The Enigmatic World of Decentralised Finance

By Finn Anderson

Two months after the Lehman Brothers declared bankruptcy in 2008, an entirely new asset class was born. 2008 was a time defined by uncertainty and distrust in the modern financial system, as it shook people’s faith in financial institutions. Failing financial institutions were bailed out by government relief programs, and taxpayers were left in malaise, uncertain about who to be infuriated at in particular, other than the larger figure of the financial system. The tech response to this period of unrest was the birth of a new asset class, spearheaded by Bitcoin.

Bitcoin is a single-purpose blockchain and acts as a decentralized money system. It is a digital ledger that records the sending, receiving, and exchanging of its eponymous native coin. It also acts as a store of value, where users are able to purchase the coin in exchange for fiat currency, like the US dollar. Unlike the dollar, and other currencies that exist today, there is a fixed amount of Bitcoin tokens – 21 million.

Most people ignore the significance of this development, and the subsequent innovations, because the space is murky: there is a lack of clarity, as well as an over-abundance of specialised literature that prevents most readers from indulging. But beyond this layer of difficulty, crypto acts as a fantastic intersection of many areas of study- economics, human relations, history, computer science, psychology – and it should be looked into further. Cryptocurrencies enable consumers to progress beyond the traditional restraints set by the existing financial system by prioritizing decentralisation.

These decentralised systems enable individuals to deposit money, take out loans, use exchanges, trade derivatives, and become liquidity providers without the need for a third party. More interestingly, and in accordance with the amount of backlash against centralised systems, consumers’ accessibility to these financial services are not separated by labels like credit score: they are only limited by their own capital.

I want to start by laying some groundwork. The decentralised nature of Bitcoin poses many questions, primarily pertaining to its security and validity. Bitcoin solves this by building on top of decades of research, and already existing systems, surrounding Byzantine Fault Tolerance (BFT). Decentralized systems are able to sustain order, and progress beyond centralized constraints, through the use of an agreement mechanic- Byzantine Fault Tolerance. BFT describes the difficult nature of reaching consensus in a group if some members are malicious and have ‘byzantine’ intentions.  This problem is known as the ‘Byzantine Generals Problem’ and describes how a reliable computer system must be able to withstand the failure, or resistance, of one or more of its components (It’s called the Byzantines General Problem because the computer and its components are mirrored as a general and his lieutenants).

Leslie Lamport, who produced the original paper surrounding this idea, concluded BFT systems could reach consensus if less than 1/3 of the nodes, the participants, operating on a network were malicious (had opposing intentions). Put simply, an agreement can be reached and action carried out if loyal lieutenants make up 2/3 of the group. In the following three decades, BFT algorithms proliferated in a variety of industries. For example, in aeronautics, the correct flight path of an airplane is reliant upon the communication of numerous independent sensors, many of which have the potential to fail (same as being ‘byzantine’).

Before the Nakomoto Consensus, the only way to achieve BFT in a distributed, or equivalently, decentralised, leaderless network was by limiting the number of nodes. Nakomoto Consensus, created by Satoshi Nakomoto for Bitcoin, was the first decentralized solution to the Byzantine General’s Problem. The Nakomoto Consensus is able to obtain permissionless consensus in a distributed network with up to 50% BFT, an improvement from less than 1/3, through the use of Proof of Work (PoW). This development allowed for decentralized systems to keep a record of where digital money was moved.

When a node does work it’s called a miner. Once a miner has selected transactions to bundle together- a block- they are required to do work in order to verify its validity and add it to the blockchain (the string of already existing blocks- the digital ledger). This makes it difficult for poorly intentioned members to have an effect on the actions of the entire group.

This work revolves around the continuous hashing of values (turning any input into a specified value) through the SHA-256 function, a function used to establish the new state of the blockchain, in the hopes of reaching a specified output. The difficulty of this process is dependent on the target hash, the output required to verify a block, which is altered by the system to keep block mining time at approximately 10 minutes.  This prevents individuals from having to wait multiple days to receive approval for a certain action from a third party, like when applying for a loan.

The miner must also hash together the actual transactions bundled in the block to form a Merkle tree, like a digital receipt of the work done. A Merkle tree can be read in a similar way to a tournament bracket, but as opposed to teams being eliminated as one moves up the tree, the transactions are hashed together until they form a final hash known as the Merkle root. The Merkle root is then included in the block header, alongside the target hash, to validate the block.

The first miner to complete this process is the ‘validator’ of the block, who is rewarded with some of the native tokens, Bitcoin. These incentives encourage honest participation, as acting maliciously would require one to have 51% of the computational power on a network, a large barrier to entry. This allows Bitcoin to exist without a central system or a leader.

Because the Nakomoto Consensus is decentralised, it is possible for two blocks to be validated at once. Therefore, miners consider the longest chain more trustworthy as it’s had the most computational work done to it- the most blocks formed, validated, and added to the chain. So, in order to be ‘byzantine’ and alter the direction and validity of a blockchain one must consistently beat other miners to create the longest chain. This requires a lot of computing power, and may even outweigh the eventual rewards the malicious miner would accumulate. Only full nodes can verify blocks on Bitcoin due to the amount of work that needs to be done; this process is expensive and ironically relatively centralised, as few can afford the warehouses of computational power required for this procedure.

Therefore, the leap that Nakomoto Consensus has made in robustness and security has been undermined by its limitation in scalability and performance. Bitcoin is slow. It takes 10-12 minutes to verify a block on the chain, and it only revolves around one purpose: digital currency. Subsequently, other consensus mechanisms have been created to solve these issues and to progress beyond the sole purpose of digital money- through the use of smart-contract-based platforms.

The Nakomoto Consensus and digital currency allowed for the world of smart-contract-based platforms to blossom, and for consumers to further separate from the current financial system. Smart contracts are immutable pieces of code that execute a pre-determined action once a specified condition has been met. This has led to many developments, including the foundation of the second most popularized blockchain according to market capitalisation, Ethereum.

Ethereum is a general-purpose blockchain that facilitates the basic functions of Bitcoin whilst incorporating the potential of smart contracts. Through the Ethereum Virtual Machine (EVM) users are able to distribute smart contracts that perform different tasks, and each transaction, similar to Bitcoin, is validated by the nodes on the network and added to the blockchain. These smart contracts take many forms, such as non-fungible tokens (NFTs), Decentralised Autonomous Organizations (DAOs), or Decentralised Finance (DeFi) projects.

Many of you will have heard of the recent ‘boom’ surrounding NFTs, as they allow artists to distribute their work easily, and for collectors to truly validate their ownership through the use of blockchain technology. This means that people can distinguish real pieces from imitations and truly demonstrate the significance of the item they hold. DAOs, on the other hand, are essentially pooled investment funds where no individual has dominating control, enabling groups to vote equally on different actions to pursue, using their pooled treasury. DeFi, to reiterate, is a fascinating space that enables consumers to control their own funds without the use of a third or centralized party. The groundwork laid out by Satoshi Nakomoto enabled this entire world to exist, and for the average consumer to diverge from the uncertainty felt for financial institutions during the 2008 financial crisis. Individuals can act independently, whilst having confidence in a well-constructed decentralised system. It allows for money systems to exist in a decentralised way.

The views expressed in this article are the author’s own and may not reflect the opinions of The St Andrews Economist.

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