HyFi Guide to Blockchain & DeFi
Blockchain is a revolutionary technology that enables 'internets of value' to move value around the world in seconds - money, loyalty points, equity, debt, coupons, votes, IP, and more.
The Internet enables the movement of data (videos, text, photos, and more) globally in milliseconds. But try moving value (money, loyalty points, etc.) and you will be surprised by the costs, inefficiencies, and time delays.
Blockchain is a revolutionary technology that enables "internets of value" that can move value in seconds - money, loyalty points, equity shares, bonds, coupons, votes, intellectual property, and much more.
Imagine a world without computer databases. There would be no e-commerce, no ATMs, no Internet banking, no email, no social media networks, no instant messengers!
Almost everything that makes the Internet so powerful and useful depends upon computer databases.
The digital world relies very heavily on computer databases, even though most users are unaware of it.
Now imagine a database that is provably immutable/unchangeable and almost impossible to hack. That’s a blockchain.
At its core, a blockchain is an ordered and time-stamped sequence of "blocks of information".
Blockchain technology was invented by the unknown inventor of the bitcoin crypto-currency in 2008. Simply put, the bitcoin crypto-currency runs on the bitcoin blockchain — a public blockchain where anyone can become a miner and details of every single bitcoin transaction are stored on each node.
Blockchain is an innovative mix of decades-old, tried and tested technologies including:
- Public key cryptography (1970s),
- Cryptographic hash functions (1970s), and
- proof-of-work (1990s).
Blockchains are provably immutable and enable the rapid transfer and exchange of crypto-tokens (which can represent assets) without the need for separate clearing, settlement & reconciliation.
1.1 Types of blockchains
Blockchain solutions can be:
- permissioned (e.g. a Government-run land registry) or
- permissionless (e.g. Bitcoin, where anyone can become a miner).
Blockchain solutions can be:
- private (e.g. a contract management system implemented in a pharmaceutical company),
- public (e.g. an asset-backed cryptocurrency), or
- hybrid (e.g. a group of banks running a shared KYC platform).
Blockchains can handle data authentication & verification very well. This includes immutable storage (data stored on a blockchain cannot be changed or deleted), digital signatures, and encryption. Data in almost any format can be stored in the blockchain.
Blockchains can create public-private key pairs and also be used for generating and verifying digital signatures.
Blockchains can handle smart asset management very well. This includes issuance, payment, exchange, escrow, and retirement of smart assets. A smart/crypto asset is the tokenized version of a real-world asset e.g. gold, silver, oil, land.
Blockchains do not have a single point of control or a single point of failure.
For organizations, blockchain technology can minimize fraud; accelerate information and money flow; greatly improve auditability and streamline processes.
1.2 Consensus mechanisms
The original blockchain, which powers the bitcoin crypto-currency, used proof of work as a consensus mechanism. But today there are multiple distributed ledger systems that offer a host of consensus mechanisms such as:
- Proof of Work
- Proof of Stake
- Proof of Burn
- Proof of Capacity/Space
- Proof of Elapsed Time, Mining diversity
One method of providing privacy on a blockchain is the separation of concerns, in which data is sent only to the relevant parties of a transaction. Optionally, the hash of the data is broadcast to all the nodes. This method is used in Corda, Quorum, and Hyperledger Fabric.
Another method of providing privacy on a blockchain involves the broadcasting of encrypted data across the entire network.
2. Public Blockchains
A public blockchain is one whose transactions & block data are publicly available. Going by this definition, Algorand, Bitcoin & Cardano are public blockchains, while Monero is not. Some of the most popular public blockchains are:
- Binance Smart Chain
- Bitcoin Cash
3. Decentralised Finance (DeFi)
Today, almost every aspect of finance is managed by centralized systems, operated by regulated intermediaries, and controlled by Governments. Regular consumers have to deal with a web of financial intermediaries to get access to these systems. This Centralized Finance (CeFi) system suffers from many problems including those of access, efficiency, time, and cost.
DeFi (Decentralized Finance) is an umbrella term for financial applications powered by blockchain technology.
3.1 DeFi problems
DeFi has become a "wild and lawless" environment where there are virtually no regulators (pun intended). There are many problems that are holding back the decentralized finance system from mass adoption.
High & unpredictable transaction fees
Public blockchains require fees to be paid using cryptocurrency. As the project becomes more successful, its cryptocurrency becomes more expensive.
Transactions fees are very high & unpredictable, especially in the DeFi market leader Ethereum. The increasing use of DeFi protocols, dApps, and applications built on top of Ethereum has overloaded the network to the point where its fees are almost unsustainable. The average transaction cost on Ethereum has catapulted from less than $5 in 2020 to about $40 in February 2021.
An Ethereum based social media token project, Unite, announced on 10 February 2021 that the project was no longer in active development, adding that the original idea for the project had been rendered unfeasible by the recent gas price spike. The average cost of using Ethereum increased 35,600% since January 2020.
Slow transaction speed
Many public blockchains have slow transaction speeds. See details here.
Zero support for KYC (Know Your Customer)
Most public blockchains are permissionless. This means that anyone can read, write and validate. There is zero KYC (Know Your Customer) compliance.
Zero support for AML (Anti-Money Laundering)
Most public blockchains are permissionless. This means that anyone can read, write and validate. There is zero AML (Anti-Money Laundering) compliance.
Fake dApps, apps, & wallets
Recently an Apple user lost his life savings of $600,000 in Bitcoin when he installed a fake Trezor wallet app on his iPhone. Something similar also took place through a fake app on the Google Play Store. In another case, malware that replaced victims' cryptocurrency wallet addresses also spread through a "MetaMask" impersonator app. Such incidents are fairly common.
A large number of scams and rug pulls
A recent fraud around WoToken cost more than a billion dollars! According to a CipherTrace report, DeFi "rug pulls" and exit scams were the biggest chunk of crypto fraud schemes in 2020. A rug pull begins with criminals minting a new token, hyping it, listing it on Uniswap, and then providing liquidity. Once victims swap their ETH for this new token, the criminals "drain the liquidity pool" and leave the victims with a worthless token.
Unsustainably high energy consumption
The energy consumption and environmental cost of Proof-of-Work blockchains like Bitcoin and Ethereum are massive.
Creation of a new set of intermediaries
DeFi was supposed to reduce the cost and time taken for financial activities by removing intermediaries. Instead, it has created a new class of intermediaries such as miners and node operators.
Duplicate ticker symbols
Duplicate ticker symbols bring in a very high risk of financial loss as an investor can easily end up buying the wrong crypto. An example: BitRewards, BitMoney, and First Bitcoin have the same ticker symbol - BIT.
Low to zero grievance redressal mechanisms
Many public blockchains have not only anonymous users but also anonymous creators, developers, and managers! In such a scenario, there are very low to zero grievance redressal mechanisms.
Low to zero consumer protection
Many public blockchains have not only anonymous users but also anonymous creators, developers, and managers! In such a scenario, there are very low to zero customer protection mechanisms.
No insurance cover
Public blockchains do not have insurance coverage like banks do.
Vulnerability of Smart Contracts
A small mistake in the code of a smart contract can lead to a huge financial loss. A case in point is the multi-million Ethereum DAO hack of 2016.
DeFi solutions are not easy to use. In many cases, less sophisticated users end up sending assets to the wrong address, leading to huge financial losses.
DeFi is ruled by highly volatile cryptocurrencies. This adds a huge amount of unpredictability to the yields.
Some jurisdictions are pro-DeFi, some are clearly anti-DeFi and the rest are still making up their minds. This creates a lot of fear, uncertainty, and doubt.
Usage by criminals and blacklisted entities
The absence of regulators and the high level of anonymity means you could end up transacting with criminals and blacklisted entities.
There are thousands of cryptocurrencies out there. A majority of these have low liquidity which means you may get stuck trying to exit or book profits.
High collateral for loans
Unlike the CeFi world, the collateral requirement for DeFi loans is very high.
Low level of transparency
While nodes can be operated by anyone in the world, who is actually managing the project? That's something not answered clearly by most public blockchains.