CRYPTOCURRENCY
The most popular application of blockchain technology is cryptocurrency, a token (usually scarce) that is cryptographically secured and transferred. The scarcity is what assures the possibility of value and is itself an innovation of blockchain. Typically, digital objects are easily copied. As Eric Schmidt, the former CEO of Google, said,1 “[Bitcoin] is a remarkable cryptographic achievement and the ability to create something that is not duplicable in the digital world has enormous value.”
No one can post a false transaction without ownership of the corresponding account due to the asymmetric key cryptography protecting the accounts. You have one “public” key representing an address to receive tokens and a “private” key used to unlock and spend tokens over which you have custody. This same type of cryptography is used to protect your credit card information and data when using the Internet. A single account cannot “double spend” its tokens because the ledger keeps an audit of the balance at any given time and the faulty transaction would not clear. The ability to prevent a double spend without a central authority illustrates the primary advantage of using a blockchain to maintain the underlying ledger.
The initial cryptocurrency model is the Bitcoin blockchain, which functions almost exclusively as a payment network, with the capabilities of storing and transacting bitcoins across the globe in real time with no intermediaries or censorship. This is powerful value proposition gives bitcoin its value. Even though its network effects are strong, some competitors in the cryptocurrency space offer enhanced functionality.
THE SMART CONTRACT PLATFORM
A crucial ingredient of DeFi is a smart contract platform, which goes beyond a simple payments network such as Bitcoin and enhances the chain's capabilities. Ethereum is the primary example. A smart contract is code that can create and transform arbitrary data or tokens on top of the blockchain to which it belongs. Powerfully, it allows the user to trustlessly encode rules for any type of transaction and even create scarce assets with specialized functionality. Many of the clauses of traditional business agreements could be shifted to a smart contract, which not only would enumerate but also algorithmically enforce those clauses. Smart contracts go beyond finance to include gaming, data stewardship, and supply chain.
Ethereum charges a gas fee for every transaction – similar to how driving a car takes a certain amount of gas, which costs money. Imagine Ethereum as one giant computer with many applications (i.e., smart contracts). If people want to use the computer, they must pay for each unit of computation. A simple computation such as sending ether (ETH) requires minimal work to update a few account balances and thus has a relatively small gas fee. A complex computation involving minting tokens and checking various conditions across many contracts requires more gas and thus will have a higher fee. The gas fee may lead to a poor user experience, however. It forces agents to maintain an ETH balance to pay it and leads to worry about overpaying, underpaying, or the transaction not taking place at all. So initiatives are ongoing to eliminate gas fees from end users. There are also competitor chains that completely remove this concept of gas.
However, gas is a primary mechanism for preventing system attacks that generate an infinite loop of code. It is not feasible to identify malicious code of this kind before running it, a problem formally known in computer science as the halting problem. Suppose a car is on autopilot, stuck in full throttle with no driver. Gas acts as a limiting factor: the car will stop eventually when the gas tank empties. In the same way, gas fees secure the Ethereum blockchain by making such attacks cost-prohibitive. They incentivize highly efficient smart contract code since contracts that use fewer resources and reduce the probability of user failures have a much higher chance of being used and succeeding in the market.
On a smart contract platform, the possibilities rapidly expand beyond what developers desiring to integrate various applications can easily handle. This leads to the adoption of standard interfaces for different types of functionality. On Ethereum, these standards are called Ethereum Request for Comments (ERC). The best known of these define different types of tokens that have similar behavior. ERC-20 is the standard for fungible tokens and defines an interface for tokens whose units are identical in utility and functionality.2 It includes behavior such as transferring units and approving operators for using a certain portion of a user's balance. Another is ERC-721, the non-fungible token standard, which are unique and often used for collectibles or assets such as peer-to-peer loans. The benefit of these standards is that application developers can code for one interface and support every possible token that implements that interface. We will discuss these interfaces in more detail later on.
ORACLES
An interesting problem with blockchain protocols is that they are isolated from the world outside of their ledger. That is, the Ethereum blockchain authoritatively knows what is happening only on the Ethereum blockchain and not, for example, the level of the S&P 500 or which team won the Super Bowl. This limitation constrains applications to Ethereum native contracts and tokens, thus reducing the utility of the smart contract platform; it is generally known as the oracle problem. In the context of smart contract platforms, an oracle is any data source for reporting information external to the blockchain. How can we create an oracle that can authoritatively speak about off-chain information in a trust-minimized way? Many applications require an oracle, and the implementations exhibit varying degrees of centralization.
There are several implementations of oracles in various DeFi applications. A common approach is for an application to host its own oracle or hook into an existing oracle from a well-trusted platform. One Ethereum-based platform known as Chainlink3 is designed to solve the oracle problem by using an aggregation of data sources. The Chainlink white paper4 proposes a reputation-based system. We discuss the oracle problem later in more depth. Oracles are surely an open design question and challenge for DeFi to achieve utility beyond its own isolated chain.
STABLECOINS
A crucial shortcoming of many cryptocurrencies is excessive volatility. This adds friction to users who wish to take advantage of DeFi applications but don't have the risk-tolerance for a volatile asset like ETH. To solve this, an entire class of cryptocurrencies called stablecoins has emerged. Intended to maintain price parity with some target asset, USD, or gold, for instance, stablecoins provide the necessary consistency that investors seek to participate in many DeFi applications and allow a cryptocurrency native solution to exit positions in more volatile cryptoassets. They can even be used to provide on-chain exposure to the returns of an off-chain asset if the target asset is not native to the underlying blockchain (e.g., gold, stocks, exchange-traded funds [ETFs]). The mechanism by which the stablecoin maintains its peg varies by implementation. The three primary mechanisms are fiat-collateralized, crypto-collateralized, and non-collateralized stablecoins.
By far the largest class of stablecoins are fiat collateralized. These are backed by an off-chain reserve of the target asset. Usually they are custodied by an external entity or group of entities that undergo routine audits to verify the collateral's existence. The largest fiat-collateralized stablecoin is Tether5 (USDT) with a market capitalization of $62 billion, making it the third largest cryptocurrency behind Bitcoin and Ethereum at time of writing. Tether also has the highest trading volume of any cryptocurrency but is not audited.6 The second largest is USDC,7 and its holdings
