Banks are Dumb like Smart Contracts Part 1

The personal views expressed by the author in the below article should not form the basis for making investment decisions, nor be construed as a recommendation or advice to engage in investment transactions

Smart contracts are DUMB LOGIC……..Literally!

In this article we will explore some of the relationships between Users and Smart Contracts and how this compares to relationships people have with Banks and Money.

Once we have understood the relationships between People, Money, Banks and/or Smart Contracts, we will explore some of the various DeFi protocols and the user experiences certain protocols deliver using Cryptocurrency.

Creditor — a person or company to whom money is owing

When a user deposits their cryptocurrency into a smart contract, the user becomes a CREDITOR to that smart contract.

Similar to depositing your fiat money into your local banks where you might have a current account. You deposit $x into your banks, your banks owe you $x (less any fees your banks might charge, if any).

You’re trusting your banks to pay you when you want your money. You are CREDITORS to your banks who hold your money. Your account balance is how much your banks owe you.

Exactly the same notion applies with smart contracts. You deposit your money whether cryptocurrency or stable coins into a smart contract on a blockchain, and that smart contract owes you that money.

Depositors of money into smart contracts on blockchains are CREDITORS to the smart contract they deposited money into.

Smart contracts can be compared to banks in that regard. Where depositors to banks or Smart Contracts are CREDITORS.

Debtor — a person, country, or organization that owes money

DEBTORS to smart contracts are those who may have loaned some money from a smart contract or were extended a line of credit by a smart contract, whether in cryptocurrency or stablecoins.

Again, similar to taking loans from banks, whether secured or unsecured. Banks offer you a $y credit card and a $z mortgage against your house. You become a DEBTOR to your banks who advance you capital in return for repayments plus interest.

Your house might be worth $a and you withdraw $z capital as a mortgage (a > z), and you must pay $m each month of which $i is interest and $r are capital repayments (m = i + r).

Applying the notion of smart contracts where you have already deposited your money into a smart contract on a blockchain, and the smart contract enables you to withdraw some money. Such that your withdrawal is secured against your initial deposit of money (like the mortgage against your house).

A smart contract is also capable of charging you periodic amounts of money (like repayments or interest on mortgages).

Say you deposited $a of cryptocurrency into a smart contract, and withdrew $z in stable coins using your $a deposit of cryptocurrency as collateral. You might pay $m in stable coin each month to cover interest, capital repayments or premiums for protection against liquidation.

Liquidate — wind up the affairs of (a business) by ascertaining liabilities and apportioning assets.

The notion of liquidation is similar to defaulting on mortgage repayments to the banks who advanced capital against your house. As your mortgage is legally secured, the banks can take custody of your home and auction it to the highest bidder for $k.

The banks needs to recover enough from the auction otherwise the banks may have bad debt (k > z + ∑i — ∑r).

Coming back to the example of smart contracts, your $a of cryptocurrency might be liquidated for $k in stablecoins.

As long as k > z + ∑i — ∑r the smart contract has no bad debt and made a profit from the liquidation.

If k < z + ∑i — ∑r the smart contract made a loss and now has bad debt.

Bad Debt — a debt that cannot be recovered

A smart contract is also capable of extending a credit line whether in the form of a revolving credit agreement or an unsecured loan. Similar to banks granting you a credit card for $y (revolving credit agreement), a smart contract is able to grant credit to another smart contract for $y.

An example of this would be a smart contract extending credit to an Exchange or Market Maker with $y in stable coins, where the smart contract is paid back $y plus $i in interest (if applicable) periodically whether daily, monthly or annually.

Since the credit line is unsecured, there is no threat of liquidation, as no collateral was provided. Defaulting on the credit might lead to damage to ones reputation without financial penalty (Similar to defaulting on an unsecured credit card that impacts one’s credit score leading to increased premiums on future credit).

Digital Signature — a mathematical scheme for verifying the authenticity of digital messages or documents

As we have demonstrated above a person’s relationships with money whether interacting with banks or smart contracts can be defined simply as a CREDITOR vs DEBTOR relationship. Any future interactions are governed by the terms agreed between a person, banks or smart contracts.

One often signs their signature with a pen or digitally when signing banks terms and conditions. Similar to signing transactions on your wallet when interacting with smart contracts.

In Part 2 we will start exploring the user experience of interacting with certain DeFi protocols available in the market.

Stay Tuned