DeFi, AKA Decentralized Finance, is the future of the money market. Before digging deeper into the DeFi world, we must know what centralization is and why decentralized finance opens the door to a new age of economics.
Centralization means the control of someone or an organization over something. In the case of finances, the governments can control and track every transaction. They can limit someone in doing transactions and even stop them completely, I.e., close their financial account. There are various tax fees included in central transactions, and they may take a lot of time to be completed. Here is where decentralized finance comes into play to solve these problems by giving everyone the authority on the network. For example, in the case of Bitcoin, anyone has access to a list of all transactions and can mine and vote on the blockchain. Unlike centralized finance, there isn’t any third party involved, and people can directly send money to each other. The transactions take much less time to complete, and the transaction fees are ridiculously cheaper than centralized platforms!
Central finance is trust-based, which means you are trusting the government and giving them your money. Meanwhile, DeFi is totally trustless because there is no third party involved, and there are pieces of code that run and act as a bank. These codes are open-source, and it is possible to read through them and find out how secure the codes are. Not to mention that codes are also censorship-resistant.
DeFi is made from three main components:
In computer science, cryptography is a method of securing information and communication through mathematical models and algorithms. These techniques are designed to transform messages in a way that is harder to decipher, and only those for whom the information is intended can read it. These algorithms are mainly used for protecting data privacy such as transactions and credit card data, but they are also effective for digital signing and even web browsing.
For the sake of simplicity, let’s break down blockchain technology and first understand what a block is. A block is a piece of data, and data can be anything; a list of transactions or a list of people who ordered pumpkin spice latte from Starbucks today. It’s mostly a collection of records. In Bitcoin, a block consists of a list of transactions which are called a Ledger. Every block in Bitcoin’s blockchain can consist of up to 1500 transactions as of today. These blocks get added to the network when they reach their maximum storage. When a block is added to the system, it means it has been “Mined”. Block mining is for the Proof-of-Word models, where you have to “prove” that you have mined that block. This brings us to the concepts of hashing functions, which is essentially what we do when we mine a block. And don’t worry, we’ll be explaining Proof-of-Work and other models in a bit.
The hashing function is a system where you give it something, and it outputs a hash (#). As the name suggests, it is a pretty mathematical system, but to put it in simpler terms, you give it something, and it gives you something back. Bitcoin uses the SHA-256 hashing function, which stands for Secure Hashing Algorithm, and 256 refers to the number of zeros and ones in the output. It means that whether you give it just a letter or the entire terms and conditions of your favorite app, it will provide you with 256 zeros and ones in either case. Computers convert these zeros and ones to letters and numbers.
Three main things justify having enormous mining farms which use considerable amounts of electricity.
In fact, when you are “mining a block”, you’re trying to add random numbers to the block so you can get a special ending. When you find the input leading to the required output, the block is solved and verified, and “mined”. In return, you will be rewarded for going through all this. In the Bitcoin blockchain, you will be rewarded with Bitcoin. This is actually how new Bitcoins are created. The hash of the previous block is added to the next block, thus forming a chain. If someone tries to go back and change the previous block even the slightest bit, all the other blocks will be changed because their hashes are changed now. This strategy ensures that no one goes back and adds more money to their account or adds fake transactions.
Proof of work (PoW) is a decentralized consensus mechanism that requires participants to “solve” a mathematical puzzle to prevent everyone from tricking the system. By doing so, they will receive rewards in return. It is mainly used for mining and validating transactions. In fact, this consensus mechanism is what hashing function is all about. It is called “proof-of-work” because the network requires massive amounts of processing power. It’s a robust way of securing decentralized blockchains, and as the value of a coin grows, more miners join the network, resulting in increased power and security.
Although more prominent blockchains like Bitcoin and Ethereum use this consensus mechanism to secure their system, there are downsides to this. One of such drawbacks is the excessive amount of electricity used. As explained earlier, the first person who finds the hash to the block and “solves” it is rewarded. It means that other participants won’t receive anything even though they have used a lot of electricity and energy. It turns PoW into a race, and the resulting electricity waste is a massive environmental problem. Alternatives have been developed, and the most popular one which wastes much less electricity is called proof of stake.
In the proof-of-stake model, you lock up a portion of your coins. By doing so, you are creating your own validator nodes. You basically pledge your coins to be used for verifying transactions. Please note that when you stake your coins, you are unable to trade them, so you have to unstake them if you want to use them for trading.
In the PoA model, transactions are validated by approved accounts known as validators. Validators are in charge of running some software that allows them to put transactions in blocks. However, this process is automated and doesn’t require the validator to monitor their computer consistently.
A smart contract is a code that runs something if something else happens or certain conditions are met. They work similar to functions in math, and frankly, tons of math is happening in the process. Smart contracts nowadays are primarily written on Ethereum using something called solidity. For example, if people donate to a contract and it reaches a certain amount it was meant to, all the participants will receive an NFT. Smart contracts are immutable and can’t be changed once they are created. It means if there’s a bug in the contract, it cannot be fixed. To solve this, people usually develop new ones and tell others not to use the other.
These forms of contracts are distributed, which means there are no discrepancies, and they are initially designed to remove human error. Smart contracts are open-source, making it possible to look through the codes and find potential bugs and errors.
NFT is the short-term for Non-Fungible Token and is a type of digital assets like digital art, gifs, and trading cards. By buying an NFT, you’re buying the rights to that specific asset. NFTs are owned by an address and whoever has the password to that address owns the NFT. With NFTs, the owner history is always trackable and has a direct impact on the NFT’s value.
A non-fungible token can’t be changed once it is created, and they are not identical. Some tokens like XMR are entirely fungible, which means the two are equal. Whereas, some like Bitcoin aren’t completely fungible since they carry the history of whose hands they’ve been traded to. A Bitcoin used in a hack might not have the same value as a healthy Bitcoin. With that being said, even though Bitcoins are not completely fungible, they’re still identical to some level, but two NFTs are never the same and of the same value. An NFT, once owned by a celebrity like Rick Astley, is of a much higher value than when it wasn’t owned by him.
It’s crucial to know what you’re buying when investing in an NFT. You’re buying a piece of data owned by an address that points to a server that hosts an image or a gif. The server could change, or even the image or gif could be changed by whoever owns the server. You actually own the piece of data that points to a server, not the server, the access to the server, and not even the image or gif.
NFTs are seen as collectible investments. The factors that make ordinary collectibles valuable also work for NFTs. For example, the first creation of specific creators or businesses is of high value. Think of Pokemon cards; the most expensive ones are those that are produced and are first-edition. NFTs also have real-world utility. Imagine an artist selling 50 NFTs, and whoever owns one of them can have lunch with that artist once a month, or they can gain access to a club or community. NFTs are also unique and rare. Everyone can have a copy of a manga or a magazine, but only one person can have that original hand-drawn manga or an NFT.
Bitcoin is the first decentralized digital currency created by pseudonymous user Satoshi Nakamoto. It was invented in 2008 and is a sort of open-source software. It is a Proof-of-Work currency, meaning users who solve and “mine” blocks are rewarded with Bitcoins.
Satoshi Nakamoto is the inventor of Bitcoin, the first blockchain and cryptocurrency ever created. He is anonymous and uses a pseudonym, and has claimed he’s at the age of 46 now and was born in Japan. Many people have claimed or have been claimed to be Nakamoto, but the identity remains unknown to this day.
The satoshi is currently the smallest unit of the bitcoin currency recorded on the blockchain. It is a hundred millionth of a single bitcoin (0.00000001 BTC).
These are the important terms that you might have heard here or there but probably didn’t know the meaning of if you’re new to the game. Educating yourself is a must if you want to invest in crypto since there are a lot of scams out there claiming to be something they are not. To learn more about other terms and even professional strategies, stay tuned for an entire encyclopedia!
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