What’s Ethereum, and why is it the platform of choice for DeFi?
After covering what DeFi (decentralised finance) is in the last blog post today, I’d like to dive into the platform that makes DeFi possible in the first place. Bitcoin has undoubtedly been the catalyst for re-thinking the existing payment systems and how finance should work. But what made decentralised, trustless services possible are platforms like Ethereum. Ethereum was the first smart-contract platform, and while many others have been developed, often with the title of being an “Ethereum-Killer”, so far, the Ethereum network is run by an immense community. None of the Ethereum killers has been nearly as successful. But first things first. How did it all start?
The Etherum Blockchain
In 2013 a young genius developer called Vitalik Buterin published a whitepaper describing how the functionalities of bitcoin could be improved upon to enable use cases outside of just value transfer and trading. One year later, in 2014, the idea had matured enough to gather a team around and raise money to create this new kind of platform. Through an ICO (Initial Coin Offering), the ethereum team raised money by selling Ether tokens. Anyone who contributed to their fundraiser received ETH in return.
Some use Ether and Ethereum interchangeably, but Ethereum describes the platform/network while ether is the currency used for transactions and smart contracts on Ethereum. 👀
On July 30th 2015, the Ethereum genesis block was mined. Mined because when starting Ethereum was relying on the same mechanism to validate transactions as bitcoin: Proof-of-Work. Yet, unlike bitcoin, ethereum doesn’t describe itself as a ledger but a distributed state machine. The platform is run by the Ethereum Virtual Machine (EVM) that makes smart contracts possible. If you want to get into the technical details of the EVM, feel free to check out the Ethereum documentation, but if not, it’s enough to know that it exists and enables smart contracts.
I’ve mentioned smart contracts quite a bit already, without explaining them. Smart contracts are, in some sense, ground-breaking as they enable us to do a lot more in a trustless environment without any intermediaries involved. I’ve never bought a house, but I know that the process is quite long and annoying from people who did. Unless you have a suitcase of cash and a homeowner who will sell you a house without questions, you will probably have to involve a bank and several other parties. You also will have to spend some money on intermediaries that are engaged to reduce counterparty risk. All in all, it seems relatively inefficient.
In Ethereum, such transactions are automated. The code establishes conditions that need to be met for a specific transaction or event to be triggered. All this happens without involving a third party. In the buying a house process, instead of going through a process of depositing money, involving an underwriter and whatnot, the parties could deposit money in the smart contract. Once all conditions are met, the smart contract could release a code that would grant them access to the house (if it has an entrance code. If not, maybe the code to a deposit box.
Smart contracts go beyond just legal applications. They can automate many kinds of events, as applications created in DeFi illustrate. Anyone with the necessary coding skills can create a smart contract and a belonging cryptocurrency/token on Ethereum. Initially, this created a mess because everyone made their smart contracts and issued their tokens with different characteristics. This soon led to the introduction of token standards. The most widely-used Ethereum standard to date is ERC-20 and for non-fungible tokens: ERC-721.
The introduction of these standards ensured that the blockchain could communicate with them while also enabling interoperability between different projects with their respective tokens.
One risk with smart contracts is that they’re just as good as their code. Therefore, auditing smart contracts carefully are crucial for the development of a secure and trustworthy dApp.
Vitalik Buterin envisions Ethereum to create an ecosystem of decentralised Apps (this is what Apps built on it are called due to being on a decentralised network) that span across industries with use-cases ranging from social networks, entertainment to insurance and identity systems.
Remember, one year ago, crude oil futures were trading negative. At the same time, Ethereum Gas has just known one direction, and that is up. Whenever you want to transfer ETH on the Ethereum network or execute a smart contract, a transaction fee is due, which is called “Gas”. Gas is expressed in Gwei(a unit representing 0.000000001 ether). The fees are going directly to the miners that validate transactions. However, recently with NFTs booming, the Ethereum network has become quite crowded, making gas more expensive. If you want to check gas cost, head to ETH Gas Station.⛽
When gas fees increase, it’s less attractive for app developers to continue using Ethereum. Another current problem with Ethereum is its scalability. When just 30 transactions per second are supported, it’s hard to rival the existing infrastructure that processes thousands simultaneously.
Ethereum 2.0 is aiming to change that. With the change to Ethereum 2.0, the network is moving away from Proof-of-Work to Proof-of-Stake. Proof-of-Stake relies on validators to confirm transactions and not on the energy-intensive process of mining. While many PoS blockchain networks face the accusation that their networks are not decentralised enough with just a hand full of stakers, Ethereum requires a minimum of 16,384 validators. Each of whom has staked or holds at least 32 ETH. Having such a large number of validators run the network also increases security making the platform less vulnerable to attacks.
Another issue Ethereum 2.0 is addressing is scalability. Once all phases of the update are finalised, Ethereum promises to scale to 100,000 transactions per second. As quite a comprehensive update, Ethereum 2.0 is delivered in phases. In phase 0, a beacon chain storing and managing a registry of validators was implemented, and the network moved to Proof-of-Stake. During Phase 1, 64 shard chains are expected to be added to the network, automatically increasing the throughput 64 fold.
Sharding is the process of spreading a database horizontally to spread its load.
These newly implemented shards will, in the first instance, provide further data to the network but not yet handle smart contracts. In Phase 1.5, the Ethereum main net will become a shard & PoS network, and finally, with phase 2.0, the shards will become fully functional and compatible with smart contracts (some time 2021/22).
When Ethereum manages to pull this off, I don’t see how any Ethereum Killers will keep up. (But this is my opinion, don’t ask any of the BSC advocates). It’ll also be great for DeFi.
DeFi on Ethereum
When checking the state of DeFi on DeFi Pulse, you’ll quickly notice that all platforms are built on Ethereum. That’s not a coincidence. Even when checking other sources, most decentralised finance apps are on Ethereum, with just a few existing on EOS or Bitcoin. On DefiPrime, 216 services registered are running on Ethereum while just 20 use EOS and another 26 are built on the bitcoin blockchain.
Ethereum was the first smart-contract platform and has gained a lot of traction. It fuelled the big ICO boom back in 2017, where everyone started creating tokens for the hilarious things (and unfortunately, some people lost a lot of money). Nowadays, most NFTs are created on Ethereum as well. With an immense community of developers running the platform, there’s no lack of support if one decides to start a project.
Another reason making Ethereum the perfect choice is its relative decentralization compared to, for example, EOS or BSC (which is mostly controlled by Binance anyway). When building on Ethereum, no one owns the smart contract and access is granted to anyone with an internet connection. All DeFi services and products created on Ethereum speak the same (coding) language and can easily combine and integrate, creating valuable networking effects. Different apps are like legos and can be combined into something compelling.
The shared, immutable ledger keeps track of transactions and ownership. Building on Ethereum also enables self-custody and, therefore, financial freedom. (Self-custody ain’t easy, please know what you’re doing before you pour all your funds into DeFi😉).
The DeFi ecosystem on Ethereum spans a wide variety of services and products. Lending platforms such as Compound, Maker DAO or AAve allow traders to deposit their holdings and lend them against an interest payment. At the same time, borrowers can use these deposits to leverage their trades.
Decentralized Exchanges (DEX) like Uniswap enable traders to trade without relying on a centralized authority to match trades. On a DEX, tokens are swapped automatically by a smart contract tapping into a liquidity pool. Another use of Ethereum are Oracles, which provide vital data streams to the blockchain. One challenge DEX and other blockchain platforms face is that they sometimes need data from outside the chain. This is where Oracles can bridge the gap by connecting off-chain events with on-chain transactions. One noteworthy example is Chainlink.
Games have been another very early adopter of NFTs: tokenizing in-game collectibles was probably one of the first NFT use-cases. It’s no wonder that Games on Ethereum such as Axie Infinity are thriving.
Lastly, DeFi also hosts a variety of prediction markets on Ethereum such as augur or gnosis. When using prediction markets, users can hedge their bets and place money on predictions. Those can range from results of a football game to results in political elections, weather and more.
DeFi on Ethereum continues growing and with constant improvements made to the network if the biggest problems such as high gas fees and scalability can be solved, DeFi on Ethereum might well turn into a viable option for providing access to financial services for many.