Smart contracts for ICO made a splash at the time. However, for a long time, this method of raising money remained the main advantage of the blockchain—the main one, but not the only one. Now a new revolution called decentralized finance is starting. This article will discuss building a successful DeFi project and a smart contract.
DeFi and Smart Contracts
A smart contract is a computer algorithm that exactly fulfills a given agreement between two or more parties to a transaction.
Most of the DeFi protocols are based on the Ethereum blockchain. However, activity is also growing on other platforms such as Polkadot or EOS.
Smart contracts execute the terms of the transaction in the blockchain and make a financial turnover within a given site. This process is fully automated and offers the parties to the contract a guarantee that the information written in the code is protected and encrypted and cannot be used by third parties for their purposes.
In addition to a professional DeFi app development team, external data sources and tools for working with them — oracles — are required work. For example, when we pledge ether as collateral, the system must know the current value of ether – otherwise, it will not understand when to liquidate the collateral. The issue of oracles is solved using the popular ChainLink protocol, which delivers data from the real world to the blockchain.
The role of additional tools in the blockchain is so important that without them, it becomes an expensive, slow, and generally terrible key-value database.
Developing Smart Contracts
As we have already mentioned, smart contracts are written in the Solidity language, less often Rust, and use HardHat as a development environment. HardHat is a good tool that greatly simplifies smart contracts’ development, testing, and deployment. The DeFi development of smart contracts can be divided into the following stages.
- Select Blockchain
- Definition of Tokenomics
- Integration with Crypto Wallets
- Working with Oracles
DeFi takes the core premise of bitcoin – digital money – and expands on it, creating a whole digital alternative to Wall Street, but without all the associated costs (think office towers, marketplaces, bankers’ salaries). This could lead to more open, free and fair financial markets accessible to anyone with an internet connection.
Here are some of the ways people are interacting with DeFi today:
- Getting a loan: Get a loan instantly, without paperwork, including extremely short-term “quick loans” that traditional financial institutions do not offer.
- Savings for the Future: Put some of your cryptocurrency in alternative savings accounts and get better interest rates than you would normally get from a bank.
- Buying Derivatives: Bet long or short on certain assets. Think of it like a cryptographic version of stock options or futures contracts.
In a DeFi environment, you don’t need to go through KYC to trade cryptocurrencies; you don’t need to verify your solvency to take out a loan and reveal your identity for any transactions.
Advantages of DeFi Apps
DeFi applications, like any financial system element, have advantages and disadvantages. Here are their main benefits:
- Inclusion. The DeFi ecosystem is inclusive – anyone can create and use an app. Unlike the traditional financial sector, there are no controllers or accounts that require complex forms to be filled out. Instead, through wallets, users interact directly with smart contracts.
- Capabilities. In a DeFi environment, you don’t need to go through KYC to trade cryptocurrencies; you don’t need to verify your solvency to take out a loan; you don’t need to reveal your identity for any transactions.
- Decentralization. Unlike the government financial system, DeFi does not have centralized governance structures. Instead, all the rules of DeFi business operations are hard-coded in smart contracts. This minimizes human error.
- Open Source. The source code of DeFi applications is always freely available. Therefore, any user can test smart contracts for their reliability, safety, and functionality. This is necessary to exclude hidden malware while running in the background.
- Transparency. Cryptocurrencies are credited with anonymity since blockchain accounts consist only of numerical addresses, to which it is impossible to understand who they belong. But it is not so. All transactions in DeFi projects are available; if desired, you can always check their owners.
- Availability. Approximately 2 billion people worldwide cannot access financial services – open a bank account, transfer money from one account to another, and so on. DeFi, however, makes it easy and quick to use financial services for everyone.
There are also disadvantages to the DeFi application, but these are mostly minor bureaucratic aspects, but there are several main ones that are worth mentioning.
- The risk of hacking smart contracts. While working with smart contracts in DeFi eliminates the need for human trust, there is still a need to trust the smart contract code written by a human.
- Data flow centralization. Blockchain protocols draw data about the outside world with the help of oracles. If the oracle acts maliciously, the correct execution of the smart contract will be at risk. Centralized data oracles are also a weak point for DeFi, although decentralized alternatives have already been developed.
- Lack of Clear Regulation Rules. The European Commission adopted the rules for regulating crypto-asset markets in September 2020. However, they cannot influence the DeFi sector. Financial institutions are not responsible for clients’ actions within the DeFi system. If you lose your password or do something wrong, no one can help you. Crypto asset prices can rise or fall sharply. When the price of the underlying asset locked in the CDP falls sharply, investors start withdrawing their assets, and the system can collapse. DeFi protocols try to back loans with excess digital assets to mitigate these risks.
The general idea behind tokenization is to make assets more accessible and transactions more efficient. In particular, tokenized assets can be easily transferred to anyone worldwide within seconds. Moreover, they can be used in many decentralized applications and stored in smart contracts. As such, these DeFi tokens are an integral part of the ecosystem.
In smart contracts, it is calculated how many tokens we can take under which collateral. For example, liquidation rules are calculated when the value of our collateral has fallen due to market fluctuations. Or, for example, in decentralized autonomous organizations (DAO) – all management works through smart contracts. Organization token holders vote. Its result is registered in the smart contract, ensuring the decision’s irreversibility. In principle, the public blockchain today runs on smart contracts.
To build a DeFi app without smart contracts today is simply impossible. If some can do it, such an application will lose in terms of security, speed, and profitability. In turn, the decentralized finance sector is a convenient alternative to the traditional financial system with its institutions.
DeFi services and applications have made it possible to take and give loans quickly and without intermediaries. This was achieved thanks to blockchain technologies and smart contracts. With their help, anyone with Internet access can enter and conduct transactions directly without paying commissions to third parties. In addition, DeFi participants can also earn on their assets – lend, create a deposit, and so on.
Yes. Smart contracts monitor all actions of DeFi platform clients, controlling the correctness of each stage. As a result, the safety and reliability of DeFi sites are ensured thanks to smart contracts.
DeFi is financial instruments in the form of services and applications built on the blockchain. The main task of decentralized finance is to become an alternative to the banking sector and replace the traditional technologies of the current financial system with open source protocols.
The biggest risk is a hacker attack during smart contract deployment. However, practice shows that if hackers fail to install a vulnerability early in a DeFi protocol, the probability of its hacking decreases over time.