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A Dive Into Smart Contracts and DeFi

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Published on:
January 15, 2021

Contributor: smart contracts are essential to the decentralized finance space. What exactly are they?

A Dive Into Smart Contracts and DeFi

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New to Bitcoin, cryptocurrencies and blockchain technology? If yes, then the following will give you an introduction to smart contracts, the fundamental blockchain technology, the backbone of decentralized finance (DeFi) and explain how they’re being used in the most popular decentralized applications. If no, read along anyway, you may learn something new.


What Are Smart Contracts and Why Should I Care About Them? 

Before we get into the strengths or shortcomings, let’s examine what a smart contract is. In a decentralized world based on mathematical computation such as a blockchain, a smart contract is an automatic and self-executing agreement that operates without the need of a central authority or rent-seeking third party. 


Smart contracts remove unnecessary paperwork and expensive intermediaries that are required to facilitate traditional contracts, transactions and exchanges while upholding transparency and visibility on the blockchain. They work by creating a digital agreement or contract whereby each party inputs a number of predetermined conditions or provisions that must be completed in order for the contract to be executed, without a middleman.


The real value of smart contracts comes from their wide ranging use cases such as payments (in cryptocurrency or fiat) and supply chains or more complex applications that span across decentralized finance (DeFi) including lending protocol, stablecoins, derivatives, decentralized exchanges, insurances, random number generation, betting and gambling, digital asset transfers and so on. 


There is over USD $20 billion in total value locked up in DeFi smart contracts alone. This may seem like a lot at first glance, but considering the total notional amount outstanding for contracts in the derivatives market is valued at an estimated $1 quadrillion and stock markets at $89.5 trillion$13 billion is nothing, we are still very early.


While DeFi is still in its infancy, when the industry matures and begins to solve the pain points within traditional finance, we can expect DeFi to blow into mass adoption with the total addressable market for smart contracts growing easily into the trillions.


Decentralized finance is an exit from traditional banking services and norms, a highly sensitive transition, but one that is arguably inevitable.


How Are Smart Contracts Used in DeFi? 

The use of smart contracts has exploded in 2020 as the DeFi industry has developed from a small sector in 2018 to one of the fastest growing industries in the emerging technology space. 


Many cryptocurrencies and decentralized applications (DApps) function using smart contract code to facilitate the exchange of goods, services, data, funds and so on. While users of centralized financial institutions, such as a bank or credit unions, are able to rely on intermediaries to manage a transaction, DApps must use smart contracts to ensure that each transaction is legitimate, transparent and trustless — and that goods or services are, in fact, being transferred in line with the predetermined provisions of the agreement. 


In a nutshell — smart contracts ensure that party A and party B are both fulfilling their end of the agreement. 


What Are the Benefits of Using Smart Contracts? 

There are many benefits of using smart contracts over regular centralized applications or agreements. Smart contracts are faster, more transparent, accurate, secure and efficient than traditional centralized methods of exchanging goods, services or information. Users no longer need to trust the blackbox of a centralized system, but instead rely on “code is law” as users can see exactly how each application behaves.


These efficiencies come together to make a much cheaper way of managing the exchange of assets, goods or services. 


What Are the Issues With Smart Contracts and DeFi?

For use in a DeFi setting, there are some potential issues that need to be considered. In a decentralized mechanism, smart contracts are processing external data which — without having a centralized, verified data source — will need to be verified some other way. 


For example, DeFi users require access to reliable price feeds to know that the value of a digital asset is accurate and free from outside manipulation, so that they can safely and confidently transact in a decentralized environment. 


A solution to this issue is to use a data-oracle platform, such as Band Protocol. Data oracle platforms allow for decentralized applications to benefit from the use of smart contracts by providing access to trusted, verified data from multiple sources. In this way, smart contracts can be executed free from outside manipulation and remains fully decentralized. 


Where Are Smart Contracts Headed in the Future? 

The potential for adoption of smart contract features is difficult to fully understand, as there really is no limit. Smart contracts are capable of transforming many processes across a vast number of industries to remove bureaucratic bottlenecks and create efficient self-executing systems. 


For example, there are many developed use cases for smart contracts in use around the world. These include: 

Programmable/Conditional Payments

  • Smart contracts enable transactions to occur, with the optionality to be executed only once a specific set of criteria has been met. For example, the location of a shipment can be communicated by an external data oracle such as Band Protocol: when a predetermined shipment location is verified, capital/payment will be released by the smart contract. This is a simple application, saving a lot of time on logistics, monitoring and paperwork.

Decentralized Finance

  • Many DeFi applications use smart contracts to facilitate all kinds of use-cases including margin trading, derivatives, stablecoins and general lending/borrowing. Leveraging smart contract functionality, with the use of a data oracle such as Band Protocol, DeFi platforms to be able to operate in a fully permissionless, long-term, scalable manner. Aave for example, is an open source and non-custodial liquidity protocol for earning interest on deposits and borrowing assets.

Tokenized Real-World Assets

  • Tokenization is the process by which real-world assets are synthesized by digital tokens that exist and are traded on a blockchain platform. Smart contracts facilitate the movement and trading of these tokens, keeping track of exchange rates, price feeds among other critical functions. This way, markets are able to benefit from all the traditional benefits of blockchain networks — irrefutable ownership, transparent, trustless transactions and an open ledger of records for all to see. 

Gambling and Betting Applications

  • The betting industry is somewhat notorious for a lack of trust and transparency, something blockchain tech and smart contracts addresses perfectly. By harnessing smart contracts and data oracles, transactions, betting odds and the settling of bets can be done in an honest, verifiable, without any restrictions or scalability or centralized issues.

Gaming

  • Some blockchain-based games require random, lottery type data to enable a truly fair gaming experience. A combination of blockchain technology, smart contracts and VRF (Verifiable Random Function) applications make this possible. In this way, true, instantaneous random data can be generated to ensure that no player is advantaged over another.

Prediction Markets

  • Using smart contracts and data oracles, real-world, open-internet data can be relayed to the blockchain including information on market movement, weather conditions, sports results, etc. This makes life significantly easier and more trustworthy for developers and end-users alike to create niche betting or prediction markets.


Smart Contracts Overall

Smart contracts are quickly changing the way individuals and organizations exchange information, access financial services and interact with one another. As distributed ledger technology continues to make our online systems more transparent and efficient, we expect to see smart contracts implemented widely across all traditional industry verticals in due time. 


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Author(s)

Kevin Lu

I'm Kevin, head of business development and growth at Band Protocol.

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