Currently, $1.65 billion is locked in DeFi-related smart contracts, while the DeFi space continues to be touted as the catalyst for crypto’s new bull market. In case you’re not familiar with DeFi, think “blockchain-based apps that make financial services peer-to-peer.”
These apps are peer-to-peer because they’re hosted on blockchains instead of traditional databases and they’re run by their users. Both of these factors lead to them being called decentralized apps or “DApps.”
As the DeFi movement and DApps with it, continue to grow, it has never been more important to understand why DApps matter as well as where they fall short.
For that reason, I’ve put together some of my thoughts on the matter below.
Why do DApps matter and how do they work?
DApps are revolutionary because they allow web and mobile apps to be run, hosted, and governed by their users. Here, “run” refers to the fact that they are secured and hosted by specialized users of the network they’re tied to. If you know of the Ethereum network, then you know that its blockchain is currently secured by users called miners(like Bitcoin). These miners process all transactions that occur on the Ethereum chain, which include buys and sells, as well as DApp traffic.
While the first two transaction types are self-explanatory, the third requires understanding the inner-workings of smart contracts.
(A bit of a recap)What are smart contracts ?
To kick things off, picture a smart contract as a software program that works autonomously. This is also the essence of why they’re valuable. As a technology, they can facilitate massive value transfer with little to no human intervention.
With this, however, it’s important to mention that to run, they have to be triggered by pre-programmed conditions.
Consider an employment contract. Its terms are triggered once the employee starts working for the firm involved.
In a very basic sense, smart contracts are no different.
They don’t go into effect unless certain conditions are met.
What do smart contracts do?
Understanding what smart contracts do is fairly simple. Overall, their foundational usage is in transferring value on a blockchain more quickly and more efficiently than it can do itself. Think cryptocurrency exchanges since they use smart contracts to facilitate trades.
How are smart contracts launched and where are they located?
Smart contracts are launched as a single transaction on Ethereum’s chain. Once the transaction is accepted and added into a block, the smart contract is considered live.
After they go live, smart contracts continue to reside as data on the Ethereum blockchain. Any time that a transaction is done within a smart contract, it still has to be validated via Ethereum’s normal proof-of-work process.
How do smart contracts work with DApps?
Now, we’re beginning to get to the heart of the matter.
What is perhaps the most revolutionary feature of smart contracts is that they can run as what is called “the back-end code” of DApps. This means that the smart contract holds the code that makes the DApp what it is, which the user’s browser or mobile device “talks to” to launch it.
Simultaneously, the smart contract also acts as the server for the DApp since it is run as code on the blockchain.
So, without smart contracts, DApps wouldn’t be what they are.
How are DApps tied to DeFi?
Just as DeFi is presently the driving force for much of the development being done on the Ethereum network, DApps are the driving force for DeFi.
The key idea behind the DeFi movement is the decentralization of all existing financial services.
In other words, people who support DeFi believe that financial services should be truly “peer-to-peer” which means that transactions should be able to be done solely done between users with no middle-man(at least).
This vision, over the course of the last two years, has come to life through DApps like Compound and Synthetix, which allow for peer-to-peer cryptocurrency lending and peer-to-peer derivatives trading, respectively.
With both, users transact and trade directly with other users(trade peer-to-peer) via smart contracts, which substitute for a middle-man like a broker. These smart contracts are tied to, of course, DApps which share the namesakes of the services involved.
Without DApps, DeFi wouldn’t exist since the essence of it is in cutting the middleman out of all existing and future financial services.
Theoretically, this could one day also include bank accounts in which users always own their funds, which might seriously disrupt, if not up-end the existing global banking system.
Where do DeFi DApps fall short?
For now, like any early-stage technology, DeFi DApps aren’t perfect. For the most part, this comes to light in how they are governed, vs. how they run.
Take Compound, for example, which allows anyone to hold cryptocurrencies in the equivalent of an interest-bearing bank account, which are then lent out to interested users on the other side.
To facilitate such a system, Compound’s smart contracts take in popular cryptocurrencies like Ether and Bitcoin and lock them into a smart contract, in exchange for its own native cryptocurrency called cTokens. These cTokens, when held, output interest proportional to the total value of the collateral they represent.
Since only users and smart contracts are directly involved in Compound’s lending process, it may be considered as a “peer-to-peer” lending platform.
While this aligns with Defi’s vision and that of cryptocurrencies overall, Compound’s “governance” falls short.
What is DApp governance and how has it become a problem?
Generally, in this context, governance refers to how something is led. DApps, for example, are ideally supposed to be led by their users and developers, together. This is to maintain what is called “decentralized governance.”
One way that decentralized governance can play out is that users propose and vote on all improvements to the DApp they support and developers implement those that pass. Typically, this is done through tying a DApp to a DAO, and making an ecosystem in which users can both access a blockchain-based service and think of ways to make it better.
Compound and a similar DApp called Maker, which I’ve previously discussed here, claim to be working in this way.
Both depend on governance tokens. At face value, these are nothing more than cryptocurrencies which the added function of serving as votes. In both cases, it’s generally true that the more tokens you own, the more your vote counts.
The problem with such a model is that it eventually makes the DAO/DApp platform involved into a plutocracy. In other words, deep-pocketed investors hold all of the cards in terms of what DApps that run on these models become.
In the case of Compound, this comes down to mostly Coinbase and venture capital firms like A16z and Paradigm. Overall, these investors plus Compound’s development team appear to be holding 58% of its total supply of governance tokens, leaving only 42% as theoretically available to the public.
Since there are no major signs of these tokens being re-allocated, Compound seems to be on more of a path towards perpetuating the status quo in banking/investing, rather than changing it.
For this to change, Compound’s governance model needs to be adjusted. In my next post, I’ll talk about a few ways that could happen but to give you a taste, think “skin-in-the-game” and quadratic voting. Until then, I hope you enjoyed this exploration of DApps and DeFi and remember to reach out to me on Twitter @ExpatCrypto3.
Smart contracts live