DeFi Intro - Smart Contracts and Decentralized Finance
Summary
TLDRThis video offers an introductory overview of decentralized finance (DeFi), explaining its core principles and distinguishing it from traditional finance. DeFi leverages public blockchains and smart contracts to create open, transparent, composable, and non-custodial financial protocols. The video outlines the four key aspects of DeFi: openness, transparency, composability, and non-custodial nature. It also clarifies misconceptions about DeFi, emphasizing that it is not synonymous with CBDCs or in-house blockchain projects. The presenter introduces the DeFi stack, which includes layers like settlement, asset, protocol, application, and aggregation, setting the stage for more detailed exploration in subsequent videos.
Takeaways
- 📚 The video introduces decentralized finance (DeFi) as the main topic for the class, focusing on how smart contracts are utilized in a vibrant ecosystem.
- 🌐 DeFi is built on public blockchain networks and smart contracts, aiming to create open, transparent, composable, and non-custodial financial protocols.
- 🔍 The video provides a high-level overview of DeFi, with the intention to delve into specifics like tokens, decentralized exchanges, and lending markets in later videos.
- 🔑 The term 'open' in DeFi refers to the absence of access restrictions and special privileges, allowing anyone to use the independent infrastructure without KYC or whitelisting requirements.
- 🔍 'Transparent' indicates that all interactions within DeFi can be mathematically verified by anyone, ensuring security through smart contracts and public blockchains.
- 🧩 'Composable' suggests the ability to combine different financial building blocks, similar to LEGO pieces, allowing for significant financial innovation.
- 🔒 'Non-custodial' is a key aspect of DeFi, meaning users retain control over their assets and do not need to trust intermediaries with custody of their funds.
- ❌ DeFi is distinct from CBDCs (Central Bank Digital Currencies) and in-house blockchain projects, which are not open, transparent, or non-custodial.
- 📈 The video outlines the DeFi stack, which includes layers such as the settlement layer, asset layer, protocol layer, application layer, and aggregation layer.
- 🌟 DeFi offers advantages over traditional finance, including trustless execution, reduced need for intermediaries, and the ability to create atomic transactions that mitigate counterparty risk.
Q & A
What is the primary focus of the video series after the introduction of smart contracts?
-The primary focus shifts to Decentralized Finance (DeFi), exploring how smart contracts are employed in a vibrant ecosystem.
What does the term 'DeFi' stand for and what is its significance in the video?
-DeFi stands for Decentralized Finance, which is a financial system that utilizes blockchain and smart contracts to create open, transparent, and trustless financial services.
What are the four key characteristics of DeFi as mentioned in the video?
-The four key characteristics of DeFi are being open, transparent, composable, and non-custodial.
Why is the use of a public blockchain important in DeFi according to the video?
-A public blockchain is important in DeFi because it provides an independent, open, and transparent settlement layer that allows anyone to participate without special privileges or access restrictions.
What does 'trustless' mean in the context of DeFi as discussed in the video?
-In DeFi, 'trustless' means that users do not need to trust a central authority or intermediary; instead, they trust the math and the code that is transparent and verifiable by anyone.
How does composability in DeFi differ from traditional financial systems?
-In DeFi, composability allows different financial protocols and smart contracts to interact and build upon each other, creating new services without the need for intermediaries, unlike traditional systems that often operate in silos.
What is the significance of being non-custodial in DeFi?
-Being non-custodial in DeFi means that users retain full control over their assets without having to entrust them to a third party, reducing counterparty risk and increasing individual autonomy.
How does DeFi contrast with Central Bank Digital Currencies (CBDCs) as explained in the video?
-DeFi is decentralized, transparent, and built on public blockchains, whereas CBDCs are centralized digital currencies issued by central banks and often operate on permissioned ledgers with access restrictions.
What is the DeFi stack and how does it structure the ecosystem?
-The DeFi stack is a layered framework that includes the settlement layer, asset layer, protocol layer, application layer, and aggregation layer, structuring the ecosystem from basic blockchain interactions to complex financial services.
What are some of the advantages of DeFi over traditional financial systems as highlighted in the video?
-DeFi offers advantages such as trustless transactions, deterministic execution, atomic settlement to reduce counterparty risk, and programmatic composability that allows for easier interaction and innovation compared to traditional financial systems.
What is the role of smart contracts in the DeFi ecosystem as discussed in the video?
-Smart contracts are the backbone of the DeFi ecosystem, automating and executing financial agreements and protocols on the blockchain, ensuring transparency, security, and efficiency.
Outlines
🔑 Introduction to Decentralized Finance (DeFi)
This paragraph introduces the concept of Decentralized Finance (DeFi), which is the focus for the rest of the class. DeFi is a vibrant ecosystem that utilizes public blockchain networks and smart contracts to create financial protocols that are open, transparent, composable, and non-custodial. The speaker emphasizes that this is just an overview, with more detailed videos to come on specific subtopics like tokens, decentralized exchanges, and lending markets. The definition of DeFi is based on a paper from the Federal Reserve Bank of St. Louis, highlighting its trustless nature where trust is placed in the code and math rather than intermediaries.
🔍 Exploring the Core Principles of DeFi
The core principles of DeFi are discussed in detail: openness, transparency, composability, and non-custodial nature. Openness means no access restrictions on the blockchain or protocol level, allowing anyone to use the infrastructure without special privileges. Transparency ensures that all interactions with smart contracts are verifiable, maintaining security guarantees. Composability allows different financial protocols to interact, enabling innovation by building on existing smart contracts. Non-custodial refers to the user maintaining control over their assets, contrasting with traditional financial systems where custodians hold assets.
🚫 Distinguishing DeFi from Centralized and CBDC Models
The paragraph clarifies what DeFi is not, including Central Bank Digital Currencies (CBDCs) and in-house blockchain solutions. CBDCs, while digital, are not decentralized and are issued on a new infrastructure but lack the transparency and immutability of DeFi. Similarly, running DeFi protocols on a private or consortium blockchain controlled by a single entity or with heavy centralization does not qualify as true DeFi. The paragraph reinforces that DeFi is based on public, open, and non-custodial blockchains.
📚 The DeFi Stack and Its Components
The DeFi stack is introduced as a framework to understand the various layers within the DeFi ecosystem. Starting with the settlement layer, which is the blockchain itself, the stack includes native protocol assets like Ether and gas fees. The asset layer involves tokenization standards for fungible and non-fungible tokens. The protocol layer encompasses financial services recreated as smart contracts, such as decentralized exchanges and lending markets. The application layer provides user interfaces for interacting with these protocols, and the aggregation layer aggregates these services for a more user-friendly experience.
🌟 Advantages of DeFi Over Traditional Finance
The advantages of DeFi over traditional finance are highlighted, including the removal of the need to trust financial intermediaries due to the deterministic execution of smart contracts. DeFi allows for atomic transactions that eliminate counterparty risk and enable direct asset exchanges without intermediaries. It also overcomes the siloed nature of traditional financial services by offering programmatic composability, where different financial protocols can interact and build upon each other, fostering innovation and efficiency.
Mindmap
Keywords
💡Decentralized Finance (DeFi)
💡Smart Contracts
💡Public Blockchain
💡Open
💡Transparent
💡Composable
💡Non-Custodial
💡Atomic Transactions
💡ERC20
💡ERC721
Highlights
Introduction to Decentralized Finance (DeFi) as the main topic for the remainder of the class.
DeFi is based on public blockchain networks and smart contracts to create financial protocols.
DeFi protocols are open, transparent, composable, and non-custodial.
Openness in DeFi means no access restrictions and no special privileges on any layer.
Transparency allows mathematical verification of all interactions within DeFi.
Composability enables different financial protocols to interact and build on each other.
Non-custodial nature ensures users retain control over their assets.
DeFi is distinct from CBDCs and in-house blockchain projects due to its decentralized and open nature.
DeFi stack includes layers such as settlement, asset, protocol, application, and aggregation.
Advantages of DeFi include trustless execution, reduced need for intermediaries, and increased efficiency.
Atomic transactions in DeFi eliminate counterparty risk and streamline asset exchanges.
DeFi promotes composability and innovation through the reuse of existing financial building blocks.
Traditional finance is often siloed, while DeFi encourages open and programmable financial services.
DeFi's approach to financial services is fundamentally different from traditional custodial models.
Upcoming lectures will delve into specific subtopics within DeFi, such as tokens and decentralized exchanges.
The paper 'Decentralized Finance and Blockchain and Smart Contract-Based Financial Markets' is recommended for further reading.
Transcripts
in the previous videos we looked at the
foundation so you got a basic
understanding of what the blockchain is
how you can interact with it through
transactions we looked at smart
contracts and you even got a chance to
develop your own smart contract but now
it's time to turn to an actual example
of a vibrant ecosystem where these smart
contracts are employed what i'm talking
about is called decentralized finance or
d5 for short and will be the topic for
the remainder of this class
all right let's get started with an
introduction to decentralized financer
d5 now in this video you should not
expect me to go into any of the details
it's really just a high level overview
of the topic to
build a common foundation but there will
be more specific videos later on
dedicated videos and various sub topics
such as tokens for example such as
decentralized exchanges or lending
markets and there we will really go into
the details of these topics but right
here this is just an overview basically
some information of what you can expect
from the remainder of this class and
what this topic is all about
the first thing we have to do is of
course define what decentralized finance
actually is and this definition right
here is based on a paper recently
published with the federal reserve bank
of saint louis their review
and the definition goes as follows defy
employs public blockchain networks and
smart contracts to build open
transparent composable
and non-custodial financial protocols so
the idea is really that you use all of
these technologies we looked at so that
we have a public blockchain and that's
super important so one of these
independent blockchains
not a corporate blockchain not a
permission ledger a public blockchain
basically it's a settlement layer and
then you use smart contracts
like we have looked at like you've
developed to recreate many of these
financial services in a different way
and in a different way really means that
you can recreate them in many cases in a
trustless manner a trustless meaning of
course you have to trust the math of
course you have to trust the code but it
means that you can look at the code xnt
so you know exactly what's supposed to
happen you have a transparent way of
studying of scrutinizing this code and
you you basically have deterministic
execution of safe immutable storage on
the blockchain but let's look at these
four keywords so the open where is my
cursor right here
the open the transparent the composable
and the non-custodial
one by one and let me start by open what
do i mean by that open essentially means
that by default there are no access
restrictions and it's important that
this there aren't any access
restrictions on neither of the layers
and we will look at these different
layers later on so not on the blockchain
it wouldn't be good if there are any
access restrictions on the blockchain
and there are special privileges in the
blockchain but it will also not be good
if there are special privileges on the
protocol level so it really means that
it's completely open that you have this
independent infrastructure
that can be used by anyone
and that no one has special privileges
for example
that they can can do things other people
cannot do there is at least by default
no kyc and no whitelisting requirements
no minimum amounts nothing like that
it's really just this independent
infrastructure you can build on
and then the second part transparent
means that everything that happens in d5
whenever you have an interaction with a
smart contract whenever there's anything
going on really
then you can mathematically verify it
anyone can mathematically verify it so
you see the code you know what is
supposed to happen you can look at the
codexante
so the smart contract code and then you
can verify whether it actually has
happened so
all of the security guarantees we get
from a smart contract
in combination with a public blockchain
as a settlement layer are intact
depending on the implementation of
course subject to the implementation but
at least in theory you can get these
security guarantees and you can create
something that is extremely transparent
that can be scrutinized by anyone
and then composable
composability is usually described as
lego pieces so where you have all of
these different building blocks and you
can piece them together and create
something new and the way this works is
because as you have seen in the earlier
lectures small contracts can interact
with each other of course you need
somebody who is initiating the
transaction so at the beginning the
issue initiator has to be an eoa has to
be an externally owned account but then
you have all of these internal
transactions you have all of these
calls of other smart contracts and that
way you can have a
basically a sequence where one smart
contract uses a function a different
smart contract where one smart contract
builds on a different already existing
smart contract and that is usually
referred to as composability so they
give an example when you have a let's
say a decentralized exchange where you
can
swap token a for token b when that is
already in existence and you create a
new financial protocol that
may have a need to to change assets
as part of its own protocol as part of
its own contract execution this new
protocol these new smart contract can
rely on a decentralized exchange that is
already existing
to conduct these swaps and that's
something that allows of course for a
huge amount of financial innovation
that really allows you to interact with
other smart contracts and have this
composability where whenever there is
already a building block in place it can
be reused by everyone else by every
other smart contract and that's
probably one of the main reasons why we
see this massive speed of innovation in
the d5 space
and then last but not least
non-custodial and that's super important
and for many applications in traditional
finance you have custodians
so they essentially have a financial
intermediary you have to trust
basically you give you give that
custodian your assets in custody they
are holding on to it
and the only thing you can do is ask
whether they will release it back to you
whether they will send it back to you
but you're not in control anymore and
with d5 that's different with d5 again
depending on the implementation at least
in theory it can be coded in a way such
that you will never lose
exclusive access rights to your assets
until the very last second when it's
executed and then as you will see later
on there is a concept called atomic
settlement atomic transactions so the
atomicity that also ensures that you
don't have any counterparty risk when it
actually is executed the long story
short the non-custodial requirement
means that you don't have to trust any
institutions
yes you have to cross the code in the
sense of course you can look at it but
you have to
you have to check it for yourself and
you actually want to know what it's
doing
and yes of course you have to trust the
math
again something you can check if you
really want to but you do not have to
trust anything you cannot verify
yourself you do not have to trust for
example an institution that they are not
running with your money that they are
not messing up
everything you have to trust can be
verified
by you by yourself so you basically can
check the conditions you can make sure
that all of these conditions hold and
that's something that's super exciting
the information is there
and then you can verify it yourself
and these are these four
for keywords these are the four most
important aspects to d5
this is what is different to a
traditional financial system because in
traditional financial systems in many
cases it's neither open
so
the open part right here
isn't really existing i mean there are
so many access restrictions it's also
not really transparent
in many cases it's really these silos
where you don't have access to the
information you don't know exactly
what's going to happen you cannot verify
it in many cases it's not composable
because
these financial intermediaries they
either use their own core banking
systems or have a different
interpretation of many of the parameters
in there there is little to no exchange
between these core banking systems and
it's just it's just in many cases a mess
and uh also in traditional finance it's
custodial uh most of the applications in
traditional finance rely on the fact
that you give your assets away in
constantly with to someone else and in
many cases you don't even have another
option so for for many of the assets
that exist um in traditional financial
markets you will
in some cases not even have the option
to hold on to them yourself whereas in
d5
it's it's non-custodial meaning that you
can always if you choose to do so you
can always
assume self-custody and you don't have
to
trust anyone
else now what is it not that's also
super important to understand because
especially when you read articles in
many mainstream media channels but also
from some people who call themselves
experts on the topics and d5 has
absolutely nothing to do with number one
cbdc programmable euro programmable
swiss franc programming usd
it's something completely different i
mean cbdc can be interesting but they're
certainly not decentralized they're not
immutable it's essentially just digital
money that is issued by a by a central
bank
on a new infrastructure but it has
nothing to do with this decentralized
transparent way of creating financial
markets
it's usually on a permissioned ledger
and not on a public ledger and of course
you have many access restrictions there
as well so it's something completely
different that can be interesting but
it's not defined
and then of course when you're running
d5 in
air quotes
uh protocols on your own in-house
blockchain
so for example when there is a
financial intermediary and there they
are running some test case and they're
saying yes we also have our d5
applications it's on our own uh test
network we're running in-house then this
is also hardly defined i mean when you
have your own test network and you have
your blockchain that's that is under the
exclusive control of just one entity
then
it's the settlement layer is already
heavily centralized and then of course
anything you do on top of that doesn't
really matter anymore so you can hardly
call that
d5 and then last but not least of course
the same counts for heavily centralized
settlement chains
and this is something that can be also
in the domain of the cbdc or so the
in-house blockchain
but there are many consortiums around
the world where some of these financial
intermediaries they work together and
they create their own permissioned
lectures
mostly for settlement mostly for the
issuance of
various assets
bonds for example but that's also not d5
i mean again we have the access
restrictions again it's not completely
transparent in the sense that just
anyone can can check whether it match
matter and it actually works out the way
it is supposed
uh to work
it's just
there are all kinds of privileges on
there and essentially it's just a
regular database
that gets recreated d5 is different d5
is based on public blockchains d5 is
non-custodial it's open it's transparent
and these are really the things you have
to look for and that's what define that
is for d5
that is what makes it special at the end
of the day
and
there is a place of course for all of
these projects but they shouldn't be
referred to sd5
now let's look at the d5 stack this is
also part of the paper
i've published
a while ago in the federal reserve bank
of st louis review and they have
proposed
basically a framework a model
of how you can think of about d5 of the
various layers that exist within the d5
ecosystem and this is also super helpful
to structure the class and to
think of the different topics we look at
in this class so i mean we started with
the settlement layer right here and
we've looked at of course the ethereum
blockchain
looked at the basic building blocks make
sure you understand how the blockchain
works we have also looked at the native
protocol assets so ether things like gas
fees and so on and the next thing he
will do after this introduction is turn
to the acid layer on the acid layer of
course you could argue that native
protocol acid so e4 is also part of the
acid layer what we will do in these
videos is we will look at tokenization
so you look at standards like erc20 or
erc721 so standards for fungible tokens
and non-fungible tokens
to give you a quick primer fungible
token is something where it doesn't
really matter which specific token from
a class you have so when you have for
example i don't know a stable coin let's
go with that when you say it's a us
dollar packed stable coin
then it doesn't really matter whether
you have
this specific
one of this class of us dollars packed
stable coins or another one
um
it's essentially the same whereas with
non-fungible tokens we are really
talking about something that's unique so
it could represent let's say a
painting or just something that really
only exists once and therefore it has a
unique identifier and therefore every
single token is different that's the
difference between these fungible and
non-fungible tokens and you have
standards for both of them and that's
something you look at at the asset layer
then we will go to the protocol layer
with the protocol layer
you really recreate these different
financial protocols these different
financial services so for example you
would look at decentralized exchanges we
look at lending markets you will look at
derivatives synthetics
and we will also look at asset
management
as some examples so these are just some
categories and what's important and this
is also true for the asset layers that
everything you're seeing here so be it
these different tokens uh the ec20 or
c721 but also all of these protocols
everything is built on smart contracts
everything is in fact one or more smart
contracts
and we will also look at some of these
examples how these things are
implemented and then on top of that you
have two things uh i referred to as the
application and the aggregation layer so
the protocols themselves such as the
smart contracts and then on top of that
you have
basically an application that makes use
of these smart contracts there is a
gateway to the smart contract so you can
think of it a little bit as a front end
that makes makes the access to these
smart contracts much easier so a web
three based front end and with every
aggregation layers you have can think of
it a little bit like an an online
banking platform where some service
provider they aggregate these various
smart contracts they make make a they
build a nice front end that is easy for
people to interact with
make sure that in one nice dashboard you
have all the information you need and
you get access to these different kind
of smart contracts usually in a much
more
user-friendly and more convenient user
interface that's the basic idea
so why define what are some of the
advantages of course there are many
advantages
but some of the things i want to
specifically mention at this point was
number one in the traditional financial
services
world what you're doing is you have to
completely
trust these financial intermediaries
it's a trust-based execution whatever
you do
you usually
already have the assets with a custodian
but then also when you for example give
an aldo to do something
then you have to trust that these
financial intermediaries are actually
doing what you're asking from them but
you you cannot i mean you cannot verify
anything yourself you just have to trust
that they did it you have to trust and
that they that they're actually doing
that on on your behalf and that they're
not
cheating and
that of course has several implications
and
number one is that there are all kinds
of audits all kinds of regulations all
kinds of inefficiencies because somebody
has to take care somebody has to
actually verify uh whether you can trust
these people you cannot do that but
there are some certain regulators that
will do that and there are certain
requirements and that just makes the
process in many cases cumbersome and
also you could argue inefficient
now again in theory
um you have deterministic execution with
uh smart contracts and of course when
you
do a sloppy job and implementing them
then there can be some errors of course
when there are all kinds of dependencies
that are implemented
then it can also be cross-based
based but there is a way for smart
contract based financial protocols to be
completely deterministic so that you
know exactly what's supposed to happen
that you can verify everything and that
is extremely exciting so at the end of
the day we're really talking about basic
instructions basic instructions that are
coded in the form of smart contracts and
you can verify everything that happens
for yourself
the second
in traditional financial markets
most of the infrastructures built on
really complicated clearing and
settlement systems where you have some
financial intermediaries in between that
take care of clearing that take care of
settlement
of course they will not do that for free
because it's a service they provide and
they also have a
place in the system because in many
cases in traditional finance nobody
wants to make the first step so let me
give you an example let's say you have
alice on the left side you have bob on
the right side
and they want to exchange
some assets okay so we have alice has
the a asset and bob has to be asset they
want to exchange it
and in a traditional financial
services world what they would do is
they would go to a financial
intermediary both of them would deposit
their assets with that financial
intermediary or already have it there
and
then it gets exchanged eventually
the financial intermediary in between
would also take care of course of
clearing they would say everything is
fine it would take care of settlement
and this is of course somewhat
cumbersome this is of course really
expensive now what you can do with
blockchain based solutions and that's
one of the main advantages of these
blockchain based financial protocols is
you can make use of atomicity of
transaction atomicity so you have this
principle of atomic settlement
where you
have certain conditions that will only
ever get executed together so in this
case in in my example you could say okay
you make sure that
token a from alice to bob and token b
from bob where to alice
essentially becomes one transaction of
course it's two steps
of course it's two individual steps that
are part of the same transaction but we
make sure by creating an atomic
transaction that these two steps cannot
be separated so you know exactly that
token a from alice to bob and token b
from bob to alice can only ever be
transacted together as one
and that of course eliminates a lot of
the counterparty risk with this trade
and is something that's extremely
exciting and innovative in the finance
space and there are many of these
examples that build on this atomicity
principle and that we will also look at
later on and that's a big advantage
and then the third one is in traditional
finance you see all kinds of silo
services
so there isn't really
any way of sharing
information efficiently there isn't
really any way of
interacting with different core banking
systems efficiently there has been a
concept that has been discussed for a
long time it's called open banking or
open finance where people are are
advocating for these open interfaces
and in some jurisdictions this has
already happened to some extent
unfortunately it's still a pain and when
you look at the infrastructure and the
the basically the legacy infrastructure
that already exists in finance and then
this is really no surprise it's it's
really cumbersome it's hard to change
anything in many cases you cannot really
change anything because nobody knows
exactly what would break what would
happen when you do change it
and
of course on the complete opposite you
have d5 with this programmatic
composability that everything by default
happens on the public blockchain where
everything by default is open and
transparent and there everything by
default is completely composable so you
can basically have the sequence of
various smart contracts that interact
with each other and everyone can just
make use of anything that has already
been out there okay so whenever there's
anything deployed you can just reuse it
and that is extremely exciting
so these are just a few of the
advantages
again
we will
tackle the various topics
that i've shown on the device deck in
the next few lectures
but that's it with the first ov on d5
now
as a as a primer i recommend that you're
reading the paper i've teased
various times um it's called
decentralized finance and blockchain and
smart contract based financial markets
you can find it online
and it will help you
to understand the things that are to
come when we tackle more specific topics
in the next few videos with that
stay curious see you soon
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