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Defining Decentralized Finance (DeFi) - Part 2

Defining Decentralized Finance (DeFi) - Part 2

<style type="text/css"> .title-defi { text-align: center; } .h6-heading { text-align: center; margin-bottom: 30px; font-size: 20px; font-weight: 700; color: #002d9c; margin-top: 15px; } .sub-heading-defi { text-align: center; color: #002d9c; font-size: 26px !important; font-weight: 700 !important; } .sub-heading-defi2 { text-align: center; font-size: 26px; margin-top: 30px; margin-bottom: 35px; font-weight: 700 !important; } .h6-heading { text-align: center; } .defi-img { width: 100%; } .center-defi { display: flex; justify-content: center; margin-bottom: 20px; } .cards-defi { display: flex; flex-wrap: wrap; justify-content: space-around; } .cards-defi img { width: 55px !important; } .cards-defi > div { display: flex; flex-direction: column; justify-content: center; align-items: center; width: 40%; margin-bottom: 40px; background: #eff1f9; padding: 75px 45px; box-sizing: border-box; text-align: center; box-shadow: 25px 20px 20px 0px rgb(0 0 0 / 10%); } .icon-box-defi { display: flex; align-items: center; margin-bottom: 40px; box-shadow: 25px 20px 20px 0px rgb(0 0 0 / 10%); background: #f2efe9; padding: 35px 25px; } .icon-box-defi-icon img { padding-right: 20px; } .icon-box-defi-content p { margin-bottom: 0; } .icon-box-defi-content h5 { margin-top: 0; font-weight: 700; margin-bottom: 22px; font-size:22px; } .icon-box-defi-content { border-left: 3px solid #d5d6d6; padding-left: 20px; } .h5-defi { font-size: 26px; text-align: center; font-weight: 700 !important; margin-top: 80px; margin-bottom: 50px; } .cards-defi p { font-weight: 700; margin-bottom: 0; margin-top: 10px; } h3.conclusion { font-size: 26px; text-align: center; font-weight: 700 !important; margin-bottom: 55px; margin-top: 55px; } @media (max-width:500px) { .sub-heading-defi { text-align: center; color: #002d9c; font-size: 18px !important; font-weight: 700 !important; } .sub-heading-defi2 { text-align: center; font-size: 18px; margin-top: 0; margin-bottom: 35px; font-weight: 700 !important; } .icon-box-defi { flex-direction: column; } .icon-box-defi img { margin-bottom: 25px; } .icon-box-defi-content { border-left: 0; padding-left: 0; } .h5-defi { font-size: 18px; } .h6-heading { font-size: 16px; } .cards-defi > div { width: 100% !important; } .cards-defi p { font-weight: 700; text-align: center; } } @media (min-width:1000px){ .min830{width:470px;} } </style> <h3 style="margin-bottom:40px;" class="sub-heading-defi">Part 2: Smart contracts, DeFi and the Upside-Down World of Stranger Things</h3> <div class="content-defi"> In our last article, we explained the concept of DeFi and how DeFi proposes to create a system in which the core functions of financial intermediation can happen without a centralized counterparty. Let’s deep dive a little more on the concept of Decentralized finance and smart contracts. <br> <br> At first glance, DeFi sounds like a utopia, perfect and therefore infeasible. It is hard to imagine a technology infrastructure that solves for myriad standards in financial contracts, settles stakeholder disputes, controls for fraudulent transactions, and ensures a swift and cost-effective execution without a centralized node. Like the ways in which laws of quantum physics were contrary to the everyday observations seen by classical physicists, DeFi has been able to create an upside-down world of financial exchange that defies the logic of conventional finance, through automated smart contracts. <br> <br> But first let us take a detour and understand what smart contracts in the context of DeFi are. </div> <img class="defi-img" src="https://global-uploads.webflow.com/614a9edd8139f5def3897a73/61e176b745f12f813890dae3_bitcoin-chart-and-us-dollar-finance-trading-2021-09-03-06-29-49-utc-scaled.jpeg" alt="Hero Image" /> <h3 style="text-align:center;">What are smart contracts?</h3> <p class="content-defi">A smart contract is like a code mounted on a blockchain, which is itself a code. You can find a very detailed but accessible definition of how blockchains or distributed ledgers (DLs) work here. Smart contracts reside as codes on DeFi platforms, the most famous among which are Ethereum, Cardano and Polka Dot. The special feature of DeFi platforms, which started to emerge in 2015 is this: apart from a block-chain-like distributed ledger algorithm which creates an unchangeable, distributed record of transactions and ownership, they have an additional feature to the block like a wrapper over a block of wood. This wrapper is a form of API which allows programmers and app developers to write simple “if, then, else” programs alongside the blockchain’s main code, and hence develop programs that perform automated functions. This “if, then, else” program written over the block is what a smart contract essentially is.</p> <img class="defi-img" src="https://global-uploads.webflow.com/614a9edd8139f5def3897a73/61e176334ea87a2c59f3c234_Offshore-Bank-Accounts-for-US-Citizens.jpeg" alt="Hero Image" /> <p class="content-defi">In DeFi, smart contracts replace financial institutions in transactions. A smart contract is an Ethereum account that can hold funds. It is essentially an automatically executed and immutable agreement for settlement on the blockchain. <br> <br> For instance, an app developer could write a code saying – “if the borrower has a credit score above 700 and provides a collateral of 90% against the value of the asset, grant him a loan” or “if the price of a stock falls below the strike price on the date of expiry of a put option, pay the buyer of the put option the difference between market price and strike price”. <br> <br> Theoretically, a DeFi infrastructure model can solve for the <strong>twin challenges</strong> of</p> <div class="center-defi"> <ul> <li>Authorization and</li> <li>Interchange in a unique way</li> </ul> </div> <div class="icon-box-defi"> <div class="icon-box-defi-icon"><img style="width: 300px;" src="https://global-uploads.webflow.com/614a9edd8139f5def3897a73/620b71cd600a251791df9d20_document%20(1).png" alt="Icon Image" /></div> <div class="icon-box-defi-content"> <h5>How does DeFi solves the problem of authorization?</h5> <div> <p> On a DeFi platform, every financial asset or liability needed to be transacted is first <strong>tokenized</strong> – its real-world existence is registered on the chain using a non-replicable, immutable identity on the blockchain. This, to a large extent, solves the problem of authorization. Both parties in the contract are represented by a unique ID on the blockchain that can be transparently viewed by all permissioned administrators of the platform – something that does away with the need for a centralized exchange.</p> </div> </div> </div> <div class="icon-box-defi"> <div class="icon-box-defi-icon"><img style="padding-right: 10px;" class="min830" src="https://global-uploads.webflow.com/614a9edd8139f5def3897a73/620b71cdf41e1f63948c301c_trading%20(1).png" alt="Icon Image" /></div> <div class="icon-box-defi-content"> <h5>How does DeFi solves the problem of interchange?</h5> <p>The problem of a secure interchange is solved by the smart contract part of the DeFi, which allows the execution of the program only when the conditions described within are fulfilled. Ergo, if for example, a derivative contract on the DeFi platform is automatically executed, the parties can be sure with close to a six-sigma level of accuracy that all the conditions embedded within the code have been fulfilled. Furthermore, if the seller of a contract agrees to accept payment in a cryptocurrency (usually the token of a DeFi platform such as Ether), then delivery of the asset and the payment for it, happen instantaneously. That is because a block on Ethereum for the buyer is a tokenized form of asset in the form of an Ethereum smart contract, is also an Ether Coin which can be liquidated against USD for the seller.</p> </div> </div> <p>These two factors have powerful implications on any transaction:</p> <div class="center-defi"> <ul> <li>The security and automation of a contract &amp;</li> <li>A universal asset that can act as a currency and a token</li> </ul> </div> <img class="defi-img" src="https://global-uploads.webflow.com/614a9edd8139f5def3897a73/61e176334ea87a2c59f3c234_Offshore-Bank-Accounts-for-US-Citizens.jpeg" alt="Laptop Image" /> <p class="content-defi">It means that the <strong>usual operational</strong> <strong>costs</strong> for internal controls and the formidable machinery that ensures cash settlement of transactions across borders in time at large banks and exchanges can be made <strong>obsolete to a large extent.</strong> <br> <br> A good way to understand the spread of DeFi as an alternative to traditional finance is through a metric called <strong>Total Value Locked (TVL)</strong>. In simple terms, it indicates the value of blocks in a DeFi platform that have a wrapper with a unique, finance-specific, smart contract written over them. As per a Bank of America report, the TVL of DeFi contracts rose from USD1 billion in March 2020 to USD 80 billion at the end of August 2021. <br> <br> There are numerous DeFi applications being developed by Quants across the world. <strong>In our next article</strong>, we will discuss some of them which have seen the greatest traction over the past few months. <br> <br> Stay glued. Keep reading!</p>

By

Shailesh Jha

December 21, 2021

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