Understanding Decentralized Finance, Smart Contracts and Dapps

When it comes to the concept of decentralization in the financial context, the idea has existed long before what we see today. In fact, the origins of decentralization can be traced back to the anonymous e-cash protocols in the 1980s and 90s, which were largely based on a primitive version of cryptography. In modern times, decentralization has been implemented in various forms relating to finances, with Decentralized Finance, Smart Contracts and Decentralized Apps being prime examples.

Decentralized Finance

Financial services have incorporated a host of new technologies aimed at decentralizing the financial system. The main goal here is to eliminate or reduce the role of any intermediary or centralized institution when dealing with financial services. It also aims to decentralize the risk-taking from the intermediaries, as well as the decentralization of decision making and record keeping.

What is DeFi, What Does It Aim To Do?

The term DeFi is short for decentralized finance, also known as open finance in certain circles. It encompasses a broad range of financial applications that run on decentralized blockchain networks. They provide a multi-faceted financial system to replace the old traditional financial system.

So, what is DeFi and what is it all about?

Thus, in layman’s terms, DeFi refers to conventional financial tools, which run on a blockchain network. In this case, the Ethereum Network, one of the first blockchain networks of its kind, is being used by an overwhelming number of projects. They thus confer notable advantages of operating on a blockchain such as ease of access as well as censorship resistance.

There are a growing number of DeFi applications that have started offering hybrid financial services, combining digital assets, blockchain networks and open protocols to create an ecosystem.

How Many Industries Could Benefit From It?

There are several types of Decentralized Financial applications for different use cases, disrupting industries such as banking, finance, supply chain management, insurance etc. There are many different classes of DeFi.

Some of them are explained in brief below:

  • Issuance Platforms for Investing: Issuance platforms refer to a range of platforms which can include exchanges as well as issuance mediums. Issuance platforms are mainly focused on security tokens, which are expected to have more demand with the promises of future regulations and more flexible securities.

Perfect examples of issuance platforms would be Harbour and Polymath, which provide the framework, the tools and resources needed for issuers looking to launch tokenized securities using the blockchain. Both of them are integrated with service providers, including brokers, dealers, custodians, and legal entities to name a few.

  • Decentralized Prediction Markets: Another one of the most compelling components of DeFi is decentralized prediction markets, which offer huge potential. Prediction markets have been popular in trading circles for speculating on world events, as well as hedging risk. With the introduction of decentralization, the same can be done with cryptocurrencies in an uncensored market.
    Augur and Gnosis are good examples of decentralized prediction markets, both of which have started introducing features such as governance and micro-insurance markets.
  • Open Market places and Exchanges: Contrary to centralized exchanges, exchanges falling under DeFi are decentralized. These Decentralized Exchanges or DEX as they are known, refer to any P2P exchange of assets, running on the Ethereum blockchain without any third-party influence. Even though DEXs are still in the fledgling development stage, they have introduced several innovative swapping methods for tokens, such as atomic swaps, as well as other non-custodial means for asset exchange. Binance DEX, Oasis DEX and Ether Delta are perfect examples of these.
  • Stablecoins: Stablecoins are a newer addition to the decentralized financial system, as new models for issuing tokens, audits and maintaining price pegs are on this rise. They basically refer to a class of blockchain-issued tokens, which have a stable peg with an outside asset. The outside asset is generally USD, although other there are tokens pegged to other fiat currencies as well.

Stablecoins come in three different categories as given below,

  • Crypto-collateralized Stablecoins: This includes tokens where the underlying asset is over collateralized against a loaned asset, which is based on the current collateralization ratio. A good example of this would be Maker’s DAI token.
    • Fiat-collateralized Stablecoins: This class of tokens is arguably one of the most popular and regulatory compliant options available. They usually rely on the user’s trust gained by providing transparent audits. For example, Tether, which is pegged to the US Dollar, provides its users with transparent audits to gain user confidence.
    • Non-collateralized Stablecoins: These classes of stablecoins are neither centralized nor over collateralized, relying instead of contractions and expansions of the token’s supply based on an algorithm that maintains a stable peg.
  • Open Lending Protocols: Open lending protocols have been the talk of the town recently, especially after the rise of p2p protocols and liquidity pool designs. It differs from traditional credit structures in the following ways
    • Integrated with digital asset lending and borrowing
    • Transactions are Settled Instantly
    • No Credit Checks for Increased Access
    • Interoperability and Standardization which reduces cost through automation.

Public blockchain networks like Ethereum are the only open protocol lending can work. A good example would be MakerDAO.

How Defi Is Different Than the Current System and In What Ways Is It Better or Worse?

When compared to the current financial system which is highly centralized, DeFi is advantageous because of the extra functionality provided by them, along with far fewer operational risks. Besides the addition of trust-minimizing protocols into the system, DeFi also challenges the bureaucracy which is typical of the traditional as well as current financial system. Some of the benefits over traditional financial systems have been mentioned in brief below.

  • DeFi provides infinite scope for experimentation with newer financial instruments as codes and developer tools are open source.
    • DeFi makes the individual, the sole custodian of their assets.
    • Apart from running existing financial mechanisms such as loans, collaterals and debt obligations on the blockchain, it also introduces a new class of tokenized assets.
    • DeFi allows the creation of novel bearer instruments.
    • Assets are accessible and transparent, making issuances, repayments and loan terms human and machine readable.

What is a Smart Contract?

Smart Contracts refer to certain computer programs which help to facilitate any negotiation or contractual terms between two parties when certain pre-defined conditions are met. Smart Contracts are increasingly being used for a wide range of purposes with the growth of blockchain technology. They help in self-managing identities on public blockchain networks, as well as automating business collaborations in the case of permissioned blockchain networks.

How does it work?

Smart Contracts work closely inside the framework of blockchain networks. When a valid transaction is recorded on chain, the state of the blockchain is updated. Here Smart Contracts automatically trigger transactions when certain qualities are met. To understand how it works, we need to first have to look into the two types of smart contracts on offer, namely Permissioned Smart Contracts and Public Smart Contracts.

  • Permissioned Smart Contracts: Permissioned Smart Contracts run on permissioned blockchain networks, are mainly used to stimulate business collaboration. For example, if we consider the Hyperledger Project as an example, permissioned blockchains can handle collaborations involving multiple parties. It can thus leverage channels to facilitate secure and parallel transaction processing.
  • Public Smart Contracts: Public smart contracts are used on Public blockchain networks, which set no requirement for peer participation. However, since all peers have the right to deploy smart contracts, a fee is payable to prevent spamming. Ethereum smart contracts are a perfect example, which uses a Proof-of-Work mining protocol for network consensus. Ethereum’s Smart contracts are stored in an Ethereum Virtual Machine or EVM. After deployment, the smart contract obtains a unique address which is linked to a balance and can send transactions to another contract.

Real World Use Cases of Smart Contracts

Both Permissioned and Public Blockchain serve several use cases in modern times including healthcare, banking, identity management, supply chain, voting, insurance among other industries.

Some of them are explained in brief below:

  • Medical and Healthcare: Healthcare and access control of medical records are one of the major application areas of smart contracts and are seen as a secure way of sharing and accessing critical patient details. They can feature multi-signature approvals between healthcare providers and patients, providing a secure system where only authorized users or devices can access the information. Apart from this, in case of clinical trials and experimentation, smart contracts provide researchers the necessary access to certain personal health data, enabling micro-payments to be automatically transferred to any participating patients.
  • Identity Management: Smart Contracts can also work inside an identity management, to recover accounts and protect user privacy in case of any mishap or device loss. Identity management has become a crucial step in maintaining online security.
  • Banking: Smart Contracts are used to enforce rules and policies for banking and other related institutions. It helps both users and the financial institutions by decreasing the interest payable on loans as well as decreasing annual operational costs respectively.

What are Decentralized Apps and How Do They Work?

In Layman’s terms, Decentralized Apps or Dapps refer to any application, tool or program that run on a decentralized blockchain, used to connect different users and share and store resources with them.

Thus, Dapps are open-source software platforms, running on decentralized blockchain networks, which deal with tokens generated using a protocol or algorithm. When users interact or use a Dapp, they usually do so with the front end of the applications. The backend of the Dapp on the other hand represents the business logic, which is represented by the interaction between one or several smart contracts.

Comparing Dapps with Centralized Apps

Thus, Dapps function by implementing four specific criterions which separate them from normal centralized apps. These include the following:

  • Incentive: Cryptocurrency tokens or other digital assets are used as incentives.
  • Algorithm or Protocol: It makes use of an inbuilt consensus mechanism
  • Open Source: The source code of the App is openly available
  • Decentralized: Runs on a blockchain network.

Real World Examples of Dapps

Below is a collection of Decentralized Apps currently available in the market.

  1. Safe Network: A Decentralized Network for data storage and communications; Runs on the Bitcoin Blockchain
  2. Augur: A Decentralized Open Source Prediction market platform; Runs on Ethereum’s blockchain
  3. Golem: A Decentralized application for leveraging idle computer power on a global market
  4. Counter Party: A Decentralized financial platform designed for peer to peer financial applications.

Ethereum’s Role in Decentralized Finance Ecosystem

When originally introduced, Ethereum and its underlying technology was largely seen as just another cryptocurrency after Bitcoin, with some added features such as on-blockchain escrow as well as withdrawal limits, financial contracts and gambling markets. However, with the rise in popularity of decentralization, developers and users began to understand the untapped potential behind Ethereum’s protocol, moving far beyond being used just as a cryptocurrency.

Ethereum protocols could then be used for developing decentralized applications for file storage, computation and prediction markets, among other concepts. The fact that Ethereum was open-ended by design, with a rather unique protocol, made it ideal for serving as a foundational layer for a number of decentralized financial and non-financial products in the future.

Currently, an overwhelming majority of Dapps still run on the Ethereum Network despite some plaguing issues related to scalability.

Conclusion

The scale of the Dapp market is growing exponentially and has already reached billions of dollars in valuation or market cap. It is expected to rise further in the near future. Ethereum Dapps have already become a billion-dollar market collectively. As it stands, with the increase of research in blockchain networks, DeFi is currently laying out the operational ground for encouraging the development of new decentralized forms of capital formation as well as value or information transfers.

Thus, it is expected that the increased usage of decentralized financial technologies will lead to the reduction of reliance on existing intermediaries in almost all available use cases.

Thus, it is expected that the increased usage of decentralized financial technologies will lead to the reduction of reliance on existing intermediaries in almost all available use cases.

If you enjoyed reading this post consider following the blog for more updates on the market!

Leave a Reply