Part 4a: Decentralized Finance (DeFi)

Part 4a: Decentralized Finance (DeFi)

DeFi boom is very near equivalent of an apocalyptic event for the traditional financial institutions. – Mohith Agadi

We have reviewed the overall landscape of Web 3.0 in Part 1, reviewed the Web 3.0 applications in Part 2 and Decentralized Autonomous Organizations in Part 3 We will focus on Decentralized Finance (DeFi) in this post.  

• Web 3.0 applications – Community managed applications 
• Decentralized Autonomous Organizations (DAOs) – Community owned governance 
• Decentralized Finance (DeFi) – Community Finance 
• Stable-coins and Central Bank Digital Currencies – Fiat collateralized and Government issue digital coins 
• Creator Economy & Non-Fungible Tokens (NFTs) – Community creations 
• Blockchain based games – Community built, created and owned Games 

DeFi is an umbrella term to define building a new internet-native financial system using blockchains to replace traditional intermediaries and trust mechanism. Before we go deeper into DeFi, let’s review what prompted this technology to evolve.  

Let’s travel back in time to 2008 and look at some numbers. 

Courtesy: The Balance 

We all know how the banks leveraged the housing derivates to over extend and eventually fail to meet their obligations resulting in the monumental financial market downturns. There were many reasons including the greed and lack of oversight but one of the primary reasons which prompted Satoshi Nakamoto to think about a solution is the lack of electronic trails in the banking transactions. There were paper trails for the transactions but nobody can look up to see how a particular real estate has been leveraged, what kind of derivates were issued, who owned them etc., 

While decentralization may be a solution, it had trust and permissionless issues. In centralized transactions, there is one authority that oversees and approves the financial transactions. However, in a decentralized situation, there is no single authority. All the concerned parties may not know each other and by default assumed to be bad actors. There is no reliable way to confirm if the information is factual or fraud. 

 This brings us to the Byzantine General’s problem. Roman Empire has ordered its generals to occupy a castle which has enough supplies to last for a long time. The generals are camped in various directions and there is physical distance between them. Each general acts an independent decision maker but will comply with the messages to attack or hold. It has to be coordinated among themselves. Therefore, trust and communication play an important role. In a centralized network, the central authority ensures that the information is accurate which ensures the dissemination of information across all the nodes. So, the centralized agencies don’t suffer from Byzantine Generals problem but they can become corrupt.  

For a long time, decentralized solutions didn’t solve this Byzantine Generals Problem until Satoshi presented the Proof of work mechanism. Simply put, the mechanism had the following, 

• •  The miners in the blockchain acted a generals 

• • Each node must try to validate the transactions which are sent like messages to the generals 
  • The enemy can be thought as bad actors (hackers) who can maliciously write transactions or spend the currency twice 
  • The miners will compete to write a next block by solving cryptographic puzzle and whoever solves it first will get the right and the reward to write the transactions in the block. This is proof of work and has built-in mechanism to reward the work done by the miners. 
  • The blockchain is also decentralized and copies of the ledger is available in all the nodes and the blocks are hashed for security.  
  • The blockchain infrastructure paved way for peer-to-peer transaction in a trustless and permissionless environment. 

As long as there is 51% of node validators accept the truth, it will be approved as valid block for any payment transactions. In order for someone to maliciously insert a transaction, they need 51% control of the network which is nearly impossible because of the geographic spread as well as the unparalleled growth of networks. Even if some nodes go rogue, there is no impact to the overall infrastructure. 

So Bitcoin was created with this and other security measures to kickoff the decentralized technology evolution. In the next post, we will dive deeper into cryptocurrencies. before we pickup the next topic.