What is Ethereum?
The majority of DeFi Dapps are currently being built on the Ethereum blockchain. But what exactly is Ethereum? Ethereum is a global, open-source platform for decentralized applications. Ethereum is akin to a world computer that no one can shut down. On Ethereum, software developers can write smart contracts that control digital value through a set of criteria and are accessible anywhere in the world. Decentralized Applications (Dapps) built on the Ethereum blockchain provide financial services using smart contracts executed as software programs deployed on the Ethereum network and run 24/7. The network will maintain digital value and keep track of the latest state of the network.
What is a Smart Contract?
A smart contract is a programmable contract that allows two counterparties to set conditions of a transaction without needing to trust another third party for the execution.
For example, if Alice wants to set up a trust fund to pay Bob $100 at the start of each month for the next 12 months, she can program a smart contract to:
1. Check the current date
2. At the start of each month, send Bob $100 automatically
3. Repeat until the fund in the smart contract is exhausted
Using a smart contract, Alice has bypassed the need to have a trusted third-party intermediary (lawyers, escrow agents, etc.) to send the trust fund to Bob and made the process transparent to all involved parties.
Smart contracts work on the “if this, then that” principle. Whenever a specific condition is fulfilled, the smart contract will carry out the operation as programmed.
Multiple smart contracts are combined to operate with each other, known as decentralized applications (Dapps), to fulfill more complex processes and computations.
What is Ether (ETH)?
Ether is the native currency of the Ethereum blockchain.
It is like money and can be used for everyday transactions similar to Bitcoin. You can send Ether to another person to purchase goods and services based on the current market value. The Ethereum blockchain records the transfer and ensures the finality of the transaction.
Besides that, Ether is also used to pay the fee that allows smart contracts and Dapps to run on the Ethereum network. You can think of executing smart contracts on the Ethereum network as driving a car. To drive a car, you require fuel. To execute a smart contract on Ethereum, you need to use Ether to pay a fee known as Gas.
Ether is slowly evolving to become its unique reserve currency and store of value. Currently, in the DeFi ecosystem, Ether is the preferred asset choice used as the collateral underlying many DeFi Dapps. It provides safety and transparency to this financial system.
What is Gas?
On Ethereum, all transactions and smart contract executions require a small fee to be paid. This fee is called Gas. In technical terms, Gas refers to the unit of measure on the amount of computational effort required to execute an operation or a smart contract. The more complex the execution operation is, the more Gas that is needed to fulfill that operation. Gas fees are paid entirely in ETH.
The price of Gas can fluctuate from time to time depending on the network demand. When more people interact on the Ethereum blockchain, such as transacting in ETH or executing smart contract transactions, due to the limited amount of computing resources on the network, Gas price can increase. Conversely, when the network is underutilized, the Gas price would decrease.
Users may set gas fees manually. When the network gets congested due to high utilization, miners will prioritize transactions with the highest gas fees. Validated transactions will be finalized and added to the blockchain. If gas fees paid are too low, the transactions will be queued, taking a while to complete. Therefore, transactions with lower-than-average gas fees can take much longer to complete. Gas price is typically denoted in gwei.
1 gwei = 0.000000001 ether
Assume a smart contract execution to transfer tokens require 21,000 gas units.
Assume the average market rate for gas price is 3 gwei.
21,000 gas x 3 gwei = 63,000 gwei = 0.000063 ETH
When executing the transactions, you will pay a gas fee of 0.000063 ETH to process and validate your transaction in the network.
Ethereum 2.0: Reaching Consensus with Proof of Stake (PoS)
As of September 2022, the Ethereum blockchain has moved to a Proof of Stake model from a Proof of Work model of verification.
Proof of stake is a type of public blockchain consensus mechanism based on a validator’s economic stake in the network. Proof of stake asserts that a miner’s ability to mine or confirm block transactions is proportional to the number of coins the miner owns. This implies that the more coins a miner has, the greater the mining power will be.
Proof of stake measures a miner’s mining power by the number of coins they possess. Thus, a PoS miner is confined to mining a percentage of transactions equal to the ownership stake. A miner with 5% of the available Ethereum, for example, could potentially only mine 5% of the blocks. With the aid of a validator, PoS validates a transaction. A validator is a node that participates in the network’s consensus mechanism. To complete a block, it must have the approval of two-thirds of all active validators.
The algorithm that PoS uses is as follows:
Validators freeze the staked coins.
Staked coins look for a new block to add to an existing chain.
Only if a new block is discovered will the payment be given.
Advantages of PoS Over PoW
Transactions are processed quickly.
PoS has a much lower negative impact on the environment than PoW.
As it does not require downloading the entire blockchain and does not require a lot of computational power, it can more easily be mass-adopted on smaller and less powerful devices.
PoS significantly increases the cost of 51% attacks in many forms. An attacker with a 51 percent ownership in the currency who wants to attack the network would not gain from attacking the network when the attacker has the majority. If the value of the cryptocurrency drops, so does the value of the attacker’s holdings, and the majority stakeholder will be more motivated to have a safety net in place.
The PoS model of consensus verification has huge ramifications on the world of DeFi. First, it redces the overall energy footprint of executing smart contracts on the Ethereum network (reduction by 99.5%). Second, it vastly improves in the speed of execution of each transaction on the Ethereum network (~2000x). Further, it reduces gas fees by several orders of magnitude. This will enable the Ethereum blockchain to process transactions at the rate of 100,000 TPS (transactions per second) and to compete with the likes of Mastercard or Visa which have processing speeds on the order of 65,000 TPS.Last but not least, PoS will provide economic incentive to those who stake their ETH coins on the Ethereum network in exchange for transaction fees which will continue to be a lucrative draw to investors seeking yield generation with DeFi.
Reference
1. Darren Lau, Daryl Lau, Teh Sze Jin, Kristian Kho, Erina Azmi, Benjamin Hor, Lucius Fang, Khor Win Win, "How to DeFi: Beginner" , May 2021
2. Ethereum’s Proof of Stake, Explained https://supraoracles.com/academy/ethereums-proof-of-stake-explained/
Recommended Reading
1. Decentralized Finance Explained (Yos Riady) https://yos.io/2019/12/08/decentralized-finance-explained/
2. A beginner’s guide to DeFi (Linda J. Xie) https://nakamoto.com/beginners-guide-to-defi/
3. A Beginner’s Guide to Decentralized Finance (DeFi) (Coinbase) https://blog.coinbase.com/a-beginners-guide-to-decentralized-finance-defi-574c68ff43c4
4. The Complete Beginner’s Guide to Decentralized Finance (DeFi) (Binance) https://www.binance.vision/blockchain/the-complete-beginners-guide-to-decentralized-finance-defi
5. 2019 Was The Year of DeFi (and Why 2020 Will be Too) (Mason Nystrom) https://consensys.net/blog/news/2019-was-the-year-of-defi-and-why-2020-will-be-too/
6. DeFi: What It Is and Isn’t (Part 1) (Justine Humenansky) https://medium.com/coinmonks/defi-what-it-is-and-isnt-part-1-f7d7e7afee16
7. How Decentralized is DeFi? A Framework for Classifying Lending Protocols (Kyle Kistner) https://hackernoon.com/how-decentralized-is-defi-a-framework-for-classifying-lending-protocols-90981f2c007f
8. How Decentralized is “Decentralized Finance”? (Aaron Hay) https://medium.com/coinmonks/how-decentralized-is-decentralized-finance-89aea3070e8f
9. Mapping Decentralized Finance https://outlierventures.io/wp-content/uploads/2019/06/Mapping-Decentralised-Finance-DeFi-report.pdf