Blockchain, Defi, and NFT Demystified

Introduction

Cryptocurrency, NFTs, Blockchain, Defi….these are today’s buzzwords. Intrigued by this concept, I spent the past few weeks researching this topic. My primary goal was to separate media speculation from truth. As a disclaimer, this is not a comprehensive or definitive guide to this concept, rather a summary of my research. To understand this revolution, this paper is divided into three core concepts: Blockchain, Defi, and NFT.?

Part 1: Blockchain

Blockchain Fundamentals

Blockchain is the single most important concept to understand this technological revolution. The advent of this technology fuels cryptocurrencies, NFTs, smart contracts, etc. When trying to understand Blockchain, simply remember these three points:

• Public Database or Distributed Ledger = A distributed ledger is a database that is available to everyone. All blockchains allow the public to see information inside it like a publicly accessible spreadsheet. For example, in Bitcoin, all completed transactions are visible to the public, all the way to the very first transaction. A blockchain is a glorified, public database
• Limited Functionality or Immutable = Unlike a traditional database, all blockchains are limited to one function: adding new items. Previous entries in the blockchain or database cannot be edited or removed by anyone
• Publicly Owned or Decentralized = Blockchains are never owned or controlled by a company, authorization, or person. To be more concrete, computer algorithms are the source of authority because they determine the valid rules to the spreadsheet. Computer processing power from the public is used to determine this, hence it is “publicly owned”?

The term blockchain comes from terminologies used to describe this database. Each cell of information is called a block. Each block is connected to the previous block (remember, you can only add blocks), thus forming a chain of blocks (or a blockchain).?

What problem is Blockchain trying to solve?

The reason this “limited, public database” has gained popularity is its ability to establish trust without a third party. Blockchain allows information to be confidently validated (or trusted), without the need of a central authority. In some circumstances, this can be very beneficial.?

The rising popularity of Cryptocurrency exemplifies this concept. Currently, most countries’ currencies are controlled by the government. A common opinion is that this gives too much power to one entity: ability to print money, utilize for personal gain and corruption, or decide important economic factors like interest rates. Cryptocurrency solves this by removing control of a central authority: computer algorithms control how much money is circulated, all money spent is publicly visible, and the program decides important economic decisions. This ideology is what leads many people to believe Cryptocurrency is the future.?

To reiterate, any application where the removal of a third party or source of authority is beneficial, blockchain should be used. Any other application, blockchain becomes an unneeded, overly complex, buzzword system.?

Good and Bad Examples of Blockchain Technology

Britannica and Wikipedia exemplify the positive aspects of removing a central authority. In the early 21st century, Britannica served as the central source of information on everything. Although useful, the company had complete control over what information is and isn’t important, including how to frame a given event. Because of this, they controlled what the public thought of everything. Wikipedia changed this with its ability to allow everyone to edit the database. The public voluntarily wrote about everything. If one person decides to change information for their personal agenda, public watch ensures that it's reverted as per the common opinion. Wikipedia is a clear example of advantageously removing central authority.?

The blockchain solution for sports game tickets exemplifies poor use of the technology. In this scenario, the central authority should be the ones validating tickets. This is beneficial for the sports association because they only want people who paid to watch the game in-person. It is also beneficial to the buyer because they want to sit around people who paid for their tickets. Removing the sports association in ticket validation is not advantageous. Moreover, it is dramatically slower than the traditional internal database used to track customers.?

Advantages of Blockchain

Trustworthy and Secure

The public ownership of blockchain means that every person on the blockchain network must confirm a transaction. This action is done by specific people called miners (anyone with a computer can be a miner), who voluntarily use their computer processing power to validate transactions. The blockchain is very, very safe. Modern computers theoretically would take millions of years to even attempt to disrupt the blockchain.

Decentralized/Public Ownership

No person, company, or institution can own or change the blockchain. Everyone can look at past information, but not change it. The lack of a central authority works well in certain situations, like voting or storing sensitive personal information. Moreover, because blockchain is stored in the computers of all those who use it, it can never be shut down. This is unlike hosting data in a central server: when the main server is down, the whole network is down.

Transparency and Control over Information

Blockchain limits the amount of personal information that is visible to everyone. For example, cryptocurrency can complete a financial transaction without divulging your personal identity to anyone but yourself. This is unlike the bank, which needs a user’s personal information (SSN, Date of Birth, etc.) to conduct a transaction. In the bank’s case, your identity is only as safe as the bank makes it. Blockchain gives you direct control over your personal information.?

Disadvantages of Blockchain

Slow and Inefficient

Though secure, Blockchain has a complicated validation process that takes a long time to complete. A clear example of this is cryptocurrency: Bitcoin can only complete 4.6 transactions per second, compared to Visa’s 1700 transactions per second. Blockchain is not suitable for applications that require speed and efficiency.

Not Scalable for Large User Base

As more and more users join the blockchain network, the size of the ledger (or spreadsheet) grows more and more. Since the validation of a block transaction requires the traversal of all previous transactions, this technology becomes slower as more and more users are added.

Harmful to the Environment

Validating and completing a transaction on the blockchain requires enormous computing power. Although this very reason makes it safe, its carbon footprint is less than ideal. A common argument is that society shouldn’t be wasting emissions for such a trivial, non-essential technology.?

How safe is my identity in the blockchain? Can people trace me?

Although your identity is anonymous on the network, it isn’t impossible to track with the correct resources. In the ledger, you will be identified by a public address (a series of generated numbers called hash), which for 99% of people make you untraceable.?

But this doesn’t mean your identity is completely hidden. Transacting with the blockchain means your footprint (public address number) is in the spreadsheet forever. Remember that all transactions completed are recorded on the public spreadsheet. With the correct resources, it is possible to locate the origination of a transaction, though very difficult. Criminals have and will continue to be caught when using Blockchain to fund illicit activity.?

Differences between Bitcoin and Blockchain

A common misconception is to think Bitcoin is Blockchain. Blockchain is the technology Bitcoin uses to conduct transactions. Bitcoin was simply one of the first currencies that could establish trust and validation without a central party. The idea of conducting transactions without a central bank is what helped Bitcoin gain prominence, and with it blockchain.?

Part 2: Defi

High-Level

Decentralized Finance, or Defi, is the broader vision of the financial sector controlled by the public, rather than any central bank, government agency, or any financial institution. All financial operations are conducted in a decentralized fashion through the use of technology. To operate such an environment, Defi requires three key components:

• Blockchain Technology allows the validations of financial transactions without the requirement of a third party. For example, currently, transferring money from one party to another requires the validation and confirmation from your bank. With the blockchain, internal algorithms take over the role of the bank. This idea is applied to all financial operations (taking out a loan, converting currency, interest rate, etc.)
• Cryptocurrencies are virtual currencies secured using the blockchain, the primary medium of exchange in the Defi environment. Unlike the current US system, these currencies’ are governed by internal algorithms for the number of coins “printed”, securing a valid transaction, and detecting fraudulent activity. These currencies are owned by no person, government or company
• Smart Contracts are digital contracts intended to perform financial operations. These contracts are programmed to execute when certain conditions are met: approving a loan when principal amount received, matching a buyer for a work contract, etc. Once executed, they cannot be changed or controlled by anyone

Centralized Finance

Before diving into the specifics of Defi, it's important to review the current system: Cefi, or Centralized Finance. Centralized Institutions (government, banks, or corporations) control the financial sector. The Federal Reserve Bank controls the amount of money in circulation. Banks decide the interest rate and who is approved for a loan. Insurance companies charge premiums based on a person’s background. In Cefi, financial operations are controlled by central authorities.

The primary advantages of Cefi:

• Reliable and Regulated = Centralized finance is the system used for the past centuries. In this system, it is assumed that your bank has enough assets to hold your savings, that a lender has enough money for lending, or that a credit card company will not steal your money. Moreover, the government has strict guidelines and enforcement mechanisms for this sector, preventing illegal activity. The same cannot be said with Defi
• Support = The very nature of having centralized organizations means you have the ability to reach out to them for support. This may be challenging with Defi, considering there computer algorithms takeover the function of the central authority

Some disadvantages of Cefi:

• Security = The protection of your financial assets are only as safe as the bank decides them to be. Moreover, having a central authority with millions of financial accounts makes it a vulnerable target to hackers. In comparison, Blockchain’s inherent properties make it secure and unhackable with current-day technology
• Lack of Control over Personal Information = Centralized organizations often use your personal information without your permission by selling it to third parties, tracking internal data, and more. In most cases, you as the user don’t have control over whether this would be allowed. In a blockchain-centered society, all information would be controlled and used with your permission

Defi Innovations

Defi provides some very interesting, innovative applications to services and problems we take for granted. Here are a few examples:

• Instant Money Transfer = Wire transfer can take anywhere from 1 to 5 days. This time is used by your bank to properly transfer your transaction and ensure it is not fraudulent. These transfers are often paired with hefty transaction fees. Cryptocurrencies solve both these problems: the blockchain verifies transactions in minutes and will only include a small transaction fee for computation costs
• Loans Rethinked = Defi’s lending landscape is very similar to the current market. Instead of central banks or companies offering loans, individuals choose to pool their money for a loan for an algorithmically chosen interest rate. The lack of a central authority means no employees or expenses, which results in minimal backend fees
• Cheaper Insurance = Insurance companies require paperwork, actuaries, and expensive models to function profitably. Defi insurance is governed through smart contracts. These digital contracts write out the terms for premiums and use technology to determine claim terms

Primary Benefits

The Defi revolution aims to solve two main problems:

• Transparency and Control over your financial account = Although you have ready access to your checking account, the bank has full control over how to use this money. They choose how to invest and spend, without your permission. The primary pillar of Defi is you should be able to transparently own and use your financial assets. The blockchain transparently shows all spendings
• Democratize Finance = The Cefi ecosystem is complicated and requires approval from a centralized authority. This inherently prevents an equality of access to financial resources. Defi allows anyone with internet access to join the system, regardless of income, previous financial incidents, or any discriminating factors

Stable Coins

One clear problem with Defi is the volatile prices of current Cryptocurrencies. Stable coins (type of cryptocurrency) were invented to solve this problem: this currency is pegged to real world assets to limit volatility. The internal algorithm controls the currency outflow to ensure the value stays the same. Some of the most popular stable coins are tied to the US dollar (Tether and USD coin). Due to the high price fluctuations, most current stable coins require an over collateralized debt position, meaning you must hold greater than $1 USD to hold $1 of the Cryptocurrency.

Part 3: NFTs

NFT Fundamentals?

NFT, or Non-Fungible Token, is one of the most confusing concepts to understand, mainly because of how abstract and multipurpose it is. Keep these two words in mind:

• Unique or Non-Fungible: Non-Fungible means unique. Only one item of its kind exists, whether physical or digital. A one dollar bill is fungible because thousands exist, but a one dollar bill with serial number 0000000 is non-fungible because only one of its kind exists. The original Mona Lisa painting is non-fungible because it was painted only once, but the copies that exist are fungible. Owning an NFT means you are the irrefutable owner of an item, whether digital or physical.?
• Blockchain or Token: NFTs are tokenized, or present in the blockchain. The Blockchain allows NFT owners to prove to the public that they are the true owners of their unique item. This is similar to how an Art Museum will inspect a painting to determine its authenticity.?

That’s it. NFTs are not much more than that. To make things less abstract, here are some concrete examples of NFTs in use:

• Example 1: Digital Art is the most popular form of NFT. Although an image, video, or song may have multiple copies on the internet, the NFT variant of this item indicates you have the true, original copy (Non-Fungibility). Other people can check this through the Blockchain (Token). This may seem counterintuitive considering that everyone can see and use your Digital Art. Being the true owner of an image is similar to having the first edition of a production of a car: although the same car will be produced for the masses, you have the bragging rights because the first car is unique.?
• Example 2: Coming back to sports games, game tickets could be sold as NFTs. These items fit the criteria of an NFT because: they are Non-Fungible, or each person gets only one ticket, and Tokenized, or checked for authenticity through an internal blockchain system. From a holistic perspective, having NFT tickets is more of a marketing move: using the blockchain has no sizable benefits compared to a regular database system.?

How are NFTs different from Cryptocurrency?

The primary difference between NFTs and Cryptocurrency is fungibility. While NFTs are Non-Fungible, Cryptocurrency is fungible. One Bitcoin is equivalent to any other Bitcoin in the world… the same cannot be said for NFT.

Why should I care about this technology?

Removal of intermediaries to connect buyer and seller

The successful creation of a technology that validates transactions without a central authority is the primary reason NFTs have gained popularity. This means that society can trade, sell, and buy NFTs without the use of any central bank, government, or other source that means the middle man has been cut. Some disruptive applications of this technology: instant ownership and transferring of real estate, untampered history of a used car by irreversible updates on the blockchain, or government ID stored as a NFT to prevent identity fraud and have more control over personal information.?

Replace physical world assets with NFTs

One clear exciting business opportunity is to provide ownership of physical goods through NFTs. For example, Verified Organic, a blockchain farming company, can track their CBD products in the blockchain so users can transparently see the farm location, travel time, and health of their item. A more ambitious solution is using NFTs to represent citizens. By having Social Security and sensitive information on the blockchain, not only does it discern citizens from noncitizens, but protects your personal information because no central authority (government) can directly access it.

Heavy application in the Metaverse

The Metaverse is the virtual reality world owned by no central authority. Considering the widespread addiction to technology (social media, video games, mindless browsing) and extension of this world to the internet, the Metaverse will be the new reality of future generations. The virtual world’s items are governed by NFTs, hence the argument that NFTs will be central to society.?

Conclusion

A repeat of Dot Com Bubble?

Instant Millionaires, blockchain companies raising millions, and the first Twitter message sold for $2.9 million… it's natural to wonder why? This was the very reason I started researching this topic. Although I believe this technology is revolutionary, in some ways we are living in a bubble. People are aimlessly putting money into these cryptocurrencies and NFTs, for no logical reason other than the speculative opportunity for profit. In some ways it is a repeat of the Dot Com era, where investors and venture capitalists poured money into every company that had a Dot Com after it. Much like how artificial hype brought company stocks upwards of 300% after an IPO, it is possible NFTs and Cryptocurrency’s value is drastically being overvalued for the wrong reasons. With hindsight, most companies didn’t make it past 2001. The same may be true in the Crypto landscape.

Thanks for reading

I hope this article helps you understand the Crypto landscape at a very, very high level. The concepts are certainly very abstract and took me multiple days to understand. From here, there are plenty of online resources to supplement your understanding. Thank you!