What you need to know.
Much of this chapter is covered in greater detail in Solflare’s flagship course, Crypto Fundamentals.
To understand DeFi you need to understand what blockchains enable and in order to do that, you need to understand how they work. This chapter will break down blockchain basics as well as explain some of DeFi’s history.
- Blockchain Basics
- Accounts & Wallets
- Digital Economies
- DeFi History
Blockchains are ever-expanding ledgers of transactions. They have a handful of qualities that differentiate them from traditional computing networks and they open doors to entirely new ways of doing things. They’re intended to be censorship-resistant, immutable sources of record with interoperable capabilities. Immutable in the sense that these transactions can not be reversed and interoperable in the sense that blockchain accounts can seamlessly interact with other accounts and applications.
Transactions on a blockchain are grouped into blocks and are verified by a distributed network of computers that earn money for participating in the verification process. The term distributed refers to the idea that these computers are not governed by any central entity but rather a widespread collection of individual entities. This network collectively puts together a public ledger that can be indexed and searched with extreme detail. Anything that happens on a public blockchain is immediately and immutably a part of the public record.
Accounts & Non-Custodial Wallets
Each account on a blockchain is accessed with a digital wallet. Accounts hold an individual or entity’s tokens which can be freely transferred between wallets and can interact with applications that are compatible with the wallet. These applications can be of a financial nature or used for gaming, messaging, and virtually anything else. When proper security measures are practiced, only the user of a wallet has access to its contents.
For a deeper dive into non-custodial wallets, check out this article from Solflare’s Knowledge Base.
Unlike traditional markets, blockchains are operating at all hours of the day so on-chain markets are running 24/7, and transactions can’t be reversed. Anyone with a wallet can partake in them and all transactions are final.
The following properties are fundamental qualities that public blockchains possess to varying degrees. There are open and closed source private blockchains but those are custom-made and built to cater to a centralized company like JPM Chase.
|Immutability||What happens on a blockchain stays on a blockchain. Transactions can’t be reversed and each one immediately becomes part of the public record.|
|Interoperability||The open source nature of crypto and DeFi has helped kickstart significant innovation because applications can work together unlike ever before. To frame it another way, DeFi developers often describe what they’re building as money legos.|
|Capability||Different blockchains are akin to different operating systems. Each one has something unique to offer on the spectrums of speed, interoperability, privacy, and decentralization.|
|Permissionless||Anyone anywhere at any time can build or use a blockchain. This allows for digital economies to function in novel ways which open up new worlds of opportunity and are a core tenet of the crypto industry.|
While some blockchains are forks – or replicas – of others, most are built differently and each of their immutable, interoperable, capable, and permissionless qualities will differ.
When you combine the above ingredients into a network of people and computers around the world, you begin opening the door to a new paradigm. A paradigm where banks and brokers don’t stand in between you and your money. A paradigm where algorithms verify and prove that events took place rather than you having to trust a banker, broker, or government entity.
Blockchains can’t lie.
Using the tools of self-custody and non-custodial wallets, individuals can now be their own banks and brokers. All they need to do is generate a digital wallet like Solflare. Digital wallets are cryptographically secure locations for you to interact with your digital assets and they can be accessed with 12-24 word mnemonic phrases, known colloquially as recovery phrases or seed phrases. Anyone with a wallet’s phrase can access said wallet so it’s imperative that only you have access to your wallets. Learn more about recovery phrases at the link below
You can store a near infinite amount of cryptocurrencies and NFTs (non-fungible tokens) in a single wallet and you can generate and access a near infinite amount of wallets using a single recovery phrase. These wallets don’t actually store your assets but rather they are an interface for you to interact with your assets. Blockchain assets are on-chain at all times so as long as you have access to your wallet and the blockchain you use is working, you’ll have access to your digital assets. Let that sink in.
It’s not hard to realize how profound this is. Rather than carry $100,000,000 in cash, you can now remember a 12-24 word phrase that gives you access to a digital wallet that has 100,000,000 USDC in it and no one can ever take that from you – unless you get scammed or give away your secret phrase. USDC is a stablecoin that attempts to retain parity with the dollar so 1 USDC = $1. If USDC were to depeg, then that’d be an issue. Such was the case with UST, a decentralized algorithmic stablecoin.
DeFi’s roots are murky but there’s consensus that, in terms of innovations in decentralization, Bitcoin was a 0 to 1. While there have been many attempts at creating decentralized computing networks such as Tor, there has never been a network with an ingrained digital currency that was able to prevent double-spending from happening.
There were no decentralized computing networks with the functionality that blockchains have until Bitcoin came around. Bitcoin, as a cryptocurrency, only exists because of the underlying Bitcoin blockchain that is continuously verifying transactions and adding new blocks to its distributed ledger. As its value increased by over 83,000,000% in a decade, an entire industry formed around it and stands at the bleeding edge of technology, finance, game theory, and distributed systems. Some of its earliest projects were MakerDAO and Ethereum.
There is a Second Best and it might be Bitcoin
Bitcoin and its surrounding maximalist culture believe that Bitcoin is the end all be all for global reserve currencies and decentralized finance. It’s surprising that so many people think that the first iteration of a new technology is the best one.
Would you fly in the Wright Brothers’ plane?
None of what exists today in crypto would exist without Bitcoin but there is room for more than one digital asset. Bitcoin is used to pay for transaction fees on the Bitcoin blockchain in the same way that other cryptocurrencies are used to pay for transactions on other blockchains, such as Ethereum.
Ethereum has a long and colorful history that is expertly outlined in The Infinite Machine: How an Army of Crypto-hackers Is Building the Next Internet with Ethereum. Refer to that text, or to a similar book, The Cryptopians: Idealism, Greed, Lies, and the Making of the First Big Cryptocurrency Craze for a thorough account of Ethereum.
For the scope of this course, it’s important to understand that Ethereum and a new programming language called Solidity were developed to serve as a global settlement layer and to enable developers to build any complete program or protocol on top of it. This is a vague and ambiguous way of describing the function of what you can do with a distributed ledger – or a database. The programs themselves can be simple protocols that let you buy a jpeg image or trade the Ethereum cryptocurrency for another token, or they can be complicated financial wizardry that is difficult to explain.
The ERC20 Standard & the ICO Bubble
Ethereum developers built a series of protocols that were compiled into the ERC20 standard. ERC20 refers to the fungible token standard on Ethereum. Ethereum, unlike Bitcoin, lets you build and release any customized token. The economics of the token – the distribution schedule, etc – is referred to as tokenomics. Ethereum hit the ground running in 2014 and by 2017, a massive bubble had inflated around ERC20 token raises. Companies were issuing tokens in exchange for Ethereum or other cryptocurrencies by doing what’s called an ICO – an initial coin offering. It’s comparable to traditional finance’s IPO – an initial public offering but requires far less due diligence and regulatory oversight. As a result of this craze, Bitcoin and Ethereum were hitting fresh all-time highs as retail investor demand went through the roof.
It’s clear now that many of the companies involved in the 2017 debacle were fraudulent or inadequate but at the time, they were taking advantage of a novel and unregulated technology that was very early in its infancy. The internet’s dot com bubble in the early 2000s had a similar effect. Greedy people saw smart people making money and tried to get in on it.
Over the course of 2017 to now, prices have been volatile but builders have kept on building. Ethereum has boasted a hefty $160 billion worth of digital assets on-chain at its peak and continuously confirms over a million transactions per day.
Alt Layer 1s & DeFi
Ethereum, and all blockchains, are known as Layer 1s. They are the ultimate settlement layer on which all applications are built. When referring to Layer 1s that are not Bitcoin or Ethereum, industry pundits call them Alt Layer 1s. These blockchains may offer outsized rewards with a larger amount of risk involved, or they may end up being defunct and bereft of users.
The classic alt layer 1 trade in 2021 was SoLunAvax which referred to buying and holding the Solana coin, Luna coin, and Avax (Avalanche) coin. Solana is thriving and has healthy organic growth metrics, Avalanche has a fairly robust community, and Luna, unfortunately, went to zero in 2022, bringing down roughly $60 billion worth of value with it (UST and LUNA). Read more about Luna’s downfall here.
New blockchains usually have no interest in being like Bitcoin. They’re usually variations of Ethereum’s structure (referred to as EVM compatible – Luna, Avax, Near, etc) or they’re looking to iterate on other blockchain architecture (Solana) and they consistently begin with building what become known as the DeFi stack. We’ll go over that in the next chapter.
DeFi: A Tour de Force
DeFi not only stands alone as a tour de force in terms of technological advancement, but it serves as the data-rich underbelly of the burgeoning NFT, DAO, and Web3 ecosystems which are out of the scope of this course.