No site about technology can be complete without a study of one of the most important breakthroughs in tech in history. That’s blockchain. In 2017 there was a huge bubble, followed by a huge burst. The burst was so big that many people, including many pundits, shrugged the technology off as if it was a fad, something with no real interest.
They’re wrong. Blockchain attacks directly to the foundations of human organization, and that’s something so new and disruptive that we’re still wondering how deep the rabbit hole goes.
By the way, if you want to know how blockchain works and why bitcoin is better money than money, go to The journey from a coffee machine to bitcoin (I) and The journey from a coffee machine to bitcoin (II)
I’m going to refer to a few applications of blockchain in finance, something that is called normally DeFi (Decentralized Finance). Remember, this is a taste of how blockchain is redefining finance. It’s also redefining games, social networks, cloud computing and many other areas, but we’ll talk about that in another post.
Disclaimer: Very Complicated Stuff doesn’t endorse any of the products we mention here. It doesn’t discourage them either. We think that all decisions, including financial ones, are part of our individual freedom, and that good information is crucial to make good decisions. We aim only to inform.
In 2017 Bitcoin reached public awareness. In 2020 DeFi is reaching public awareness.
Imagine a world where your savings earn a 6%, where you are able to create your own money and convince others to use it, where your insurance depends on how many friends you have on social networks, where you can possess a piece of your favorite actor and he pays you some dividends, where companies are self-organized and (almost) everyone agrees on who should be their CEO… This is not science-fiction, this is happening right before your eyes.
In order to completely understand how DeFi works, you need to understand what is a smart contract and an oracle. If you already know everything about smart contracts and oracles you can proceed to the second part of this post.
Part 1. Smart Contracts and Oracles.
In order to understand what is happening in the world of bitcoin and cryptocurrencies, you need to understand what is a smart contract and an oracle. Once you get these concepts right, you can go here and see what is DeFi and how it is silently revolutionizing the world of finance. If you already know everything about smart contracts and oracles you can proceed to the second part of this post.
Smart people have defined smart contracts as programmable money and I think it’s a good analogy. Let’s see it with an example:
When Bob buys something on BigRiver.com, a lot of things can go badly. BigRiver.com can send him a defective item, or a wrong one, or maybe nothing at all because BigRiver.com could be a scam site. By the time Bob receives, or doesn’t receive, his item, the payment has been completely fulfilled; any possible reimbursement depends on the good will of people at BigRiver.com. As you can see, once Bob places his order, he loses all control about his money.
Things are not much better for BigRiver.com. If Bob uses a check, the check can bounce. If he sends the money inside an envelope, the notes can be counterfeited.
This situation is easily fixed if Bob uses an intermediary to make the payment. This way the money doesn’t go directly to BigRiver.com, but to our intermediary, let’s call it PayBuddy. PayBuddy gets the money until the transaction is complete and Bob has given his approval; then PayBuddy gives the money, minus a commision, to BigRiver.com. PayBuddy acts here as an escrow, a type of payment that is very common when purchasing a house: the money doesn’t go from buyer to seller, but it remains in a third party (escrow) until the transaction is final.
This way of making a transaction works well, but it also has a few shortcomings. The most prominent is that PayBuddy is a centralized institution and it can do whatever it wants.
We have stumbled upon blockchain’s biggest selling point: it eliminates the need for a centralized institution that you have to trust whether you want it or not. And those centralized institutions are always, always, without exception, intermediaries. So blockchain erases intermediaries. It’s no wonder that intermediaries are so against bitcoin.
Let’s see how the simple operation of purchasing something at BigRiver.com doesn’t need an intermediary like PayBuddy if it’s governed by smart contracts.
When Bob pays, that money doesn’t go to BigRiver, but it doesn’t belong to Bob anymore: it’s locked away in a box that neither BigRiver or Bob can open. Then all the magic of commerce happens: the product is picked, boxed and shipped, it arrives at Bob’s hands and he can enjoy it.
Then the payment progresses to its final state: it gets out of the box and into the account of BigRiver.
That box is a smart contract. It works like an escrow box.
What blockchain does for you: it replaces the third party for a piece of code executed in a lot of machines so it can’t be forged or fooled.
But in this smart contract there’s a flaw. In fact, there’s a flaw inherent to all smart contracts.
Let’s consider this: what is the event that triggers the resolution of the smart contract? In other words: how does the smart contract decide that the transaction is good and releases the money (or any other outcome)?
A smart contract has the rules in the form of code. In our example, it has two possible outcomes:
Outcome 1. Everything is good, the product has arrived and it’s in good condition. The money goes to BigRiver.com.
Outcome 2. There’s been a problem. The money returns to Bob.
Of course there are other possible outcomes, but we won’t take them into account for simplicity.
The problem is: how can the smart contract decide which outcome is the good one? That’s not easy: if the outcome depends on Bob, he could cheat, but BigRiver could also cheat. So we need a third party, unrelated to both of them, that can decide the truth.
This third party is called an oracle, and, yes, it’s the same concept than in The Matrix.
NEO: “Does the Oracle know everything?”
MORPHEUS: “She would say she knows enough.”
Same as in The Matrix, the oracle interacts with the blockchain, but she doesn’t belong in the blockchain. She knows things that happen outside the Matrix, sorry, the blockchain and how those things affect the entities within the blockchain. She is the smart contract decider.
Then why all of this? In the end, Bob must rely on an external source to pay for his goods. Isn’t the oracle the same thing as PayBuddy?
Some people claim so: they say that oracles are the weakest points of smart contracts and they can’t be decided in a decentralized way, so all the effort of decentralization is for nothing. Others don’t know it can’t be done and, consequently, are doing it. For example, ChainLink or Oraclize.
Even in the case of a centralized oracle, smart contracts have a lot of advantages over their more traditional counterparts. Let’s imagine another situation:
Bob and Alice want to bet over the price bitcoin will reach in exactly one month from now. Bob is bearish and wants to bet that bitcoin will go down; Alice, on the other hand, wants to bet that the price of bitcoin will rise.
On august 6th, each of them locks $1,000 in one of those escrow boxes we have talked about and signs a smart contract with the following premises:
Per every dollar the price of bitcoin goes up, Alice will get $2 and Bob will lose $2.
Per every dollar the price of bitcoin goes down, Bob will get $2 and Alice will lose $2.
This smart contract Bob and Alice have signed is called in real life an investment fund. A traditional investment fund needs a fund manager, a fund administrator, a board of trustees, some unitholders and a distribution company. In our example, we have two people with different beliefs who are willing to bet, sorry, invest their money.
Isn’t it powerful? I’ll give you a few seconds to think of the implications. I’ll give you just two additional details to ponder: the fund in our example is leveraged, which means that Bob and Alice will earn more (or lose more) than the bitcoin price variation. And there’s no need, no need at all, to have real bitcoins to replicate the price change.
On september 6th, the smart contract ends and doles out earnings and losses. But how can the smart contract decide what is the price of bitcoin? It can read it from an exchange, or it can check a public feed, or read it from many exchanges and calculate an arithmetic mean. None of these solutions is a decentralized oracle, but for many purposes they are good enough.
Let’s finish with a question: how could we implement an oracle in our example depicting Bob and BigRiver.com? There are a lot of options, but I’m going to give you an example. Imagine a blockchain dedicated to track information about how objects behave in the world. Yes, that’s IoT (internet of things). If the packet from BigRiver is able to send a signal to the second blockchain saying it’s arrived to Bob’s hands, our problem would be solved.
Part 2. A taste of DeFi.
DeFi stands for Decentralized Finance. You might think we’re talking about another cryptocurrency, but DeFi is no crypto. It’s a suite of products that are being created on a blockchain specialized on smart contracts, that is, ethereum. Ethereum is the second biggest cryptocurrency, after bitcoin.
Think of DeFi as a myriad of new banks that are not regulated. I repeat: they are not regulated. That means two things: they can innovate much faster than their traditional counterparts, but there’s no government to back their losses: if they go bankrupt, they go bankrupt for good and their customers money, or coins, or tokens, disappear completely.
Let’s see a few of the things DeFi offers. Some will surprise you.
You have investment funds, savings accounts with a high interest, stablecoins, derivatives, insurance, prediction markets and many other things. I won’t discuss all of them, but I’m going to give you four examples to whet your appetite: savings accounts with a twist, tokenization, DAO’s and stablecoins.
Saving accounts are a way to save money. In the cryptoworld there are many accounts that offer a really high interest, even an 8%, which is very high for these times. But there are more creative products, like for example pooltogether, that won’t give you a high interest for your savings. Instead of it, they will give you something similar to a lottery ticket: you can earn all the interest generated by the pool if your ticket wins; if it doesn’t, your savings will remain the same. It’s like playing the lottery without losing any money.
The second example: tokenization. Imagine you are a singer and you have this idea for a really cool song with a video full of special effects, but you don’t have enough money to produce it. You can start a campaign on kickstarter, for example. But if you are serious about your contracts, you can divide your future video in little fragments and offer them to whoever wants to buy them. These transactions remain forever recorded on a blockchain, are immutable and offer a proof of ownership that can’t be forged. How much would you pay to own the 37th second of a famous song? It’s not only a moral reward: you can get paid every time anyone listens to that particular second. In the same way, a football player could sell his even minutes on the field, or a reality TV star could sell their Tuesdays. Tokenization makes it possible to think of these possibilities.
More things that can be done: DAO’s. This is a particularly intriguing concept, because it tackles the fundamentals, the way in which human beings build things. An enterprise is not a place where you go every day from nine to five to do a usually nonsensical work. An enterprise is the combination of many human beings to build a product. The product can be a screw or an interplanetary ship, or the travel from Earth to Alpha.Centauri, or a movie, or a refreshment. Almost everything you use daily is the product of a human enterprise, but also almost everything you dream of.
Products of enterprises can be magnificent, but the enterprises themselves usually are not. I had an old economics teacher who used to say: “Where there’s humans, there’s crap”. Excuse the mild profanity, but in my defense I’ll say the actual words were much more colorful.
If you think about it, we have progressed a lot in a lot of things, but our enterprises have almost the same structure since the pyramids were built: they are big, hierarchical behemoths where orders flow, almost always inefficiently, from top to bottom, and where new ideas are stifled somewhere in the ladder.
Can an enterprise be open, with no secrets, with a loose hierarchy, ruled by meritocracy, and steered by the majority of their members? Can companies be democracies? A DAO aims to achieve these goals. Can they work? One can hope, but only time will tell. This is an example of a platform to create DAO’s.
Stablecoins. Many people say all these things are okay, but there’s a fundamental problem underlying them: the price of bitcoin and cryptocurrencies is too volatile. How can we use bitcoin as a payment method, for example, if its price can go up or down a lot in a matter of minutes. How could I open a finance account, even if it offers me an 8% interest ratio, if in a few hours the money I’m placing there can lose 50% of its value if there is a downturn?
That’s where a stablecoin makes sense. They are coins that are pegged to a fiat currency like the dollar, which means that 1 of such coins is worth exactly 1 dollar, and will always be worth 1 dollar. There are many of them, like Dai or Tether. Even you could issue your own stablecoin.
This is just a taste of what DeFi is doing. We have just dipped our toes. We haven’t talked about insurance, derivatives or borrowing money. The possibilities are just too many and they are, quietly, redefining our world. Keep yourself informed. Come back to Very Complicated Stuff.