Welcome to the third installment of PYMNTS ‘eight-part series on DeFi!

Over the next few days, take a look at every part of decentralized finance – the most important, hottest, most rewarding, and riskiest part of the blockchain revolution.

By the end, you will know what DeFi is, how it works, and the risks and rewards of investing in it.

See part 1: What is DeFi?

See part 2: What are the best DeFi platforms?

So, you want to know what a smart contract is and why you should care?

Well, start with that. Smart contracts are what turned crypto into an industry.

Bitcoin may be the biggest and most well-known cryptocurrency, but aside from it – and a few other pure cash substitutes like litecoin and stablecoins like tether and the USD coin – every token operates on a blockchain which can properly be called a smart contract platform.

Smart contracts are the building blocks of decentralized finance, or DeFi. And non-fungible tokens (NFTs), blockchain-based games, video streaming platforms, and social media sites – well, you see the picture.

At the highest level, smart contracts threaten to disrupt big business, reinvent the supply chains that move goods around the world, and even lay the groundwork for the next-gen Web3 that proponents say will end the world. the domination of big technologies on the Internet.

Smart contracts were introduced to the blockchain in 2015 with the launch of Ethereum, better known as the smart contract platform – despite the fact that its token, the ether, is now the second largest crypto-currency. currency with a market capitalization of more than half of a trillion dollars. This gives you an idea of ​​the importance of smart contracts.

Immutable agreements

More prosaically, smart contracts are agreements written on blockchains that execute without any outside approval or human intervention when the conditions are met. These are “self-executing” contracts.

The point is, once they have been written and accepted, they are immutable – the terms cannot be changed and the agreement cannot be canceled. Any payment stipulated in the contract is locked in the contract when it is created, so there is also no recovery of your crypto.

This eliminates the need for a trusted intermediary to make sure the terms of an agreement are enforced, like Visa, whom a merchant trusts to be sure they’ll get paid, and a customer trusts to get paid. ensure that its goods will be delivered and will not be defective.

Let’s take a simple example of DeFi. Tom wants to borrow $ 10,000, so he goes into a loan protocol and sets up a smart contract. Tom agrees to deposit $ 15,000 of ether (or other cryptocurrency) – 150% of what he borrows – as collateral in the contract, in exchange for $ 10,000 in stablecoins.

When Tom returns them, the smart contract will return its collateral, less fees and interest. The goal is to get quick cash without selling the cryptocurrency which Tom says will continue to rise in value.

However, the smart contract also states that if the value of Tom’s collateral drops to 110% of what he’s borrowed, the collateral will be liquidated – sold at a loss during a downturn – to make sure the lender doesn’t lose. if Tom doesn’t repay the loan.

There is no bank to charge Tom a fee and take a share of the interest he pays. But, there is no banker who can help him either.

Warnings

Agreements are written in the “if-this-then-that” language of computer coding, so there are some really big caveats to this “trust replacement” idea.

On the one hand, just as computer code can be buggy, the language of a smart contract can have some really nasty surprises if it doesn’t say what you think it does. Remember that once the contract is done and locked, there is no going back to correct mistakes. The crypto industry’s term is “code is law” – which roughly translates to “do it right the first time, otherwise.” “

Because smart contracts eliminate the need for trust and because cryptographers should never be allowed to name anything the general public will use, they are called “trustless.”

This acts as a good warning for the other big caveat – in particular, warning emptor – or let the buyer beware. Since many cryptocurrency transactions are between (theoretically) anonymous parties, it’s impossible to prosecute someone who sold you a gold watch that turns green when you sweat on it.

Next level

However, smart contracts can get much more complex. Because they’re written in the language of coding, a sufficiently complex smart contract can be an app like anything on your laptop or smartphone.

So, that DeFi exchange that you are trading on? It’s a smart contract. That NFT you bought from Lebron James doing a slam dunk? It’s a smart contract. Blockchain games as simple as CryptoKitties or as complex as the Axie Infinity MMORPG? They are smart contracts.

Video streaming sites, social media platforms, metaverse – every application running on a blockchain is a smart contract.

Next Up: What is staking?

With one very notable exception of Ethereum, virtually all DeFi blockchains use eco-friendly staking as a consensus mechanism, in which “validators” set up the amount of good behavior bonds in exchange for the rewards for doing so. adding a new block of transactions to a blockchain. Why do you care? Well, staking is a popular and increasingly easy way to earn passive income on your crypto holdings.