Blockchain & DeFi clearly explained
If you thought blockchain is a new technology that is yet to be considered in mainstream financial processing, think again. Around 90% of banks in the US and European had begun exploring blockchain’s potential as early as 2018. Both blockchain and Defi hold significant potential that is yet to be unlocked as alternatives to traditional financial services.
What is Blockchain?
Blockchain is a purely digital and decentralised ledger of transactions that are distributed across the entire network of connected computers. Although blockchain became popular for its role in supporting cryptocurrency transactions, this technology is being used for a host of purposes, like identity management, supply chain management, voting systems, providing government benefits and maintaining healthcare records.
Did You Know?
While bitcoin’s blockchain is the most well-known, the Ethereum blockchain is the chosen one for enterprise use cases as it supports smart contracts, which are programs that get automatically executed when predetermined conditions are met.
How does blockchain work?
In the realm of traditional financial services, the database of transactions is maintained by the financial institutes involved in the transactions. In blockchain, the database is decentralised, which means it is managed by multiple participants in a system known as Distributed Ledger Technology (DLT). Here, every time a new transaction takes place, a record of this is added to the ledger of each participant in the network.
When a transaction takes place using blockchain technology, the information is sent to a network of computers across the world that is connected to the specific blockchain. The participants in the network solve mathematical equations or puzzles to verify the transaction. Once verified, the transaction is recorded in a block that contains many such records, along with their digital signature, timestamp, and other information. The only information that the block does not record is the identities of the users involved in the transaction.
The transactions are recorded in the form of blocks, and each block can contain several transactions. When the storage capacity of a block gets full, it is closed and linked to the previously filled block using cryptography or numeric codes called hash. This forms a chain of blocks, hence the name blockchain. Any new transaction is added to a newly formed block.
Did you know?
A cryptographically secured chain of blocks was first proposed by scientists Stuart Haber and Scott Stornetta as early as 1991. The first commercial deployment of a blockchain began in 1994.
Main types of blockchains
Anyone can participate in this type of blockchain, without the need for permission. All you need is an active internet connection to join the network, for checking the ledger anytime you want and participate in the verification process of the blockchain. A public blockchain is permanent and immutable, which means once a transaction has been verified and recorded, it cannot be erased or modified.
A single entity has complete control of the network in a private blockchain. It is managed by a network administrator and users require permission to access the network. Given the fewer participants, this type of blockchain can process transactions much faster and protects the privacy of the transactions.
This combines the benefits of public and private blockchains. A hybrid blockchain controls access but in a democratic way. The users of the blockchain decide whether to provide someone with access. Once access has been provided, you have all the rights as you would on a public blockchain.
These are new mechanisms that allow the transfer of assets from one blockchain to another and back if needed. It works as a two-way door that allows the exchange of information in transactions. Sidechains are being developed to increase the scalability of blockchain.
What is Defi?
Defi or decentralised finance eliminates the need for centralised financial agencies by replacing them with intermediation and trust mechanics. In defi, financial services are provided over the distributed ledgers of public blockchains. Decentralised finance has evolved to support various financial activities, including borrowing, investing, insurance and purchases of goods. Defi is a global, peer-to-peer method that is open to everyone and has contributed significantly to financial inclusion.
Did you know?
Some of the most popular dApps include:
PancakeSwap – allows users to buy and sell cakes
Yearn Finance – supports borrowing and lending of cryptos
OpenSea – facilitates trading in digital collectables or NFTs
Alien Worlds – allows users to earn rewards by playing games and completing tasks
NBA Top Shot – marketplace for digital basketball collectables
PoolTogether – a no-loss lottery
How does Defi work?
Defi works on blockchain technology that supports smart contracts, by using defi apps (dApps) to handle the transactions. It uses smart contracts and cryptocurrencies to offer services that do not require any middlemen. To understand the defi mechanism better, here’s a look at the five elements that make up the application.
The foundation element comprises the blockchain and its associated asset. For instance, a defi app can function on the Ethereum blockchain. The second element is the token or cryptocurrency that is native to the chosen blockchain. dApps that use the Ethereum blockchain have ether as the native asset. Then comes the protocol, which sets the guidelines for the execution of smart contracts. The fourth element is the application, which creates a user interface for the protocols so that customers can use it easily. The final element is the set of aggregators that connect dApps and protocols.
Since dApps currently use crypto coins or tokens for payment, users need to open an e-wallet to store and exchange them.
While decentralised finance holds immense potential, some risks need to be overcome. For instance, if a user forgets his/her password, there is no way to retrieve it, since there is no centralised authority or governing body. The lack of consumer protection rules has been a deterrent for those who are not tech-savvy. Moreover, while blockchain has found a way to secure transactions, not all dApps have the same level of security.
Defi can be used with stablecoins, which are digital coins whose value is fixed to a fiat currency. For instance, the value of Tether is fixed to US dollar, which is why its symbol is USDT.
While blockchain technology is useful without decentralised finance, defi loses the value it adds without a blockchain to operate on. On the other hand, blockchain is a technology, while defi applications can represent the entire ecosystem of the function or sector where it operates. The reasons for the growing popularity of blockchain and defi include the benefits of transparency, low cost, high speed and ease of use. The coming together of these two concepts has the potential to revolutionise the world of finance as we know it today.
Learn the Terms
Cryptography: The use of mathematical concepts and codes to secure a connection or network.
Hash: This takes the input of different lengths and returns outputs of fixed lengths to prevent tampering with the data being transmitted. It is a function that is needed to solve a blockchain puzzle to verify a transaction.
Block time: The average time in a blockchain required to create one new block.
dApps: A decentralised application that works on a blockchain. Most dApps operate on the Ethereum blockchain.