Blockchain basics, part two. Exploring a world built on Ethereum.
NFTs, DeFi, and the future of blockchain-based applications.
Introduction
Thank you to everyone who read the first article about the basics of blockchain (found here). This time we’ll be looking at some interesting programs that have been built using Ethereum and what utility they could provide us in the future.
NFTs
Many of you may have already heard of NFTs in the news, such as the sale of Beeple’s collection of NFT art for $69 million at an auction at Christie’s, London. But what exactly is an NFT? An NFT (Non-fungible token) is created through smart contracts like other types of tokens on Ethereum, however NFTs point to a link in their code that stores an image, video, audio, or some other type of digital file which “authenticates” the file when the NFT is created.
The value that this authentication provides is up for debate; nothing stops people from creating a different NFT with the same file as another. However, just as with fake baseball cards and other collectibles, there’s some inherent value in the fact that the card was produced by the creator themselves (which can be tracked), and not a forgery made by others.
NFTs can also be created out of digital assets such as avatars/characters/game items, and then freely exported into other dApps. There are currently plenty of places where users can trade their NFTs with each other, many going for thousands of dollars.
In the future, we could see our digital items or profiles used on a whole range of applications. For example, our game characters could be made into NFTs, allowing them to be used on platforms that users can connect their wallets to. Facebook CEO Mark Zuckerberg recently made a reference to this very idea, calling it the creation of a Metaverse.
These are all just ideas for now but it’ll be exciting to see what comes out next in the world of NFTs.
Our next topic is DeFi, something that’s very real and extremely important in the world today.
DeFi, or decentralised finance aims to not only bring finance to blockchain, it also plans to innovate and create new financial systems that are fairer and create more opportunities than the traditional system.
Stablecoins
One of the most important bridges between traditional finance and DeFi are “stablecoins”. Stablecoins are tokens that are pegged to a certain fiat currency, which in most cases is the US dollar. They help in “digitizing” your real-world funds and allow you to use a currency that you’re familiar with in the world of blockchain.
The most used stablecoin at the moment is Tether, or USD-T which is said to be backed by real-world assets equivalent to $1 per 1 USD-T. (Although this has been disputed, as seen here. )
As non-volatile assets, stablecoins are also essential for reducing slippage on a DEX. Slippage is the difference in the price of the cryptocurrency between requesting the transaction and its price when committed to the chain. DEXs are a bit more complicated, as we explain below.
Exchanges
There are two types of exchanges found on blockchain at the moment, CEXs (Centralised Exchange) and DEXs (Decentralised Exchange).
CEXs work similarly to a real-world exchange, allowing people to trade assets between each other through an order book. They’re called centralised exchanges because one company is in charge and receives the fees collected through trading.
An example of a CEX exchange for cryptocurrencies is Binance.
DEXs however, are radically different and various innovations were made to get them to provide the same utility as traditional exchange. Although DEXs allow people to buy and sell assets, this isn’t done through an order book, it’s done through an AMM (Automatic Market Maker) using what’s called a liquidity pool.
An AMM is a system that allows a pair of assets to be traded freely, by automatically filling buy and sell orders using a liquidity pool instead of an order book that is filled via people actually buying and selling to each other.
A liquidity pool is where people can stake (deposit) a pair of these assets for other people to buy and sell into.
The ratio between these two assets in the pool is set to be constant, which then determines the prices.
The following example, adapted from here, may make this clearer:
Finding the price impact of ETH when bought in USD-T through an ETH/USD-T pair.
(This example assumes the world has fallen into ruin and ETH has gone down massively in price.)
USD-T = ($)100
ETH = 10
Constant Product (ETH * USD-T) = 1000 (Note: Also our Constant Ratio)
Price of ETH (USD-T / ETH) = $10
Now let’s say someone buys ETH for $50 from the exchange, how much ETH will they receive and how will the price adjust?
USD-T = ($)150 (Someone added $50 USD-T to the pool)
Constant product = 1000
New amount of ETH (Constant Product divided by USD-T) = 6.67
Received amount of ETH (Old ETH — New ETH) = 3.33
Price paid per ETH = $15.15
New price of ETH = $22.49
Price impact in % = 124.9%
As you can see, liquidity pools that are low in total asset value create massive price swings when orders are made, which requires DEXs to provide incentives for people to add liquidity. They do this by distributing the transaction fees they make. Staking your assets in the hopes of making a return through these fees is called “Yield Farming” or “Liquidity Mining”.
(“Liquidity Mining” is not to be confused with “Mining”, which we covered in the last article. ”Mining” is being rewarded for validating transactions in a blockchain, such as bitcoin’s proof-of-work system).
In real life, not only are these kinds of pools a lot bigger but there’s also plenty of other ways to buy the same tokens (e.g through a CEX), which help stabilise these price impacts through arbitrage. We’ll get more into how this works in our next article.
We’ve stepped up the difficulty in this article but we’ve managed to finish the next stage of our journey into the world of blockchain.
In Part 3, we will be going a little deeper into DeFi and the Metaverse, as well as taking a look into layer 2 solutions and cross-chain interoperability.
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