BLOCKCHAIN REVOLUTION IN THE FINANCIAL SECTOR
Bitcoin and Ethereum’s Role in the Emergence of DeFi. How to Participate in This Financial Revolution
An Insight into the Movers and Shakers in DeFi
Decentralized Finance (DeFi) is conventional Financial services on the public Blockchain. In other words, it is the freedom to make financial transactions without being bound by borders, authorities, banks, and governments.
The Blockchain operates on top of the existing internet infrastructure. It is comprised of blocks of transactions linked together made up of 3 components; Peer-to-peer (P2P) network, Cryptography and Game Theory.
The first form of Blockchain was introduced through the launch of Bitcoin in 2009. It was invented to solve the weakness of a trust-based financial model in e-commerce.
How so?
Online transactions are reversible in case of a dispute. Financial institutions need to mediate the dispute which gives rise to transaction costs. Furthermore, due to the possibility of disputes, customers are required to provide more information than necessary to their merchants.
Bitcoin built on the public blockchain solved the following problems in conventional Finance;
- Trust.
The cryptographic proof is used to validate transactions between the buyer and the seller without needing a trusted 3rd party or centralized authority to mediate the transaction.
- Reversible transaction and fraud.
On the Blockchain, transactions cannot be reversed. Hence, transaction costs are kept low and submission of detailed customer data is no longer necessary.
- Intermediary for transactions.
Bitcoin transactions form new blocks on the Bitcoin Blockchain through Machine Consensus. Meaning, new transactions are validated by Bitcoin miners in exchange for incentive in the form of Bitcoins. Anyone with sufficient CPU power can participate in validating transactions.
The emergence of Bitcoin in 2009 got the community thinking about how Blockchain can be applied in other industries as its features showed the massive potential to revolutionize centralized economies. As a result, Bitcoin paved the way for the Ethereum Project.
The basic concept of the Ethereum platform
Bitcoin, the first version of the Blockchain, executes simple transactions of sending money from A to B through the Smart Contract.
The 2nd version of the Blockchain was proposed via The Ethereum Project by Vitalkin Buterin, a cryptocurrency researcher and programmer in 2013. The Ethereum platform makes it possible for anyone with programming knowledge to create Decentralised applications (Dapps) and Smart Contracts on its Blockchain.
On its site, ‘Ethereum is described as the foundation for a new era of the internet
where;
- Money and payments are built-in.
- Users can own their data, and your apps don’t spy and steal from you.
- Everyone has access to an open financial system.
- The internet is built on neutral, open-access infrastructure, controlled by no company or person’.
The Ethereum Project provides an opportunity to create and build new applications like Cryptocurrency wallets, Financial Applications, Decentralised markets, games, etc
Dapps and Smart Contracts
A Dapp is equivalent to a traditional website. The difference between the 2 is that the Dapp runs on a P2P network connected by a network of computers while the websites we currently use are connected to a central server where data is stored.
A Smart Contract is a contract between the buyer and the seller, written in a piece of code. It executes by itself once the conditions to the contract are triggered.
Dapps and the Blockchain are connected by Smart Contracts. The image above illustrates the transaction flow between Dapps, Smart Contracts, Blockchain, and the Internet layer.
Dapps and Smart Contracts directly connect all parties to the transaction eliminating the need for an intermediary to mediate the transaction giving both parties control over the data they share.
A simple example: Tom wants to rent his apartment to Sam. The Smart Contract has a set of conditions that Sam and Tom need to fulfil for the rental agreement to take effect. If both parties fulfil the conditions, Tom receives his rental deposit and the Smart Contract triggers the digital lockbox so Tom has access to keys to the apartment.
Decentralized Finance
When it comes to your Finances, trust and safety take centre stage. All this while, central banks, and governments have acted as the custodian of our assets. The major Financial Crisis of 2007–2008 brought forward the issue of trust, yet there was no alternative at the time where people could turn to.
Today, 11 years since the launch of Bitcoin, Blockchain technologies applied to Financial products show massive potential to disrupt the industry. One of its top feature;
Elimination of the need for a central custodian.
That brings us to the next question, who then governs your digital assets?
The Decentralised Autonomous Organisation (DAO).
What is DAO?
A traditional organization has a top-down approach, where every member of the organization is given a set of responsibilities to fulfil the company’s mission. The DAO is made up of a set of Smart Contract protocols. It executes automatically, it is permissionless and does not need anyone to approve transactions.
Bitcoin is the earliest form of DAO. It is fully automated and is not controlled by any central party. With Ethereum, the DAO ecosystem is more complex. The Ethereum DAO is not just a set of rules in the form of Smart Contracts that exist on the Internet. It needs individuals to write code, mine and interact with each other in accordance with the Ethereum protocol.
In the DAO ecosystem, decisions are made through voting. Users can purchase tokens to vote. The stakeholder with the most tokens has the most influence during voting.
This scenario allows for members of the DAO community to govern a DeFi product or service as opposed to leaving it to a central authority to make decisions that affect nations and the entire global financial systems.
DeFi products
The Ethereum platform powers the decentralization of financial products and services as most DeFi protocols today are built on Ethereum. The products complement each other as it shares the same Blockchain and uses the standardized ERC20 token.
Lending
Lending currently has the biggest piece of the Defi market with Maker leading the way with $455.6 million locked in as collateral followed by Compound and Instadapp. Here’s a How-to guide for beginners considering lending in the DeFi space using the new Oasis app by Maker.
Trading in DEX
The decentralized trading platform is known as Decentralised Exchange, DEX for short. Currently, Uniswap is the most well-known DEX dominating 71.1% of the DEX market followed by Bancor and Kyber.
Uniswap allows users to swap a large selection of ERC20 tokens, send tokens to a 3rd party and pool their tokens for a small incentive of 0.3%.
Pooling tokens in the Uniswap Liquidity Pool is pretty straightforward. You can choose which 2 tokens you would like to pool. For example, if you wish to pool Eth and Dai. Both tokens must be pooled at equal value. However, when you withdraw from the pool, the ratio of both tokens may not be the same due to the movement of tokens in the Liquidity Pool.
This video by Chris Blec provides a step by step guide on how to use the Uniswap Liquidity pool.
Derivatives & Synthetics in DeFi
In traditional Finance, derivatives are traded over the counter(OTC) or on the exchange. Derivatives traded on the stock exchange are generally heavily regulated.
Synthetics emulates the price of an underlying asset, giving the trader an option to trade without owning the asset itself.
Synthetix currently leads the way in DeFi Derivatives. It is a synthetic asset (Synths) issuance platform built on Ethereum. It operates as an incentivized lending and trading platform.
Users can stake on Mintr using the Synthetix Network Token, SNX and receive incentive or trade locking in SNX as collateral. The collateralization rate is currently at 750%. Live prices of the synths offered are sourced from credible financial markets and updated every 3 minutes. Trading fees charged are distributed to the users who provide collateral to power the Synthetix network.
Synths currently offered by Synthetix are as follows;
How does trading on this platform differ from traditional finance?
- No central custodian of funds. The market participants pool their capital and act as a clearinghouse.
- Trading fees collected are paid out to users providing collateral.
- No intermediary is needed. Smart Contracts execute deposits and withdrawals.
- Don’t need multiple trading accounts as Synthetix offers a varied choice of asset class.
- Trades are immediate and do not need a counterparty to transact with.
Basically, Synthetix offers programmed derivative contracts. Users can choose to trade in synths or stake to receive incentives. As buying synths does not need a counterparty, trading on Synthetix is just an exchange of one synth for another synth at the market price of the actual assets. For example, iBTC to iETH.
‘So essentially, you are not trading, what you are doing is taking debt and re-pricing it.’ — Kain Warwick
In conclusion, the rapid growth in DeFi is set to revolutionize the Financial sector even though most products and services are now only in phase 1 and may have foreseen or unforeseen drawbacks. It may be wise not to put your entire life savings in this market for now. However, the concept of decentralized finance, digital assets, and Blockchain technologies are changing the way we view money.
All in all, the brand new year anticipates more exciting breakthroughs in DeFi than the last!
Thanks for reading and I hope this article gives you clarity about DeFi and its products.
