DeFi and the Future of Finance

IIIDeFi INFRASTRUCTURE

In this chapter, we discuss the innovations that led to DeFi and lay out the terminology.

BLOCKCHAIN

The key to all DeFi is the decentralizing backbone: a blockchain. Fundamentally, blockchains are software protocols that allow multiple parties to operate under shared assumptions and data without trusting each other. These data can be anything, such as location and destination information of items in a supply chain or account balances of a token. Updates are packaged into “blocks” and are “chained” together cryptographically to allow an audit of the prior history – hence the name.

Blockchains are possible because of consensus protocols – sets of rules that determine what kinds of blocks can become part of the chain and thus the “truth.” These consensus protocols are designed to resist malicious tampering up to a certain security bound. The blockchains we focus on currently use the proof of work (PoW) consensus protocol, which relies on a computationally and energy intensive lottery to determine which block to add. The participants agree that the longest chain of blocks is the truth. If attackers want to make a longer chain that contains malicious transactions, they must outpace all the computational work of the entire rest of the network. In theory, they would need most of the network power (“hash rate”) to accomplish this – hence, the famous 51 percent attack being the boundary of PoW security. Luckily, it is extraordinarily difficult for any actor, ...