What is DeFi, and why is it important for proof of stake blockchains like Algorand?

To understand that, we need to understand a brief history of crypto.

For the better part of the 2000s, digital cash was the entire impetus of blockchain technology. That is to say, Bitcoin was invented in 2008 solely to be a form of digital money. The idea was that you could create a decentralized ledger of all transactions, and you could force truth in the transactions by rewarding the work of maintaining the ledger. This is, at a high-level, known as proof of work.



You’ve probably heard the story of the first purchase using Bitcoin: BTC in exchange for pizza. The idea expressed even then was that Bitcoin could replace our cash in this mundane, everyday sort of way, all run by transactions validated by moral 👼 computations.


In fact Bitcoin’s ‘white paper’ (a written thesis outlining its operation) was named “Bitcoin: A Peer-to-Peer Electronic Cash System.” You can read the entire paper here if you’re feeling 🤓



Much of the past decade has been spent building on the concepts first outlined in that historic white paper. Among these was the primary idea that you could store value without middlemen taking a cut, and without fraud or centralized banks or governments inflating the currency. A true peer-to-peer network, transferring value.



The future in code?


Bitcoin blocks, sets of transactions on the network, are mined, or computed and validated, every 10 minutes or so, and the miner (an electronic device owned by someone on the network) receives the value of the mined coin. This incentivizes “moral” or truthful work on the network.


However the computing required to mine a block increases over time, such that today everyday people can no longer do it with a gaming computer. Instead “money begets money,” as they say, and in crypto, the wealthy are able to mine in concert, running thousands of computers together at reduced electricity costs, all validating transactions on the network.


Currently .5% of Bitcoin wallets own 87% of Bitcoins mined! 💸


This has led to the further centralization of wealth.


Over time, drawbacks to Bitcoin became obvious. The block was far too costly to produce, the coin too volatile to predict its value and make day-to-day transactions, and the premise of the protocol was leading to increasing centralization through massive factories built solely to mine Bitcoin.



Which leads to another unfortunate consequence of Bitcoin mining: ever-increasing electrical draws, putting more strain on an already precarious environment.


And underlying all these constraints was the simplicity of Bitcoin. Designed to replace cash in simple user to user transactions, Bitcoin ultimately lacks the finesse of modern financial instruments.


Enter Ethereum.


Ethereum was intended to remedy many of Bitcoin’s shortcomings and complement the blockchain by using its own proof of work consensus protocol. In particular it was designed to allow for decentralized apps and smart contracts. 💰


You can think of decentralized apps (dApps) just like the ones on your phone — only not filtered through Apple Store or Google Play. The Algorand Post intends to write more on these soon.


Smart contracts, on the other hand, allow for the tokenization of assets. In other words, a corporation might represent their loyalty points in sub-tokens created on the Ethereum network. At a less modest level than loyalty points, smart contracts allows for options trading, real estate transactions, and even more complicated financial transactions.



More imaginatively, think of royalties for your favorite band effortlessly tracked across the globe: your band rewarded directly, instead of through Spotify. That is the possibility of DeFi.


Yet the inherent drawbacks in crypto remain.


Ethereum intends to transition away from a proof of work protocol. The reason is that transaction costs on Ethereum have skyrocketed due to the demand drawn by smart contracts, dApps, and retail investors. The utility of crypto has paradoxically crippled its usefulness, at least temporarily. In 2021, as decentralized finance has taken flight, miners are charging more and more exorbitant fees to execute transactions on their blockchains.


However, a few years ago in 2012, a new protocol for cryptocurrency was introduced. “Proof of stake,” or PoS, is a crypto protocol invented by Sunny King and Scott Nadaal. Intending to reduce the high energy costs associated with coin mining, proof of stake relies on actors “staking” their holding of coins on the network, thereby increasing the chances that they would get chosen to write or validate the next transaction in the blockchain — and thus receive the rewards of the computation.


In other words, these protocols no longer reward miners for performing exhaustively complex equations, but individuals receive rewards simply by having a holding on the network and validating transactions non-maliciously.


Because of these innovations, transactions cost less, process faster, and the network maintains stronger decentralization by not requiring massive amounts of computing power and electricity. 🌎



This is where DeFi truly starts to shine.


If the goal of crypto was to create a digital decentralized currency, decentralized finance is supposed to be the entire apparatus of transactions running atop those networks.


Think buying houses and cars, lending, and savings accounts. Think playing the stock market, gambling, and 401ks. DeFi seeks to use the promise of Bitcoin to realize the power of a decentralized world economy.


But to truly succeed, the industry requires fast transactions, lower volatility in price, and near-zero fees. This is because if you loan someone $10,000 to buy a car, you want to know that the value of your loan won’t have deflated just by market volatility driven by memes.



While Bitcoin and Ethereum have proven their value in building secure and open-source transactions, Proof of Stake coins like Cardano, Algorand, Cosmos, and NEO allow faster transactions at lower costs, and with coins bound by lower market volatility.


These benefits along with crypto's inherent security have led to this extraordinary moment in history — where banks are tokenizing their assets on crypto, and billionaires like Elon Musk and Mark Cuban are signaling the end of traditional banking. Major governments like the US are considering digital currencies of their own.




It’s not that none of this was possible before. But everything designed before was not designed for this moment. This is the magic of 2021, and it’s why the next few years will be incredible for crypto.


The Algo Post




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