In a previous article, I discussed the core tenents of blockchain: decentralization, transparency, security. The key point of this article was that blockchain does not necessarily need to involve money, finance, or building wealth– it is a technology with a variety of use cases. However, it is undeniable that one of the most popular applications of blockchain technology is DeFi, or decentralized finance. Although DeFi has emerged as an important part of the blockchain ecosystem, the core principles that drive DeFi applications are not the same as those in blockchain, although they are mutually compatible.
But what is DeFi? As stated above, DeFi stands for Decentralized Finance. While Bitcoin was created in reaction to the misuse of FIAT currencies, which are currencies issued by government authorities, DeFi extended this concept to involve not just currency, but all financial services including, but not limited to, taking out loans, buying insurance, and investing. These financial services have traditionally been run by centralized authorities such as banks, who offer little transparency and questionable security– issues that can be solved through blockchain technology. Yet, DeFi again takes blockchain a step further, creating an ecosystem built on the additional tenents of interoperability/composability and automaticity.
Interoperability/Composability
First and foremost, DeFi seeks integration with other DeFi platforms and even, sometimes, legacy systems. Much like the Metaverse, the appeal of the blockchain system is that moving assets between platforms allows for a seamless user experience. The way that DeFi platforms achieve this is through composability. Since DeFi runs on smart contracts, many of which are open-source, the most successful DeFi platforms are, at least in part, aggregators of the most well-executed and battle-tested smart contracts. This also allows for the interchangeability of DeFi applications based on user preference, enhancing user experience.
In order to explain interoperability for those unfamiliar with web3 and blockchain, picture going to your local coffee shop and purchasing your coffee. As you tap or swipe your card to pay for your coffee, both you and the shop are unaware of the details behind the payment– the shop does not care what bank you are using and you do not care which bank the shop is using. All you know is that your funds will be properly transferred to the shop’s accounts in the correct amount, regardless of this detail. This is the interoperability between banks. DeFi platforms seek to create a similar experience by allowing interoperability both between applications and between different chains. One of the most common applications of this is the creation and use of wrapped tokens.
An example of a wrapped token is WBTC, wrapped Bitcoin. Although the value of WBTC is pegged to Bitcoin, operating on the Bitcoin network, it is a token that operates on the Ethereum network. Transferring Bitcoin from one chain to the other is as simple as minting or burning WBTC on Ethereum and storing the appropriate amount of Bitcoin in a smart contract that acts as a vault, allowing for deposits or withdrawals as needed. Through the creation and use of wrapped tokens, DeFi platforms allow for easy interoperability, or movement of funds, between chains.
Automatic/Permissionless
One of the key global financial issues that DeFi seeks to solve is access to the tools that allow for financial independence and wealth building. In order to understand the gravity of this issue, one must first look at the current global financial system and the discrimination that exists within it. In order to participate in the global financial systems, such as the World Bank, countries are required to meet certain economic standards, set by the U.N. For example, countries must operate on a capitalistic, free market as well as meet certain criteria on the U.N.’s human development index. Therefore, countries that do not adhere to Western standards of “development” (i.e. democratic, capitalistic) are barred from participating in the global financial system and, consequently, their citizens suffer.
Additionally, banks themselves can bar individuals from entering the financial system. Because they rely on a physical location, it may be impossible for individuals to travel to a bank in order to open an account. They may also lack initial capital required by the bank (in the United States, $25 is needed to open an account at most major institutions). According to the World Bank, 1.7 billion people in the world do not have a bank account. A core aspect of DeFi is that it allows these people access to the tools used to build wealth– investment, insurance, savings, loans, and more. To further this accessibility, DeFi operates in a permissionless manner. There is no central institution that prevents individuals from opening an account as long as they have an internet connection and, typically, can perform a KYC (Know Your Customer), which requires at most a form of identification. Unlike many global institutions, the entry to DeFi is not discriminatory. In countries where certain demographics, such as women, are prevented from accessing centralized financial institutions, DeFi becomes a much-needed solution for individuals’ financial independence.
Unlike centralized financial institutions, which can be discriminatory, DeFi platforms operate under one key rule: Code is Law. This means that any transaction you are able to execute with the given code is considered a valid transaction and happens automatically. Crucially, the code in these scenarios (smart contracts) need to be designed with this in mind and prevent hackers and cheaters. An interesting case for this is the DAO hack, where $60 million ether was stolen from smart contracts due to a reentrancy attack. This prompted a split within the community on whether to roll back the blockchain to restore this stolen ether, or to allow the transaction to stand.
The key argument the hacker made during this attack was that the code allowed for the transaction, therefore he was within his rights to keep the ether he had gained. The community ultimately decided to split the blockchain, with the rolled back chain gaining more transaction and legitimacy over time, thus reverting this transaction. Since then, however, progress in the development of blockchain technology and security, through upgradeable contracts, proxy contracts, and auditing services, makes it unlikely that these types of hacks will be rectified in the future. Code has indeed become law. And the most incredible thing about this is that code, unlike traditional financial institutions, doesn’t care who you are. The code executes automatically without checking gender, race, religion, or any other aspect of the caller’s personal identity.
Conclusion
The core tenents of blockchain– decentralization, transparency, security– are very well suited for the use of blockchain in the financial sector. However, DeFi platforms seek to go further to rectify the specific issues caused specifically by a centralized financial system. Interoperability/composability allows for seamless user experience and extensive innovation, while permissionless/automatic code executions allow a wider demographic access to financial independence and wealth-building. For these reasons, DeFi becomes an important part of not only blockchain technology, but global economic and human development.
