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CORE COMPONENTS OF DEFI

Understanding the core components of decentralized finance (DeFi) is essential for anyone looking to navigate this innovative field.

WHAT ARE SMART CONTRACTS?

Smart contracts are self-executing contracts with the terms of the agreement directly written into code. They automatically enforce and execute the terms of the contract when certain conditions are met, without the need for intermediaries. These contracts run on supported blockchain networks (such as Base, Ethereum, Arbitrum, Solana), where they leverage the decentralized and immutable nature of the blockchain to ensure trust and transparency.

As an example, for instance, we are at a vending machine and the only way to get a bottle of coke out of the vending machine is to insert a golden coin that has an imprint of a skull, if we insert a silver coin with the imprint of a skull or a golden coin with the imprint of a lion, we will not get a bottle of coke, we might get other things in the machine or nothing at all but to get the bottle of coke we have to insert a golden coin with an imprint of a skull. This is a simple demonstration of how smart contracts work just like the vending machine in our story as long as the machine is up and running (in smart-contract scenario as long as it is deployed to the blockchain with the conditions to be met) when we insert a golden coin with the imprints of a skull (when we meet the encoded conditions in the smart-contract) we get a bottle of coke and nothing else (we get a deterministic output i.e our output is vastly determined by the instructions and data we pass to the smart-contract).

HOW SMART CONTRACTS WORK

We established earlier on that smart contracts are made up pre-defined conditions that when met gives us an input that depends greatly on the input we pass to them. Here’s a step-by-step breakdown of how they function:

Code Deployment

A smart contract is coded and deployed on a blockchain network. The contrac’s code includes the terms and conditions for executions by users.

Triggering Conditions

The contract is set to execute when specific conditions or events occur. These conditions are part of the contract’s code. For example, a smart contract might be programmed to incentivize every StudBit member that completes quizzes on StudBit and submits.

Execution

Once the triggering conditions are met, the smart contract automatically executes the corresponding actions. This could involve transferring funds, releasing digital assets, or providing access to a service.

Immutable and Transparent

Once deployed, the smart contract cannot be altered(except on some special cases where upgradeability mechanism is added to the contract). This immutability ensures that the terms of the contract are enforced exactly as written, providing a high level of trust. Additionally, because the contract operates on a blockchain, its execution is transparent and can be verified by all parties involved.

Open marketplaces focus on offering users a place to exchange non-fungible tokens (NFTs). These tokens can also be referred to as crypto-collectibles. Opensea and Rarebit are two such platforms that help with the discovery, buying, or selling of such crypto-assets.

Due to the transparent nature of the blockchain, this smart contract are visible to everybody who has the capacity to connect to the blockchain.

EXAMPLES OF SMART CONTRACTS APPLICATIONS IN DEFI

Smart contracts is the core of Decentralized Finance (DeFi), enabling a wide range of financial services without traditional intermediaries. Here are some notable examples:

• Lending and Borrowing Platforms: Platforms like Compound and Aave use smart contracts to enable peer-to-peer lending and borrowing. Users can lend their cryptocurrency to earn interest, or borrow against their crypto assets by providing collateral. Smart contracts automate the entire process, from the calculation of interest rates to the execution of collateral liquidation in case of defaults.

Which platforms use smart contracts to enable peer-to-peer lending and borrowing?

Compound and Aave.Uniswap and Sushiswap.Opensea and Rarebit.
• Decentralized Exchanges (DEXs): Platforms like Uniswap and Sushiswap are examples of DEXs that use smart contracts to enable the trading of tokens directly between users. Smart contracts handle the matching of buy and sell orders, the execution of trades, and the distribution of fees to liquidity providers, all without a central authority.
• StableCoins: Stablecoins like DAI use smart contracts to maintain their value pegged to a stable asset, typically the US dollar. DAI, for instance, is generated through the MakerDAO protocol, where users lock up collateral in the form of cryptocurrency into smart contracts to mint new DAI tokens. The smart contract ensures the stability and proper collateralization of the stablecoin.
• Yield Farming and Liquidity Mining:Yield farming involves providing liquidity to DeFi protocols in exchange for rewards. Platforms like Yearn Finance aggregate various yield farming opportunities and automate the process using smart contracts. These contracts manage the allocation of funds to different protocols to maximize returns for users.

What is the primary benefit of yield farming platforms like Yearn Finance?

Centralizing all DeFi services.Offering traditional banking services.Automating the process of providing liquidity in exchange for rewards.

These are few examples of well-known smart contracts use cases in DeFi the uses and applications of smart contract in DeFi and other industries are of smart-contracts is numerous.

BENEFITS OF SMART CONTRACTS

• Trustless Transactions: Parties do not need to themselves or a third party; they only need to trust the code.
• Efficiency: Automating processes reduces the need for manual intervention, making transactions faster and cheaper.
• Transparency: All transactions are recorded on the blockchain, providing a transparent audit trail.
• Security: Cryptographic security ensures that transactions are secure and tamper-proof.
• Reduced Costs: Eliminating intermediaries reduces the costs associated with traditional financial transactions.

CHALLENGES AND CONSIDERATIONS

• Code Accuracy - The code must be flawless; bugs or errors can lead to significant financial losses
• Legal Recognition - The legal status of smart contracts varies by jurisdiction and is still evolving.
• Complexity - Creating and auditing smart contracts requires specialized knowledge and skills.

Smart contracts represent a revolutionary shift in how agreements and transactions are executed. By utilizing the decentralized, transparent, and secure nature of blockchain technology, they offer tremendous potential for innovation in various industries, particularly in DeFi. As the technology continues to grow, smart contracts will likely become an important part of our digital economy, enabling more efficient and trustworthy interactions.

DECENTRALIZED APPLICATIONS (dApps)

Decentralized Applications, commonly referred to as dApps, are applications that run on a blockchain network rather than on a centralized server. Unlike traditional applications, which rely on a central authority to manage and control the data, dApps operate largely in a decentralized manner, leveraging the distributed nature of blockchain technology.

A dApp can be anything from a simple game to a complex financial system, but all dApps share common characteristics: they are open-source, autonomous, and operate within a blockchain ecosystem. The Ethereum blockchain is the most popular platform for developing dApps, thanks to its robust smart contract functionality.

KEY FEATURES OF DAPPS

• Decentralization: dApps run on a decentralized network of nodes rather than a single central server. This decentralization ensures that no single entity has control over the application, making it more resilient to censorship and single points of failure.
• Open Sourced: The codebase of a dApp is open-source, meaning it is available for anyone to inspect, audit, and contribute to. This transparency fosters trust among users, as they can verify the application’s functionality and security.
• Smart Contracts: Due to the self-executing nature of smart contracts, they are used in dapps to automate the execution of agreements and processes withing dapps, reducing the need for intermediaries and increasing efficiency.
• User Control: Users have control over their data and interactions within a dApp. Since there is no central authority managing the data, users can interact directly with the application and retain ownership of their assets and information.

POPULAR DEFI DAPPS

DeFi, or Decentralized Finance, is one of the most prominent use cases for dApps, revolutionizing traditional financial services by making them more accessible, transparent, and efficient. Here are some popular DeFi dApps:

• Uniswap: Uniswap is a decentralized exchange (DEX) that allows users to trade cryptocurrencies directly from their wallets without the need for a central authority. It uses an automated market maker (AMM) system, where liquidity providers contribute to liquidity pools, and prices are determined algorithmically. Users can trade tokens, provide liquidity, and earn fees, all facilitated by smart contracts.
• Compound: Compound is a decentralized lending and borrowing platform where users can earn interest on their crypto holdings or borrow against them. Users supply assets to liquidity pools and earn interest, while borrowers can take out loans by providing collateral. Smart contracts handle the calculation of interest rates and the liquidation of under-collateralized loans.
• Aave: Aave is another DeFi lending protocol that allows users to lend and borrow cryptocurrencies. It introduces unique features such as flash loans, which are instant, uncollateralized loans that must be repaid within the same transaction block. Aave also offers a wide range of collateral options and flexible borrowing terms, all managed by smart contracts.
• MakerDAO: MakerDAO is the protocol behind the stablecoin DAI, which is pegged to the US dollar. Users can generate DAI by locking up collateral in the form of Ethereum or other supported assets in Maker Vaults. The system uses smart contracts to ensure the stability and proper collateralization of DAI. MakerDAO also features decentralized governance, where MKR token holders vote on protocol changes.
• Yearn Finance: Yearn Finance is a yield aggregation platform that optimizes yield farming strategies for users. It automates the process of moving funds between different DeFi protocols to maximize returns. Users can deposit assets into Yearn’s vaults, and the platform’s smart contracts manage the investment strategies, providing users with the best possible yields.

BENEFITS OF DAPPS IN DEFI

• Transparency: All transactions and operations within a dApp are recorded on the blockchain, providing a transparent and immutable audit trail
• Security: The decentralized nature of dApps and the use of cryptographic algorithms ensure high levels of security against hacks and fraud.
• Efficency: Automation through smart contracts reduces the need for intermediaries, lowering costs and increasing transaction speeds.
• Accessibility: dApps are accessible to anyone with an internet connection and a compatible wallet, democratizing access to financial services.

CHALLENGES OF DAPPS IN DEFI

• Scalability: The current blockchain infrastructure, particularly Ethereum, faces scalability issues that can lead to high transaction fees and slow processing times although, L2s has made it easier and much cheaper to process transactions there is still need to increase scalability going forward to accommodate more users
• User Experience: The user interface and experience of dApps can be complex and less intuitive compared to traditional applications, posing a barrier to mainstream adoption.
• Regulator Uncertainty: The regulatory environment for dApps and DeFi is still evolving, with potential legal challenges and compliance requirements that could impact their operation.
• Security Risks: While dApps are secure by design, vulnerabilities in smart contract code can lead to exploits and significant financial losses.

In DeFi, dApps are transforming how we interact with financial services, offering innovative solutions that challenge the traditional financial system. As the technology matures and scalability issues are addressed, dApps are poised to become integral to the future of finance and beyond, driving forward the vision of a decentralized web.

DIFFERENCES BETWEEN DAPPS AND SMART CONTRACTS

If you have read to this point and you are new to these terms you might have mixed it all up wondering, what is the difference between smart-contracts and DApps?

Smart contracts and decentralized applications (dApps) are essential components of blockchain technology but are distinct components. Smart contracts are self-executing contracts with the pre-defined rules directly written into code. They automate processes and transactions without third parties, ensuring trustless and transparent operations. For instance, smart contracts power DeFi lending platforms like Compound by automatically enforcing loan agreements

While, dApps are full-fledged applications that run on a blockchain, utilizing smart contracts for backend processes. They offer user interfaces that allow individuals to interact with blockchain functionalities easily. Examples of DApps include Uniswap, a decentralized exchange for token swaps, and MakerDAO, a platform for issuing stablecoins.

So, when you go to Uniswap.org or the website of any other platform that offers DeFi services, what you see and interact with are dApps. Under the hood, these dApps are powered by smart contracts. In summary, dApps allow users to interact with smart contracts without needing technical knowledge of the underlying smart contract code.

The primary distinction is that smart contracts are the building blocks, executing specific tasks and automating agreements. In contrast, dApps are the end products that provide a comprehensive user experience by integrating multiple smart contracts to perform various functions. While smart contracts ensure the secure execution of individual transactions, dApps enable users to leverage these transactions through accessible and user-friendly interfaces.