After reading my last article, some of you might started searching up various crypto exchanges such as Binance or Kucoin to try to invest in some cryptocurrencies related to DeFi right? And upon that attempt, only to realize:
“Why are there so many cryptocurrencies to invest in?”, and most importantly, “What does USDT or USDC mean?”
Well, not to worry! In this article, we touch on the basics — the ones that you need to know — so that you will be able to navigate through the crypto space and eventually explore DeFi applications and ecosystems next week.
By the end of this article, you will be able to understand:
- How blockchain works and what a cryptocurrency is
- The different crypto wallets and how bridging different coins work
- The definition of stablecoins and why it is essential for DeFi
How blockchain works
Before diving into DeFi, let’s understand how blockchain works. This will also unfold the reasons as to why there are so many cryptocurrencies available right now.
If you recall, in my last article, I stated that “…because DeFi is built on the blockchain, it’s transparent.”
But how exactly does a blockchain work? Simply put, a blockchain is a long list of transactions that are stored on a network of different computers (or as people say: “a distributed ledger”)
Just imagine that you’re writing on a piece of paper and whatever you write also appears on different papers worldwide, in real-time. Apart from it just being a magical piece of paper, a blockchain is also able to:
- Keep all the transactions in sync even if a huge number of computers in the network goes down (what you might see on the internet as a “smart consensus of state’’)
- Ensure that past transactions cannot be deleted or modified through cryptography
- Be transparent as is gives anyone the ability to see the history of every transaction since the beginning of the chain’s creation
- Secure its own existence through financially incentivizing people to provide more computers for the network
The Blockchain Trilemma
Now, to understand why there are so many cryptocurrencies in existence as of now, you need to know the limitations of creating a blockchain. This limitation can be explained with “The Blockchain Trilemma”:
The Blockchain Trilemma — termed by Vitalik Buterin — addresses the issue that developers face as they create a new blockchain, as they have to compromise on either decentralization, security, or scalability.
To read more about the blockchain trilemma in-depth, head over to this well-written article by CertiK.
What the Blockchain Trilemma means
Essentially, what the Blockchain Trilemma means is that no single blockchain as of right now can fully capture the value of the blockchain technology.
Because developers need to compromise on one thing, it makes it hard to build a “one-stop” solution using blockchain technology. This is why there are so many cryptocurrencies, as different cryptocurrencies aim to solve problems in various different niches.
For example, you have Ethereum which aims to facilitate the creation of smart contracts and other decentralized applications, or Bitcoin which aims to facilitate peer-to-peer transactions without a need for a third party.
But where does cryptocurrency fit in with blockchains? We’ll look into defining what a cryptocurrency is in the next section.
Cryptocurrencies can be split into 2 different categories: “coins” and “tokens”. And by definition, cryptocurrencies just refer to either “coins” or “tokens” that are traded on the market as money.
Although “coins” and “tokens” are used interchangeably, the main difference is that coins are used as the primary currency of a blockchain, and records the difference in value, whereas tokens are much more complicated than that.
Tokens can even be further split into the several types of use-cases, mainly (but not limited to):
- Asset tokens: Tokens that represent ownership of an asset
- Governance tokens: Tokens that allow holders to make decisions or contribute to a blockchain
Now that you have a brief idea of what blockchains are and what classifies as cryptocurrencies, here comes the next few questions:
- “How does one interact with the blockchain or the applications built on top of it?”
- “How do you transfer assets from one blockchain to another?”
These are questions we will be answering next. And after that, we’ll touch base with stablecoins, which is a form of token that is heavily used in DeFi.
Meanwhile, here’s what we have covered thus far with a simple graphical overview!
What are crypto wallets?
“How does one interact with the blockchain or the applications built on top of it?”
A cryptocurrency wallet is essentially a hardware or software wallet that enables you to interact with the blockchain to make transactions. A cryptocurrency wallet consists of a public address, and a private key.
The public address is a long sequence of letters and numbers, similar to a bank account number.
The private key allows access to your cryptocurrencies and approval of transactions. Similar to how you wouldn’t give anyone your iBanking ID and password, you shouldn’t give your private key to anyone.
Types of Crypto Wallets
Now, there are different types of wallets, but I am going to go through the 3 main types of wallets that are used in DeFi.
Cold wallets or hardware wallets, are completely offline and are virtually hack-proof, hence the term “Cold Wallets’’. Cold wallets allow users to send or receive funds only when the device is connected to a computer with access to the internet. One also cannot send funds without a user pressing a physical switch or button on the device itself. Some examples are Trezor and Ledger.
Hot wallets or digital wallets are always connected to the Internet. These allow quick and immediate access to your digital currencies, but because these wallets are constantly connected to the network, there is a risk of the wallet being hacked by exposing the private key. Examples are Metamask and Terra Station.
Exchange wallets, or online wallets are accessed through cryptocurrency exchange accounts. Online wallets are easy to access and use, but don’t provide full control over user funds and are at risk of getting hacking. Examples include Binance and Kucoin.
Understanding how bridges work
“How do you transfer assets from one blockchain to another?”
Here comes the fun part! Somewhere along the road, you’ve purchased a token from an exchange, and you decide to move your token to the Polygon network. You want to participate in voting as the token you’ve bought is classified under “Governance Tokens”. However, you realize that the DeFi application is on the Ethereum blockchain!
So how do you move your token from Polygon to Ethereum? To do that, we use this concept called bridging — something you need to know — which allows you to move coins and use it on various blockchains. Essentially think of bridging in this manner:
1. Ethereum is an “English-speaking country”, so for any coin to be able to find its way into your wallet, it needs to know how to speak “English”.
2. Polygon is a “Chinese country”, so all Polygon tokens are natively “Chinese”. If you accidentally send your token from Polygon to your Ethereum wallet address, it will get lost in the Ethereum blockchain. The moment it gets lost, it’s lost forever.
3. So to be able to send a “Chinese-speaking token” (Polygon) to an “English-speaking country” (Ethereum), you need to tag it to a translator, which is the Polygon to ETH bridge.
With that in mind, always double-check that you’re sending it to the correct network before you press “confirm”.
DeFi Essential: Stablecoins
Now that we have covered the basics of blockchain, we can start diving into our niche — Decentralized Finance.
First and foremost, we need to understand a specific class of “token” called stablecoins, and why it’s heavily used in DeFi.
Stablecoins are used to tackle price fluctuations by tying the value of cryptocurrencies to other assets. If you have seen tokens such as USDC or UST, they are all classified as stablecoins. Your 100 UST or USDC will always be worth 100 USD be it one month, one year, or 10 years from now.
This is the reason why stablecoins are heavily used in DeFi. If we were to tackle the problem of savings, you would want your $1000 deposited to be worth $1200 next year, and not $500! And in the case of employers, it would be unrealistic to be paying your employees with an asset that is volatile.
Stablecoins are mainly categorized based on what they are backed by, with the major main ones being:
- Fiat-backed Stablecoins
- Crypto-backed Stablecoins
- Algorithmic Stablecoins
Examples of Fiat-backed Stablecoins include Tether (USDT) and Coinbase USD (USDC). How it works is that for every 1 USDT or USDC that is in circulation, there will always be 1 dollar worth of cash or real-world asset backing it.
Although Fiat-backed Stablecoins are easy to understand and simple, the issue lies in the fact that it requires some form of centralization. Not only that, but you would also need to ensure audits are run from trustworthy parties to ensure that the Stablecoin is fully collateralized.
Like Fiat-backed Stablecoins, Crypto-backed stablecoins work the same way. The difference is that instead of backing the stablecoins with physical cash or real-world assets, it’s backed by other cryptocurrencies. To account for price volatility, stablecoins that are backed in this manner are usually over-collateralized. An example of this stablecoin is Maker Dao (DAI).
This means that for every $100 worth of stablecoins in circulation, there needs to be at least $250 worth of Ethereum backing it. This way, even if Ethereum drops 30%, the stablecoin is still collateralized as there is still $175 worth of Ethereum backing it.
Crypto-backed Stablecoins addresses the issue of decentralization, but it is hard to scale. For example, if there’s a 1 billion demand for a particular stablecoin, you would need to have at least 2 billion worth of cryptocurrencies backing the stablecoin to account for price volatility.
Also, in an instance of a “black-swan” event, where the asset collateralizing the stablecoin declines in value significantly, there might be a chance where the stablecoin can collapse.
So… if “Fiat-backed” stablecoins is not decentralized, and “Crypto-backed” stablecoins is not scalable, how then do we then create a stablecoin that allows for the best of both worlds? Meet Algorithmic Stablecoins.
Basically, how “Algorithmic Stablecoins” work is that it has the ability to automatically manage supply by minting and burning assets in response to market conditions. One example of this is Terra USD (UST).
UST‘s volatility is absorbed by LUNA. Considering that you know the basic understanding of supply and demand, how the algorithm work is as follows:
UST is worth $1.01:
- The protocol burns LUNA to make UST
- UST’s supply is then increased, causing UST to be less scarce
- UST is now $1
UST is worth $0.99:
- The protocol burns UST for LUNA
- UST’s supply is then decreased, causing UST to be more scarce
- UST is now $1
But because Algorithmic stablecoins are still in their early stages, it’s still hard to say that it will be 100% successful. However, this form of stablecoin will be positive for DeFi.
Remember, our goal in DeFi is to not have any third parties involved, and since it doesn’t require any form of explicit collateralization, it’s scalable.
I hope that this week’s article has given you a solid foundation of how Blockchain technology works and a rough introduction to stablecoins!
Next week we will be going through core DeFi applications in various ecosystems and the terms that are widely used in DeFi, so that by week 4, we will be able to finally harness the powerful yields from DeFi, for ourselves.