their own identity data, selectively sharing verified credentials without relying on centralized authorities.

Academic credentials: Universities issue diplomas as smart contract-based digital certificates that employers can verify instantly without contacting institutions.

Professional licenses: Medical licenses, bar memberships, and other professional credentials recorded as smart contracts provide tamper-proof verification.

Access control: Smart contracts manage permissions for digital resources, automatically granting or revoking access based on credential verification.

Real Estate Transactions

Property transactions are streamlined significantly through smart contract automation.

Title transfers: Smart contracts can represent property ownership, automatically transferring title when payment conditions are met, potentially eliminating title companies and reducing closing times from weeks to minutes.

Fractional ownership: Smart contracts enable multiple parties to own fractional shares of properties, automatically managing ownership percentages and profit distribution.

Rental agreements: Automated rent collection, security deposit management, and lease term enforcement through smart contracts reduce landlord administrative burden.

Tokenization: Converting real estate into digital tokens on blockchain enables smaller investment minimums and instant liquidity through trading on digital exchanges.

Insurance Claims Processing

Insurance automation through smart contracts accelerates claims processing and reduces fraud.

Parametric insurance: Smart contracts automatically pay claims when predefined conditions occur—flight delay insurance pays when flight tracking data confirms delays exceeding specified thresholds, crop insurance pays when weather data confirms drought conditions, eliminating lengthy claims investigation processes.

Automated underwriting: Smart contracts assess risk and issue policies automatically based on provided data.

Fraud reduction: Transparent smart contract execution and immutable claim records reduce fraudulent claim opportunities.

Instant payouts: Automatic execution means claims pay within minutes or hours rather than weeks or months.

Intellectual Property and Royalties

Creative rights management becomes more efficient and transparent through smart contracts.

Automatic royalty distribution: Music, art, and content smart contracts automatically distribute royalties to creators, producers, and rights holders based on predefined splits whenever works are purchased or streamed.

Licensing management: Smart contracts enforce usage rights and automatically collect licensing fees.

Secondary sales royalties: NFT smart contracts ensure artists receive percentages of secondary market sales automatically, something impossible with traditional physical art.

Anti-piracy: Smart contract-based access control prevents unauthorized content distribution.

Voting and Governance

Decision-making processes gain transparency and security through smart contract implementation.

DAO governance: Decentralized Autonomous Organizations use smart contracts to manage treasury funds, proposal voting, and organizational decisions without traditional corporate hierarchies.

Corporate governance: Shareholder voting through smart contracts increases transparency, reduces manipulation, and enables instant result tabulation.

Political elections: While still mostly theoretical, smart contract-based voting could increase election security, accessibility, and verifiability (though significant challenges remain).

Gaming and Virtual Assets

Digital ownership becomes truly portable and verifiable through smart contracts.

NFT gaming items: Smart contracts represent in-game assets as non-fungible tokens that players truly own, can trade freely, or transfer across different games.

Play-to-earn mechanics: Smart contracts automatically reward players with cryptocurrency or tradeable assets based on gameplay achievements.

Verifiable scarcity: Smart contracts prove digital item rarity and authenticity.

Interoperability: Smart contract standards enable assets to work across multiple games and platforms.

What Smart Contracts Can’t Do: Limitations and Challenges

Despite their capabilities, smart contracts face significant limitations preventing universal application.

The Oracle Problem

Smart contracts cannot directly access real-world data—they’re confined to blockchain environments.

Core issue: Smart contracts need external data (weather conditions, stock prices, sports scores, delivery confirmations) to trigger many practical use cases, but blockchains cannot inherently access outside information.

Oracles as solution: Third-party services (Chainlink, Band Protocol) provide external data to smart contracts, but this introduces several problems:

Centralization risk: If a single oracle provides data, it becomes a centralized point of failure and potential manipulation, undermining blockchain decentralization benefits.

Data accuracy: Oracles must be trusted to provide accurate, unmanipulated data—”garbage in, garbage out” applies to smart contracts.

Timing delays: Oracle data updates lag real-world events, potentially causing smart contracts to execute based on outdated information.

Cost: Each oracle data request costs money, increasing smart contract operational expenses.

Security vulnerabilities: Compromised oracles can feed false data to smart contracts, causing incorrect execution with no recourse due to immutability.

The oracle problem remains one of the most significant technical barriers limiting smart contract applicability to real-world scenarios requiring external data verification.

Immutability as a Double-Edged Sword

Code permanence prevents unauthorized changes but also prevents fixing bugs or adapting to new circumstances.

Bug disasters: The 2016 DAO hack exploited a smart contract vulnerability, draining $60 million worth of cryptocurrency. Immutability meant the contract couldn’t be fixed—only a controversial blockchain fork recovered funds.

No amendments: Traditional contracts can be amended through mutual agreement when circumstances change; smart contracts cannot, requiring complete redeployment with new addresses.

Coding errors: Programming mistakes in smart contracts become permanent, potentially locking funds forever or creating exploitable vulnerabilities.

Outdated logic: As laws, regulations, or business needs evolve, smart contracts cannot adapt, requiring migrations to new contracts with associated complexity and cost.

Limited workarounds: Upgradeable proxy patterns exist but introduce security concerns and complexity while partially undermining immutability benefits.

Legal and Regulatory Uncertainty

Smart contracts exist in legal gray areas with unclear enforceability and liability.

Contract validity: Most jurisdictions haven’t established clear legal frameworks determining whether smart contracts constitute legally enforceable agreements.

Jurisdictional ambiguity: Blockchain’s borderless nature creates questions about which country’s laws apply when parties are in different jurisdictions.

Dispute resolution: Traditional contracts rely on courts to interpret ambiguous terms or handle breaches; smart contracts lack clear dispute resolution mechanisms when code execution produces unintended or unjust results.

Liability questions: When smart contracts malfunction, determining liability among developers, deployers, users, and oracle providers remains unclear.

Compliance challenges: Regulated industries (finance, healthcare, insurance) face uncertainty about whether smart contract implementations satisfy legal requirements.

Consumer protection: Traditional contract law includes consumer protections (cooling-off periods, fraud remedies) that smart contracts may not accommodate.

According to analysis from Harvard Law School, the legal status of smart contracts requires substantial clarification before mainstream business adoption becomes feasible for applications beyond cryptocurrency.

Scalability Constraints

Blockchain limitations restrict smart contract transaction throughput and complexity.

Throughput limitations: Ethereum processes roughly 15-30 transactions per second, far below traditional payment networks (Visa handles 65,000+ per second). This limits smart contract viability for high-volume applications.

High costs during congestion: Network congestion causes gas fees to spike dramatically—simple transactions that normally cost cents can temporarily cost $50-100+, making many use cases economically unviable.

Computational limits: Smart contracts on platforms like Ethereum have execution limits (gas limits), preventing overly complex computations, restricting the sophistication of logic smart contracts can implement.

Storage costs: Storing significant data on blockchains is extremely expensive, limiting smart contracts to minimal data storage.

Layer 2 solutions: Technologies like rollups and side-chains partially address scalability but introduce additional complexity and potential security trade-offs.

Programming Complexity and Security Risks

Smart contract development requires specialized expertise with minimal room for error.

Specialized skills: Writing secure smart contracts demands knowledge of blockchain-specific programming languages, unique security considerations, and platform-specific quirks.

Security vulnerabilities: Common smart contract vulnerabilities include reentrancy attacks, integer overflows, access control issues, and front-running exploits.

Testing challenges: Comprehensive smart contract testing is difficult due to the need to simulate all possible execution paths and attack vectors.

Audit necessity: Smart contracts handling significant value require expensive professional security audits, increasing development costs substantially.

Irreversible consequences: Unlike traditional software,e where bugs can be patched, smart contract vulnerabilities can result in permanent, unrecoverable loss of funds.

User Experience Barriers

Mainstream adoption faces significant usability obstacles.

Cryptocurrency requirements: Interacting with smart contracts typically requires holding cryptocurrency for gas fees, creating barriers for average users unfamiliar with crypto.

Wallet complexity: Users must understand wallet creation, private key management, and seed phrase security—concepts intimidating to non-technical users.

Irreversible mistakes: Sending cryptocurrencyto theo wrong addresses or contracts results in permanent loss with no customer service recovery option.

Transaction finality: Blockchain transaction confirmation times create unusual user experiences compared to instant traditional digital transactions.

No password recovery: Lost private keys mean lost access forever, unlike traditional account recovery mechanisms.

These user experience issues prevent smart contracts from achieving the seamless convenience consumers expect from digital services.

Lack of Flexibility and Human Judgment

Automated execution eliminates beneficial human oversight and adaptability.

No discretion: Smart contracts blindly execute programmed logic regardless of context, unusual circumstances, or whether outcomes seem unjust or unintended.

Emergencies: No ability to pause or override execution during crises, market manipulation, or unforeseen circumstances.

Ambiguity handling: Traditional contracts allow courts to interpret ambiguous terms based on intent; smart contracts cannot handle undefined scenarios.

Relationship considerations: Business relationships benefit from flexibility and good faith interpretation; smart contracts enforce terms rigidly regardless of relationship history or circumstances.

Force majeure: Traditional contracts recognize acts of God or extraordinary circumstances as excusing performance; smart contracts cannot.

Many situations benefit from human judgment and contextual decision-making that automated systems cannot replicate.

Privacy Concerns

Blockchain transparency conflicts with privacy requirements in many use cases.

Public visibility: Most smart contract platforms are transparent—all transactions, addresses, and contract code are publicly visible forever.

Compliance conflicts: GDPR’s “right to be forgotten” contradicts blockchain immutability and transparency.

Business confidentiality: Companies may not want competitors to see contract terms, transaction volumes, or business relationships.

Personal data: Storing personal information on public blockchains creates privacy and regulatory risks.

Privacy solutions: Technologies like zero-knowledge proofs and private blockchains address some concerns but add complexity and may sacrifice other benefits.

Real-World Limitations: Case Studies

Practical examples illustrate where smart contracts have failed or proven unsuitable.

The DAO Hack

The DAO (Decentralized Autonomous Organization) raised $150 million in 2016 as a venture capital fund governed entirely by smart contracts.

What happened: Hackers exploited a reentrancy vulnerability in the smart contract code, draining $60 million worth of Ethereum.

Lessons learned:

• Smart contract security is extremely difficult to get right
• Immutability means bugs cannot be fixed after deployment
• The community ultimately executed a controversial blockchain fork to recover funds, undermining immutability principles

Parity Wallet Freeze

Parity multisig wallets used smart contracts to secure cryptocurrency holdings with multiple signature requirements.

What happened: A developer accidentally triggered a function that destroyed the library contract all Parity wallets depended on, permanently freezing $280 million worth of cryptocurrency in 500+ wallets.

Lessons learned:

• Smart contract dependencies create systemic risks
• Immutability can result in permanent, unrecoverable loss
• User error or malicious actions can have irreversible consequences

bZx Flash Loan Attacks

bZx DeFi protocol suffered multiple attacks in 2020, exploiting smart contract logic interactions.

What happened: Attackers used flash loans (uncollateralized loans that must be repaid in the same transaction) to manipulate oracle price feeds and exploit smart contract logic, draining approximately $900,000.

Lessons learned:

• Complex smart contract interactions create unexpected vulnerabilities
• Oracle dependencies introduce manipulation risks
• DeFi composability creates systemic attack vectors

The Future of Smart Contracts

Smart contract technology continues evolving, potentially addressing current limitations.

Technical Improvements

Emerging solutions tackle existing challenges:

Layer 2 scaling: Rollups and side-chains dramatically increase transaction throughput while reducing costs.

Improved languages and tools: Better programming languages, development frameworks, and testing tools reduce vulnerabilities.

Formal verification: Mathematical proofs of smart contract correctness increase security assurance.

Upgradeable patterns: Design patterns allowing controlled smart contract updates balance immutability with necessary flexibility.

Cross-chain bridges: Interoperability protocols enable smart contracts on different blockchains to interact.

Regulatory Clarity

Legal frameworks are slowly emerging:

Wyoming’s DAO law: First US legislation explicitly recognizing DAOs as legal entities.

EU blockchain strategy: The  European Union is developing comprehensive blockchain and smart contract regulations.

FATF guidance: Financial Action Task Force guiding cryptocurrency and smart contract compliance.

Industry standards: Organizations like the Chamber of Digital Commerce are working on smart contract legal frameworks.

Hybrid Approaches

Combined solutions leverage smart contract advantages while mitigating limitations:

Ricardian contracts: Combine human-readable legal text with executable code, creating legally enforceable smart contracts.

Controlled automation: Smart contracts handling routine executions with human oversight for exceptions.

Private blockchains: Permissioned networks providing smart contract benefits with additional control and privacy.

Legal wrappers: Traditional legal agreements incorporating smart contract executions as enforcement mechanisms.

Deciding When to Use Smart Contracts

Evaluating suitability helps determine appropriate smart contract applications.

Ideal Use Cases

Smart contracts excel when:

• Transactions follow clear, predetermined rules
• Transparency benefits all parties
• Automation provides significant efficiency gains
• Disintermediation reduces costs meaningfully
• Parties need trust without knowing each other
• Value justifies blockchain transaction costs
• Legal ambiguity is acceptable or manageable

Poor Fit Situations

Smart contracts prove unsuitable when:

• Flexibility and human judgment are essential
• Privacy requirements conflict with transparency
• Real-world data integration creates insurmountable oracle problems
• Legal enforceability is critical
• Transaction volumes exceed blockchain capacity
• Costs outweigh benefits
• Parties prefer traditional recourse mechanisms

Decision Framework

Key questions for evaluation:

1. Do predetermined rules govern the agreement?
2. Would automation provide meaningful benefits?
3. Is transparency acceptable or desirable?
4. Can all necessary information be reliably captured on-chain or through oracles?
5. Are parties comfortable with immutability and finality?
6. Does the regulatory environment permit smart contract implementation?
7. Do efficiency gains justify implementation costs?
8. Are users capable of managing cryptocurrency and wallets?

Honest answers guide appropriate technology selection.

Conclusion

Smart contracts explained comprehensively reveal powerful automation technology capable of transforming specific industries and use cases—particularly decentralized finance, supply chain tracking, digital credentials, and other applications where transparent, automated execution of predetermined rules provides clear advantages over traditional intermediary-dependent processes—while simultaneously exposing significant limitations including the unresolved oracle problem preventing reliable real-world data integration, immutability creating irreversible consequences from bugs or changing circumstances.

Legal and regulatory uncertainty leaves enforceability questions unanswered, scalability constraints limit transaction throughput and computational complexity, programming challenges require rare expertise with minimal error tolerance, user experience barriers prevent mainstream adoption, and a fundamental inability to exercise human judgment or adapt to ambiguous situations that characterize many real-world agreements.

What smart contracts can and can’t do ultimately depends on matching their specific strengths—trustless execution, transparency, disintermediation, and automation—with problem domains where these characteristics provide meaningful value while acknowledging their weaknesses—inflexibility, data access limitations, legal ambiguity, and technical constraints—that make them inappropriate for countless other applications where traditional contracts, centralized systems, or hybrid approaches deliver superior outcomes.

The technology’s future likely involves gradual improvement addressing current limitations through layer 2 scaling, better development tools, emerging legal frameworks, and hybrid models combining smart contract automation with necessary human oversight and legal structures, but successful implementation today requires clear-eyed assessment of both capabilities and limitations, choosing smart contracts only when their unique properties genuinely solve specific problems rather than adopting them simply because blockchain technology generates excitement, and maintaining realistic expectations about what these self-executing digital agreements can accomplish in today’s technological and regulatory landscape.