DeFi, or decentralized finance, has become one of the most popular technologies emerging in the crypto world in recent years. It is an alternate financial system that works on a decentralized network and is not managed by a central entity such as a government or banks. It aims to create an open and permissionless financial system for everyone using blockchain technology. It has become popular because it provides financial services that are more transparent, efficient, and, most importantly, accessible to the unbanked.
DeFi leverages Smart contracts to unlock multiple use cases, such as borrowing, lending, trading, and derivatives. It is built on the composability principle, as it can combine different Smart contracts to create new financial instruments. Smart contracts are the foundation that enables DeFi development to provide more efficient, transparent, and accessible financial services. They will play a significant role in the success of DeFi in the future.
What are Smart Contracts?
Smart contracts are computer programs that usually operate on a blockchain network when certain predetermined conditions are triggered. They are used to automate contract execution so that all participants are assured of the outcome without intermediaries. They reduce costs and other formalities without compromising credibility. They also improve trust and transparency as no intermediaries are involved. Crypto data is encrypted, making it hard to alter or edit. They also reduce fees and delays.
- Immutable: Smart contracts cannot be modified or altered once released to a blockchain network. They can only be removed once their function has been completed.
- Autonomous: Smart contracts can automate any task and remain on hold if they do not receive any activation.
- Distributed: Smart contracts are replicated and distributed by all nodes. Every node gets a copy of the Smart contract, which cannot be altered.
- Trustless: Smart contracts do not need intermediaries to verify the integrity of the process. They use blockchain technology to maintain the accuracy of the crypto data.
Use Cases of Smart Contracts in DeFi
DeFi can offer similar financial services provided by traditional systems, such as lending, borrowing, spot, and margin trading. Smart contracts can take care of the review process and make it easier for borrowers and lenders. DeFi lending offers better returns and interest rates when compared to traditional institutions.
AMM, or automated market maker, automatically supports buy and sell orders on decentralized exchanges (DEXs). AMMs use Smart contracts to settle transactions between buyers and sellers. They also eliminate the need for another user or participant when executing a trade, as buyers and sellers can trade directly with the AMM algorithm that determines the value of cryptos.
Yield farming platforms incentivize liquidity providers (LPs) to lend their crypto to liquidity pools. Incentives could be a fraction of the transaction fees, governance tokens, or interest from lenders. Decentralized exchanges (DEXs) are peer-to-peer marketplaces where traders can make crypto transactions without giving control of their funds to intermediaries. DEX transactions are facilitated and secured using smart contracts.
Read more: What is Yield Farming
Smart contracts in the insurance sector have multiple applications like automating policy issuance, risk scoring, claim validation, and manual workflows. They can instantly process insurance data from various systems and intermediaries to improve claim resolution and underwriting.
Ethereum and Smart Contracts in DeFi
The Ethereum network did not invent Smart contracts, but it is responsible for making them popular and mainstream. Smart contracts and blockchain were conceptualized before Ethereum but became popular after it expanded their applications dramatically. The Solidity programming language was developed by Ethereum for building and designing Smart contracts. It is used to implement business logic in smart contracts and record the chain of Ethereum transaction records. It is used to create machine-level code on the EVM (Ethereum Virtual Machine).
EVM provides a runtime environment for smart contracts and ensures network security through a global network of nodes. It specializes in preventing denial-of-service attacks. Some popular DeFi protocols built on Ethereum include DAO Maker, Sushiswap, Compound, and Balancer.
Other Blockchain Platforms and Smart Contracts in DeFi
Hyperledger Fabric is another popular platform for building smart contracts. It was built by the Linux Foundation in 2016 and is one of the top competitors to Ethereum. Several frameworks are being developed under the Hyperledger banner, such as Hyperledger Burrow, Hyperledger Sawtooth, and Hyperledger Indy. Hyperledger Fabric has proven to be a viable alternative to Ethereum for Smart contract development. It is a permissioned blockchain that facilitates Smart contract execution, co-developed by IBM.
The Stellar Network is another platform for developing Smart contracts and expressing them as Stellar Smart Contracts (SSCs). SSCs have connected transactions that have various constraints on their operation such as multi-signature, time bounds, sequence, and atomicity. One of its vital solutions is facilitating cross-border payments. It partnered with KlickEx and IBM to create a low-cost method for cross-border transactions. It is easier to use than Ethereum, making it a top platform for Smart contract development. It is usually used to build and design simple Smart contracts like ICOs (Initial Coin Offerings).
Security Considerations and Auditing
Smart contract audits are detailed analyses of functions and data that get automatically executed when initiated by a user and pre-set terms are successfully met. They offer enhanced security by testing the code for any weaknesses or vulnerabilities. Threats are identified, evaluated, and fixed during Smart contract audits. They significantly increase network security and reduce unauthorized access and bugs. They also help in the mitigation of coding errors and business logic flaws.
Some best practices for secure Smart contract development include penetration testing and periodic audits. Developers should write smart contract codes with best practices followed by top organizations globally. They should also create and follow a security checklist. They should also build and run automated security scans on the smart contract code. Finally, developers should use trusted tools for the design, security, development, and auditing of smart contracts.
The Future of Smart Contracts in DeFi
Nick Szabo introduced the principle of smart contracts in 1996, way before the emergence of blockchain technology. In 2008, Bitcoin became the first crypto introduced to the market and created the basis of blockchain technology. This technology created an environment that led to the development of smart contracts. A few years later, Ethereum built real-life use cases for smart contracts, leading to their widespread popularity. Today, many platforms allow for Smart contract development, but Ethereum remains the most preferred Smart contract platform. Many industries are recognizing the power of Smart contract technology and investing in them to develop revolutionary applications. Smart contract technology is transforming many sectors with innovative solutions including finance, supply chain, gaming, and healthcare. It is extensively deployed in DeFi applications such as decentralized lending, borrowing, and trading.
Read more: DApps VS Smart Contracts
Risks and Challenges
One of the vital Smart contract challenges is reentrancy, which occurs when two smart contracts submit an external call to interact. Hackers and scammers can steal these external calls and make a recursive call through the callback function. They can build a smart contract at an external address using dangerous codes. Hackers can call the withdraw function when the smart contract fails to update its state, enabling them to siphon money.
Jurisdiction is one of the significant legal issues faced by smart contracts and blockchain technology. It is hard to determine which jurisdiction is applicable to enforce Smart contracts and resolve disputes, as these are global technologies. High technical expertise is required to operate and maintain smart contracts. Users must equip themselves with the necessary resources and skills to develop and deploy Smart contract protocols.
Conclusion: The Power of Smart Contracts in DeFi
Smart contracts are essential to the DeFi ecosystem and enable the development of various DeFi protocols to offer users more accessible and efficient financial tools. Smart contracts will be vital in shaping the future of finance.
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Frequently Asked Questions (FAQs)
What exactly are smart contracts in DeFi?
Smart contracts support DeFi to offer similar financial services provided by traditional systems, such as lending, borrowing, spot, and margin trading without intermediaries.
How do smart contracts function in the blockchain ecosystem?
Smart contracts are computer programs that run on a blockchain network when certain predetermined conditions are met. They improve trust and transparency in the blockchain ecosystem as no intermediaries are involved.
What are some popular use cases of smart contracts in DeFi?
DeFi can offer similar financial services provided by traditional systems, such as lending, borrowing, spot, and margin trading. Smart contracts in the insurance sector have multiple applications like automating policy issuance, risk scoring, claim validation, and manual workflows. DEXs (decentralized exchanges) transactions are facilitated and secured using smart contracts.
How does Ethereum support smart contracts in the DeFi space?
The Ethereum network did not invent Smart contracts, but it is responsible for making them popular and mainstream. The Solidity programming language was developed by Ethereum for building and designing Smart contracts. It is used to implement business logic in smart contracts and record the chain of Ethereum transaction records.