The overnight ascension of cryptocurrencies has thrust an entirely new vocabulary onto investors. Blockchain this, token that. Then there are phrases such as "decentralized applications" and "smart contracts" that get thrown about when discussing specific platforms and cryptocurrencies. It can be a lot to digest -- and a bit confusing.

Of course, all of these things matter greatly to investors. Why? The ultimate success and proliferation of each digital platform will be determined by software developers, who will find it easiest to adopt the blockchain-token pairings offering the most functionality and capabilities. In other words, all of that jargon will decide the winners and the losers.

One of the most important things for forward-thinking cryptocurrency investors to better understand is how smart contracts on the blockchain work. With that in mind, here's a beginner's guide to smart contracts and several considerations for your cryptocurrency investing strategy.

A chalkboard with circuits and two hands shaking drawn on it.

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Smart contract basics

A blockchain is a digital network built and maintained by distributed computers running specific pieces of software. In the discussion of cryptocurrencies (which aren't actually required for blockchains), blockchains comprise a digital and distributed ledger that track monetary transactions. Many blockchain networks utilize their own unique digital tokens as a way to transfer value in transactions, which is what created the hundreds of cryptocurrencies on the market now.

But aside from the fact that blockchains are decentralized (read: not controlled by banks) and tend to process information more quickly than traditional ledger technologies (read: banks), transferring value with digital tokens isn't all that useful. That's where smart contracts come in.

A smart contract is a software program that adds layers of information onto digital transactions being executed on a blockchain. It allows for more complex transactions than simply exchanging digital tokens for a product or service. In other words, it's exactly what it sounds like: a contract, or an agreement between parties involved in a transaction that holds each party responsible (buyer vs. seller, for example) for their role. 

Hacker Noon offers a great example to illustrate the value of smart contracts:

Crowdfunding systems are often plagued by founders who fail to meet expectations. Even worse, we've all heard of stories where fraudulent founders... proceed to raise tens of thousands of dollars, only to drop their mission soon after and disappear with the money. This phenomenon is a systematic failure and inefficiency caused by placing all authority over funding in the hands of a single center figure to hold both donors and founders accountable.

Put another way, Kickstarter transactions are centralized. If crowdfunding sites instead used smart contracts and the blockchain, then donors could put up money, all donations would be held in an account distributed across the network (read: there is no single owner), and the total amount only would be released to project owners if they deliver -- as specified in the smart contract. If the project owners don't deliver as outlined in the smart contract, then the monies would be returned to donors.

In the future, the same framework could work for funding large capital projects, such as a multi-billion dollar liquefied natural gas export terminal, except donors would be shareholders or debt owners, just spread across a distributed network.

Another example of smart contracts in use: receiving your next paycheck. Rather than wait to be paid every two weeks or the last Friday of the calendar month, an employer that utilized smart contracts and the blockchain could pay its employees every day or even every hour. Such a system would work exceptionally well for contractors in the quickly expanding gig economy (think Uber drivers and freelance programmers), who can suffer from lumpy, project-based income.

That said, not all smart contracts are created equal. And that matters greatly to cryptocurrency investors.

A chart and the logos of several leading cryptocurrencies.

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Investing considerations

The most popular blockchain, bitcoin, doesn't support decentralized smart contracts at all, but is instead used for simple peer-to-peer transfers of monetary value. Meanwhile, the Ripple blockchains don't support smart contracts, although the blockchains and digital tokens are rarely used together anyway. Lacking this key functionality could severely hurt the value of both popular cryptocurrencies in the not-too-distant future. 

That's especially true considering there are at least 23 different platforms currently utilizing or planning on using smart contracts. It hasn't yet been a major differentiator for investors -- half of the 10 largest cryptocurrencies by market cap back up blockchains that can support smart contracts -- but that will likely change as more features are rolled out in 2018 and beyond. 

Among those five cryptocurrencies, the Ethereum-ether blockchain-token pairing is by far the most successful. Currently supported by the second most valuable token, Ethereum was built as a second-generation blockchain with smart contracts in mind. It allows anyone to author a smart contract in widely used programming languages, and provides rules that determine how smart contracts are executed. That has helped the Ethereum network to rush out to an early lead providing a framework and ecosystem for various other digital tokens to thrive. 

While much of ether's value is no doubt wrapped up in its ability to support a blockchain that can deploy smart contracts, the functionality provided isn't perfect. That's because Ethereum currently utilizes single-layered smart contracts. That means all of the information involved in a transaction -- the identity of the buyer, the identity of the seller, the timing of the transaction, the value of the transaction, and the like -- is jumbled together. Since not every transaction requires all of this information, including it in a single layer can make ether transactions relatively bulky. And bulky transactions are slower and more expensive to execute. 

Third-generation blockchains such as Cardano, supported by the next most valuable digital token to utilize smart contracts, learned from that pitfall to support multi-layered smart contracts. That should allow faster, smoother transactions to take place -- although right now Cardano is still no better than bitcoin in functionality. That will change with an upcoming upgrade, called Shelley, in the second quarter of 2018. 

NEO, Stellar, and EOS round out the remaining major blockchain-token pairings that can support smart contracts, and more are on the way. Simply put, any cryptocurrency that wants to have a shot at thriving in a smarter digital economy will likely need to support smart contracts. 

A laptop, pen, and paper contract sitting on a desk.

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Can smart contracts elevate the blockchain?

At the end of the day, investors that choose to invest in cryptocurrencies will need to become comfortable with all of the jargon and educate themselves on all of the nuanced details of competing blockchains. Smart contracts serve as a perfect example of that. While they promise to deliver on the true value of what blockchain has to offer, not all blockchains support smart contracts -- and not all smart contracts are created equal. That matters a lot to investors, and will eventually begin to separate the winners from the losers.

Maxx Chatsko has no position in any cryptocurrencies mentioned. The Motley Fool has no position in any cryptocurrencies mentioned. The Motley Fool has a disclosure policy.