September 02, 2023 - 8 min read
An overview of how smart contract wallets work and the contributions to human flourishing that trustless, P2P liquidity embodies.
Smart contract wallets have emerged as an advance in threshold cryptography and distributed networks. These wallets are not just digital wallets that simply hold your crypto assets which you must sign with a private key to release. Rather, they’re an example of programmable and self-executing code that facilitates exciting use cases for DeFi via the automated management of lending, trading, forex exchange, and as many if-then transactions as the imagination can conjure.
Using robust and decentralized Oracles, assets can be tokenized and brought on-chain for trading, meaning that smart contract wallets are truly at the heart of the DeFi revolution. In this primer, we’ll delve into how smart contract wallets work, how they allow users to interact with DeFi applications, and the profound ways that smart contract wallets contribute to human flourishing.
Digital wallets can be easily categorized and understood by considering the concept of custody. A shorthand way to remember this is that centralized exchanges normally operate custodial wallets, while more decentralized options offer non-custodial wallets.
The primary difference between custodial and non-custodial smart contract wallets pertains to who controls the private keys and thus, the digital assets stored within. Let’s break down a few key differences between these two ownership arrangements.
Simply put, users need to trust the custodians with which they entrust their assets. Users sign up for accounts on these custodial platforms, like Coinbase, Gemini, or Binance, for instance. In these cases, opening accounts do not involve users receiving or holding a private key for signing off on transactions.
In fact, the custodian holds the private keys and acts more like a traditional bank in that they allow or restrict access to user funds, and in many cases involve long delays to withdraw crypto assets. Many users prefer to use these custodial accounts as fiat on-ramps to bring money from their bank accounts into the crypto world, but withdraw the crypto assets soon after to a wallet of which they retain greater control via private keys.
Without going into too much delta on non-custodial wallets, there are two basic options: hot wallets or cold wallets. Hot wallets are simply downloadable software that leverages threshold cryptography and public-private key pairs for holding and transferring digital assets. That is to say that they are online rather than physical.
Cold wallets, on the other hand, are non-custodial and often involve several additional layers of security, like storing the private key on a physical device or requiring biometric scans to access the device itself. There are plenty of options to choose from when it comes to cold wallets as a variety of companies are constantly innovating when it comes to additional security redundancies, methods for wallet recovery, and optimized user experiences.
Smart contract wallets are a type of digital wallet built to interact with blockchains. Some blockchains like Bitcoin use UTXO wallets which track balances instead of accounts, and are operated by private key signatures unlocking wallets to transfer balances.
In other cases, smart contract wallets are account abstractions which function on a set of predefined rules and conditions encoded allowing for users to set orders to transact with each other securely and trustlessly. The major difference is how funds are held and transferred, with UTXO being the simpler model and account-based offering more programmability.
Furthermore, both arrangements support multi-signature security, often used by groups needing to share funds which require permission from multiple parties to approve on-chain actions. Examples of this are 2 out of 3 setups, 3 out of 5 setups, or in some cases even higher threshold parameters for increased redundancy. In this way, both UTXO and account-based wallets are highly secure.
A significant difference between UTXO and account-based smart contract wallets boils down to automation and programmable logic, allowing developers to create customizable logic and set very specific conditions for settling transactions. For instance, users can automatically split incoming funds between different addresses, trigger if/then transactions based on chronology or specific events, and much more. In the case of Ethereum, smart contract wallets are further distinguished by whether they’re controlled by private key signatures (EOAs) or simply an automated wallet which functions in response to stimuli from those externally owned accounts.
Unlike UTXO wallets which can only be recovered with seed phrases, some account-based wallets include decentralized account recovery mechanisms like social recovery, where a subset of trusted contacts can help recover access to a smart contract wallet. After all, there is a considerable risk of permanent loss with UTXO wallets if the recovery seed or in the case of multi-sig, a majority of the seed phrases are lost.
With UTXO wallets, your blockchain can publicly view locked boxes with coins inside, and so the coins within those boxes can be considered “unspent.” To spend your coins, you must submit a transaction to the mempool for settlement, funds are derived from one or more UTXOs that were generated with your private key.
If you have 1 BTC and spend 0.5 BTC, the UTXO will be completely spent, the receiver will gain a UTXO of 0.5 BTC, and you as the sender will have a fresh UTXO with the remaining 0.5 BTC. The remainder could not possibly go back to the original UTXO because it was just “spent” during the transaction. We could also simply call them spent transactions (TXs) as opposed to unspent transactions (UTXOs) for clarity. Unfortunately, this creates storage problems for blockchains and results in a lot of “dust.”
On the issue of privacy, since so many new UTXOs must be generated for each new transaction, it’s more challenging to track users. On the other hand, tracking and managing UTXOs can sometimes require more data storage, increased hardware and software requirements to participate in the network, and more costly accounting practices due to the complexity and sheer volume of data.
While most people associate smart contracts with account-based systems like Ethereum, there are well-known UTXO-based systems that integrate and implement smart contracts by extending the UTXO model, like in the case of Cardano’s Plutus. In this extended model, UTXOs can also contain arbitrary data in addition to a simple address and associated value.
In the case of account-based wallets, like in Ethereum’s case, functionality takes precedence over simplicity. Account abstractions offer a kind of management system which is more reminiscent of your bank account, and your digital assets can be spent partially in contrast to UTXO models. This method is argued to be more efficient, though opponents argue that the UTXO model offers more user privacy. Nevertheless, additional features can augment these wallets with privacy-enhancing parameters so as to optimize the balance between security, efficiency, and privacy.
Some blockchains, like Ethereum, use account abstractions for their smart contract wallets, enabling developers to automate and customize their UX as users interact with their DeFi protocols seamlessly. Increased functionality is the name of the game here, as account-based wallets allow for more programmability and, in many ways future-proof themselves in that functionality can be added later on via the composability of Web3 tech.
One advantage that account-based smart contract wallets enjoy is that they can be automated to participate in yield farming strategies on DeFi protocols. This gives stakers a chance to maximize their ROI for a variety of tokens they hold and re-stake without the hassle of active management. Liquid staking protocols like Lido Finance come to mind as pioneers in this space, leading the industry with over $14B TVL worth of digital assets on their platform at the time of publication.
Setting limit orders for swapping crypto assets on decentralized exchanges directly from between peers without any intermediary is also possible in this arrangement. In addition to smart contract automation, users still retain control over their wallet account’s private keys and therefore the associated funds.
Account-based smart contract wallets enable developers to automate interactions with money market protocols as well. By doing so, users can borrow or lend out crypto assets according to their own curated collateralization parameters, all governed by decentralized consensus and protected with advanced cryptography like ZK proofs.
Smart contract wallets are already contributing significantly to human flourishing. Individuals who previously lacked access to traditional banking or financial services can now participate in a global network and add to global wealth through their participation, thereby growing the economic pie, as they say. With the emergence and adoption of Web3, people are going on-chain in order to better earn, save, invest, borrow and lend, and transact without the need for centralized and frankly, antiquated financial rails.
What’s more, users have greater autonomy over their savings and by extension, their personal and professional lives. No more waiting for the bank to open when you want to transfer money on a weekend. Smart contract wallets reduce our dependence on centralized institutions and intermediaries that don’t always have incentives aligned with optimizing the user experience.
These days, developers can quickly innovate and bring their ideas to market when it comes to novel financial tools and services. As we optimize and make financial services more personalized and efficient, more people will be brought on-chain and more effectively add their value to the global economy via intelligent human capital. The economic pie grows exponentially larger since time and again humanity proves that we’re far greater than the sum of our parts.
Think of it this way, your computer is just a blank screen until you plug it into the wall. Does that mean your computer can’t do anything, or that the connection to a power source is weak? We will leave this rhetorical question for the audience to ponder as they consider the untapped possibilities of the world as it is today.
Alas, smart contract wallets represent a paradigm shift in how we manage and interact with each other financially. As these technologies continue to evolve, they hold the promise of reshaping the way we cooperate with each other at a global scale, ultimately unlocking the human superpower of capital accumulation and commerce which has contributed to human flourishing for thousands of years and with any luck, many thousands more to come as we reach for the stars.
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