Updated: Nov 20
Author: Chiara Dal Monte
Publishing date: 9/1/2021
Since 2008, when the first Bitcoin was mined, the cryptocurrency market has been growing exponentially. Due to the open-source nature of the blockchain, developers can create new codes. The blockchain has huge potential in not only the financial sector but also in healthcare, supply chain, and IoT. The decentralized approach means there is no risk of information getting lost or manipulated. Since there are different sectors of cryptocurrencies, they will be explained. Additionally, DeFi is explored, as it provides financial services.
Cryptocurrencies are divided into categories according to their function. CoinMarketCap counts more than 100 categories, but this article focuses on the most important ones.
Initially, cryptocurrencies were created to facilitate transactions. Bitcoin was advertised
as an alternative payment without a financial intermediary. Every transaction is stored as information in a block and verified by miners. Because of the decentralized approach, the system is trustless. So, there is no need to trust a third party. Some advantages of cryptocurrency payments are lower fees and cross-border payments. Additionally, there are no limitations by a centralized authority and it’s faster.
One of the main sources of risk for holders of cryptocurrencies is their high volatility. Therefore, Stablecoins were created to reduce virtual currency volatility.
· The Fiat-backed coin Tether is backed by the U.S. dollar, being exchanged for tokens called USDT. A reserve acts as a deposit guarantee. USDT is not impacted by pricing fluctuations.
· Cryptocurrency-backed coins use over-collateralization to avoid volatility.
· Asset-backed cryptocurrencies are pegged to an external good. It can be used like any other cryptocurrency.
· In “non-collateralized” stablecoin the blockchain itself uses algorithms and smart contracts to avoid price fluctuations.
In the Metaverse, users connect with an avatar and interact with each other. Users can live almost every aspect of life virtually. Metaverse cryptocurrency is used as an exchange on these platforms. Then, users buy properties, attend events, gamble, and much more.
Fungibility is the property of being interchangeable and indistinguishable. Consequently, non-fungible tokens are unique units of data stored in the blockchain. NFT can be traded in the digital market. However, it can only have one owner at a time. So, the properties of NFT are uniqueness, indivisibility, and scarcity.
“Internet of things” indicates the connection and exchange of data between devices and the Internet. Cryptocurrency connects the digital wallet to perform automated payments. For example, paying bills according to energy consumption or for food. The biggest IoT project is IOTA. This is an open, feeless, and scalable distributed ledger. Furthermore, it supports frictionless data and value transfer. Importantly, IOTA has no blocks and miners.
Because of the public ledger, it’s impossible to guarantee full anonymity for users. Therefore, private cryptocurrencies can be used. In that instance, the origin and destination of blockchain transactions can be obscured. Consequently, transactions are anonymous and untraceable. But, not all jurisdictions allow the use of privacy coins.
Decentralized finance defines a set of financial services carried out through the blockchain. Instead of a centralized system with a third party, it uses a decentralized
ledger. The new system is defined as trustless as there is no intermediary during the transaction. The transaction is recorded in the blockchain, thus being public to all participants in the network. So, it’s impossible to reverse transactions.
DeFi uses smart contracts for transactions. To elaborate, these are computer transaction protocols that automatically execute the terms of the contract. Also, they are used to digitally facilitate, verify, and enforce without a third-party intermediary. Ethereum is the main DeFi platform providing smart contracts. Additionally, it can carry data in the form of arguments. So, contracts can be self-executing.
“yield farming” is the name of staking or lending crypto assets to generate high returns or rewards. Due to this financial innovation, the DeFi sector market cap grew to $10 billion in 2020. Additionally, it’s possible to deposit your cryptocurrency as collateral and borrow fiat money against it. Furthermore, there are flash loans. A loan can be received, used, and paid back with no collateral requirement. Failure of payment leads to the transaction being reverted.
Traditional assets serve as capital backing for companies. Virtual assets have similar purposes. However, because of the blockchain, they are public and movements are transparent. Using smart contracts, they can be traded automatically and censorship-less.
· Decentralized exchange (DEXes)
Users can invest in cryptocurrencies on the Ethereum platform through smart contracts. There is no sign-up or ID verification needed. Furthermore, no initial deposit or fees are required.
Two parties sign the smart contract. One takes the long position while the other takes the short position. One side locks collateral in the trade that’s worth more than their bet. Then, the program transfers collateral to a party according to the price movement of the established asset. This depends on the timing and rules specified in the contract.
The decentralized system allows worldwide connections. Moreover, assets can be insured without going through an insurance company or agent. Also, smart contracts ensure a fair, secure, and trustworthy process. Still, there is the possibility of cyber-attacks. Therefore, there are security measures:
· Crypto wallet insurance, against the risk of theft during a cyberattack. One of the most famous is Etherisc - Decentralized Insurance;
· Collateral protection for crypto-backed loans. Collateral provided by the borrower is insured;
· Smart contract cover. For when the address is hacked and manipulated.
Problems to be addressed
Decentralized finance is still in a growing phase. Therefore, there are still some problems:
· Scalability problem: the blockchain has limited transaction throughput. So, the criteria for verification is to choose the ones with the highest fees. This causes higher average fees for transactions.
· Centralization risk: a limited number of nodes have the necessary technology. Therefore, there are still risks of corruption.
· Usability: cryptocurrency wallets suffer from usability issues. The software is difficult to understand for general users.
· Smart contract vulnerability: the investment could be lost due to flaws in the contract code.
· User error: if the user inputs the wrong address it is very difficult and expensive to reverse the transaction.
· Liquidity problems: Liquidity indicates the ability to buy or sell an asset at a stable price.
The lack of liquidity contributes to crypto price volatility. Furthermore, during transactions, there could be slippage. The expected price can differ from the execution price. For that reason, providing liquidity could help reduce slippage and uncertainty.
To address the problem of scalability there are two possible alternatives:
· Improving the consensus mechanism of blockchain technologies
· Applying sharding techniques: dividing the blockchain into shards, independent nodes. Only specific shards are responsible for validating new transactions.
Another solution to DeFi problems is addressed by Relite Finance, a cross-chain lending project built on Polkadot. Polkadot is a separate blockchain from Ethereum. It allows cross-chain transfers of any data or assets. Also, fees for users are decreased and there is lower complexity. Finally, liquidity pools provide asset liquidity for traders to swap between currencies.
The world of cryptocurrency is developing at a fast pace. It offers different payments and exchanges for unique items. However, critics point out that cryptocurrency does not have real value. But Stablecoins try to overcome this problem by pegging the digital coin to another asset. As for traceability, privacy coins make transactions anonymous. Importantly, decentralized finance has the most potential. Smart contracts offer many financial services without a financial intermediary. Still, scalability, usability, and liquidity are lacking in the DeFi sector. However, this does not prevent investors from getting more involved in this new technology.