Today (12 September 2021) is a big day for Cardano because the Alonzo hard fork upgrade will finally bring smart contracts and NFT support to this third-largest blockchain. This upgrade means that Cardano will finally be able to compete with Ethereum because of the added functionalities.
The largest crypto exchange in the world, Binance (25% of all worldwide crypto trade is done on Binance) has already announced that it will support the Cardano network upgrade. This allows users to utilize the DeFi applications on the Binance platform which means that they can send, store and manage ADA (Cardano) DeFi tokens. This was not possible in the past because the Cardano network didn’t support DeFi before the Alonzo hard fork upgrade.
Decentralized Finance (DeFi)….or not?
Let’s take away some confusion about Decentralized Finance: I fell into that trap as well when I was introduced to DeFi for the first time. Financial institutions are looking into blockchain as well but what they are looking for is not purely related to peer-2-peer blockchain. This means that the scope of “DeFi” is much bigger and that might be confusing to people because the blockchain of financial institutions has nothing to do with the peer-2-peer blockchain network.
Why do financial institutions want to use blockchain?
Back to 2008 again. The financial crisis was not only responsible for the introduction, adaption and big support of Bitcoin but it also got the financial institutions thinking about ways to prevent a financial crisis in the future. As discussed in one of my previous posts the root cause of the 2008 financial crisis was the very complex financial instruments (CMOs) that were supported by outdated financial architecture that blended analog systems with digital systems spread all over the world. The balance sheet problems for a couple of large financial institutions were the catalyst of a big domino effect of tumbling economies and a global recession that was unheard of. Because of this, trust in the financial system was at an all-time low and financial institutions needed a solution for this in order to reinstate trust with their customers.
DeFi, CeFi and blockchain
When Satoshi launched Bitcoin, financial institutions didn’t like it. I think at first they saw blockchain as a threat, but over time they started to appreciate the value of blockchain in their search for a medicine that would prevent a repeat of 2008 and would reinstate the trust of their customers in the financial system. The technology of blockchain creates more transparency and more clarity because of the fixed ledgers that are being used. This eliminates the symptoms that were responsible for the domino effect in 2008:
- Outdated architecture and analog systems that can be replaced by a state of the art digital system with clear financial products that can’t be altered by protecting it with cryptography
- The elimination of shattered “hubs” all over the world that are beyond control by setting up one central point that fully regulates the system
So the medicine is there but not the way they want it to be: Satoshi’s system is peer-2-peer. This just doesn’t fit the business models of the financial institutions because they also need to receive certain benefits for their services and they also want to control their system themselves. To solve this problem, you can develop a blockchain inside your own network.
A good analogy to use is the intranet that is regulated and owned by companies themselves and the internet which is not regulated by anyone. This means that financial institutions still have full control over their own blockchains and that there are still middlemen, handing over services to end-users.
Of course, that is not a bad thing because it has a big chance of preventing a financial armageddon like we had in 2008 but it’s not my personal preference. It is still fully regulated by a central institution which makes it a central system that I don’t prefer. This is also the reason why this system is called Centralized Finance: the use of blockchain inside a central system. So when financial institutions (including central banks) would be talking about a decentralized finance system I personally would not agree with that because it is still under central control.
How does DeFi work with blockchain?
With the introduction of the smart contract functionality by launching the Alonzo hard fork, developers will be able to build decentralized applications (DApps) on the Cardano network. DApps support its users in managing their digital assets cross-chain with low latency and large capacity. One of the functionalities that DApps can bring is that of Decentralized Finance (DeFi). With this, developers can offer users DApps to allow forms of Decentralized Financing with the support of DeFi specific applications.
DeFi uses blockchain technology. This blockchain technology combines shared databases (transparency) and cryptography (safety). Multiple parties have access simultaneously to a digital ledger that is continuously updated without the possibility of any alterations.
This blockchain-based form of financing enables lending, borrowing and trading of assets over the blockchain network, peer-2-peer, without the requirement of any centralized intermediaries such as banks, brokerages or other financial institutions. It doesn’t require a bank account or a brokerage account, ID checks, Social Security numbers, proof of addresses, etc. It makes it possible for buyers, sellers, lenders and borrowers to interact anonymously on a peer-2-peer platform instead of a company or institution facilitating a transaction (including transaction costs that have to be paid). This form of financing (DeFi) is something I personally prefer over any central (digital) form of financing (CeFi).
The components of a DeFi system are pretty similar to those of existing financial ecosystems. This means that you require stable currencies and a wide variety of use cases. DeFi components take the form of stablecoins and services like a crypto exchange or a lending service. Smart contracts are the binding agent because they provide the framework for the proper functioning of the DeFi apps. This is because smart contracts encode the terms and activities that are necessary for the functioning of these services. A smart contract has a specific code that establishes the exact terms and conditions of a loan between two individuals. If certain terms or conditions in that contract are not met, there is collateral that can be liquidated. This is all fully conducted through coding with a specific code, rather than manually by banks or institutions.
Devil’s advocate
DeFi is still in the beginning stages. In other words: the system is far from mature as of now. The infrastructure is still bothered with infrastructural challenges and hacks. Scams also happen, for instance, “rug pulls”, which allows hackers to drain a protocol of funds while it disables investors to trade. However, there are more and more well-established protocols available that reduce these risks significantly.
Because of the openness of the DeFi ecosystem, there might also be problems with existing financial regulations in the future. The laws that we currently have are based on separate financial jurisdictions with their own sets of rules. This does not work in a DeFi ecosystem and this gives regulators a headache because they don’t know exactly how to act. This also makes the ecosystem unpredictable which also brings uncertainty to the market.
Smart contracts are also a concern because we are fully dependant on the coding of those contracts. The algorithm of smart contracts is encoded with the necessary constructs and terms of use to conduct transactions between the two parties. But software can also malfunction due to a wide variety of factors that contribute to the instability and the uncertainty of the DeFi platform.
Shortly summarized: it’s all still a work in progress and there are risks involved but this is always the case in a juvenile market. As an investor, the risks are higher than but the potential rewards are higher as well. It’s up to you if you accept these risks or not.
Now that I gave a bit more insight about DeFi in general and DeFi on blockchain specifically, let’s get back to Sunday’s key event of the Alonzo upgrade, including a few bumps on the road before its launch.
The Alonzo hard fork upgrade: what is it?
Technologically speaking, the Alonzo upgrade at Cardano is a hard fork. This means that it is a major change in the base code that will no longer be backward compatible. If a large number of network points decided not to implement Alonzo, two separate blockchains would emerge and ADA would face competition in the form of Cardano ahead of the hard fork. However, current data from PoolTool shows that more than 80 percent of nodes have already updated their software to version 1.29.0 and are thus prepared for Alonzo. In this regard, there is no discordant hard fork to be expected with Cardano, as Bitcoin Cash had to experience in November 2018, where it weighed on the price trend.
Alonzo hard fork pre-launch challenges
As with a lot of software launches, the launch of smart contracts on Cardano has not been smooth sailing. After the Alonzo testnet rollout, Cardano’s first decentralized application (DApp), Minswap had to be closed prematurely due to a so-called “concurrency” issue, meaning only one user could interact with a smart contract per block or transaction.
However, the Minswap team stressed that they have been aware of the challenge since they first started building on Cardano more than six months ago. According to Miniswap, it is not a fundamental flaw on the Cardano blockchain and the problem will certainly be solved in the long run.
Cardano downtime
Alonzo will be unlocked on September 12 when the era reaches 290 in the Cardano blockchain. It is expected at 11:44 PM GMT+1 on Sunday evening. Binance has announced that it will temporarily shut down ADA deposits and withdrawals half an hour in advance and then restart when the network on Cardano is stable again. This is not expected to last long. Trading in ADA will not be suspended during the upgrade. Other crypto exchanges will likely act the same way.
Final thoughts
ADA currently trades around € 2 and the price will be influenced by whether Alonzo is really paving the way for Cardano’s success in the booming DeFi sector: the DeFi Market Cap currently is at about € 120 billion. The next weeks and months will show whether developers manage to deal with the controversial features of Alonzo smart contracts and thus position Cardano attractively for DeFi and other use cases.
Personally, I have full faith in the Alonzo hard fork and the extra boost it can give to the DeFi sector. The current state of DeFi is not perfect and still not at a mature level but I have full trust in the maturation of DeFi in the future.
DeFi is still a pretty new concept to me and it takes time to fully grasp it so if you have any additional tips/advice on this subject please do so by contacting me. If you want to keep in the loop when I upload a new post, don’t forget to subscribe to receive a notification by e-mail.
