Nakamoto created Bitcoin to provide a platform for a decentralized, secure and private peer-2-peer financial system. It’s creation was born out of a concern that the distribution of economic power is too reliant upon centralized entities.
After the 2008 Mortgage Crisis, it is clear that the fractional banking system and ever increasing M2 and M3 money supply can easily get out of hand with various synthetic derivatives. This is a clear indicator of monetary mismanagement by centralized entities. Money shocks can occur because of a liquidity crisis and over-extended credits. In this scenario, the value of fiat currencies will inevitably decrease due to inflation.
Too Big To Fail
Banks have an incredible amount of power over individuals with the ability to influence phenomenal changes on a national or global landscape. When they get in trouble, governments often have to interfere to prevent them from collapsing because these institutions are inextricably linked to their respective economies. When these institutions get too big, their decision makers can become reckless with an expectation that the government will bail them out.
A fractional-reserve banking system often requires banks to provide between 0-10% cash liquidity after deposit transactions. The low reserve requirements allow more money to flow into the economy, often in the form of credit and loans. This can cause two problems: uncontrollable inflation of fiat money and a liquidity crisis in the event of a panicked run on banks. After trusting banks with their cash and investments, customers are the ones who stand to get hurt the most since they have no control over the bank’s decisions.
P2P Cash System
To prevent these issues caused by centralized banking, zero-knowledge authentication is proposed through the proof of work algorithm in Bitcoin.It should be noted however, that a PoW structure is not immune to flaws. In PoW, if a malicious actor takes over 51% of the nodes, then they can execute Sybil Attacks and perform double spending or network halting actions. Therefore, decentralized mining and more varied mining pools are highly recommended for securing the decentralization of blockchain.
Bitcoin is the pioneer of cryptocurrencies and is the prototype for what is to come. It is the first global implementation of a peer-2-peer autonomous monetary system where its native currency is traded on free markets. Bitcoin has only one implementation of blockchain though, which is as a cryptocurrency. Bitcoin functions as either a store of value or a transaction unit. A lot of different implementations were left empty in its design. Ergo is building a new approach to Layer 1 and novel ideas of decentralized finance are showing that Layer 2 implementations are vastly improved from the initial launch of Bitcoin.
Smart contracts provide the infrastructure of a decentralized financial system. For example, consider a bank’s borrow/lend pool where you can deposit and borrow money.
Banks charge certain fees in order to match depositors and borrowers. The matching process considers different elements such as:
- How much money is deposited?
- How many individuals want money?
- When will be the execution of borrowing and lending contracts?
This is where smart contracts come into play on a decentralized network. Instead of using your bank, you can use blockchain based immutable smart contracts and verify smart contract pools with on-chain metrics. Through the use of the blockchain, individuals will be able to reclaim their economic freedom by controlling their finances through decentralized autonomous organizations(DAO).
You can learn what kind of applications are being developed for DeFi Ecosystems here.
It should be noted that blockchains are more than just vehicles for providing cheap and fast transactions. Distributed ledgers can expand to cover every aspect of virtual data processing services, including cloud storage, cloud computing, governance and finance.