Is DeFi Complicated? Here is a Simple Analogy
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Decentralised finance (DeFi) uses applications and projects that are run on the back of public blockchain technology using smart contracts. Smart contracts are automated enforceable agreements that are concluded between parties via the internet. DeFi and smart contracts are used to facilitate lending, borrowing, and trading of financial tools and non-fungible tokens (NFT). Most Defi contacts are built on the Ethereum network. However, new networks that deliver speed, security and scalability are starting to emerge.
This new blockchain and smart contract technology can be overwhelming. The technical details of how it all works are well beyond the understanding of most people. The challenge is for it to be made easy to use, just like driving a car. You don’t need to understand how the carburettor works to be able to use a car.
While DeFi and smart contracts appear to be shiny and new, like most innovations, their origin is in some existing system that has been upgraded. I was recently reminded of a DeFi smart contract system in its original form. An explanation of its origins may make the new shiny version easier to understand.
I recently spent a night at a remote hotel while travelling with a group of trail runners. After a long day on the trails, we were parched, and we found ourselves in the bar seeking a cold ale to soothe our thirst. The bar used a smart contract system that they had relied on for decades. I remember first coming across the system back in the 1980s. Each guest was allocated a small booklet that had their chalet number written on the front cover. The booklet resided behind the bar and was used to record the drinks that you ordered over the time of your stay. The bartender was responsible for recording each purchase, and the guest scrawled their signature next to the book-entry as a form of contractual approval. At the end of the stay, the guest settled the balance via credit card or cash and the contract was closed.
Translated into the DeFi world, the bar was the platform that hosted the transaction mechanism (the booklet with the chalet number on it). The platform recorded the transactions of trade between the beer consumer and the bartender. After the event (project, contract), the sum of the trades was settled in ZAR. If agreed as part of the smart contract, any form of settlement (cash or crypto) could have been used. All these transactions took place between people speaking their chosen language. In Defi, transactions are concluded between members of the online platform using the language protocols of the applications that link to the platforms.
If I knew that a popular brand of beer was about to be sold out, I might have, for a small fee, acquired an option on the last six-pack. That transaction would have been recorded in the booklet. When my fellow runners realise their predicament, they might be prepared to buy my rights to the last six-pack. I could trade my six-pack beer option for a small profit. My profits on the option could be used to offset the cost of my beer consumption for the night. The contracts and the platform worked seamlessly in the background to facilitate the transactions.
Defi contracts are concluded without the need for a third party, no bartender is needed. All the security requirements and transacting protocols are pre-written and agreed upon before any transactions are entered. This is a whole new world of opportunities for value creation. If you can think about it, soon you will be able to trade it using a DeFi smart contract.
Justin Spencer-Young
