What is decentralized finance (DeFi)?
Cryptocurrencies have exploded into a trillion-dollar industry, sparking a wave of worldwide financial disruption.
At the heart of cryptocurrencies is a remarkable history of innovation that goes back to the 1980s and major advancements in cryptography. Since then, many events have shaped the crypto space. However, the most prominent of these is the appearance of the first cryptocurrency, Bitcoin, in 2009. Despite Bitcoin’s spectacular growth, financial services have appeared very slowly for Bitcoin — mostly due to its inherent lack of stability and adoption. Mainstream institutions won’t accept a Bitcoin loan because of its significant price volatility. It makes Bitcoin a poor asset for planning any investment accurately.
Things change quickly in crypto, and decentralized finance (DeFi) is a current trend. It is being used in many new and exciting ways, so let’s dig deeper into DeFi and learn more about it.
Decentralized finance (DeFi) explained
Short for decentralized finance, DeFi is an umbrella term for applications and projects in the public blockchain space geared toward disrupting the traditional finance world. DeFi refers to financial applications built on blockchain technologies, typically using smart contracts. Smart contracts are automated enforceable agreements that do not need intermediaries to execute. Anyone with an internet connection can access them to perform financial transactions and many other activities.
DeFi consists of applications and peer-to-peer protocols developed on decentralized blockchain networks that require no access rights. The decentralized apps (dApps) are used for easy lending, borrowing, or trading of financial tools. Most DeFi applications today are built using the Ethereum network, but many alternative public networks are emerging that deliver superior speed, scalability, security, and lower costs.
Why smart contracts?
Most smart contracts offer Turing Complete programming languages that allow multiple parties to interact with each other without a centralized intermediary. Blockchain’s ability to capitalize on smart contracts makes them ideal platforms to choose when building financial applications.
How did DeFi get its start?
Historically, central authorities have issued currencies that underpin our economies. As people developed trust in those currencies, the power of monetary systems grew. However, trust has been broken repeatedly, making people question the centralized authorities' ability to manage said money. DeFi was developed to create a financial system that is open to everyone and minimizes the need to trust and rely on a central authority.
It’s argued that DeFi started in 2009 with the launch of Bitcoin, the first p2p digital asset built on top of the blockchain network. Bitcoin made it possible to envision a transformation in the traditional financial world. Blockchain technology became an essential next step in decentralizing legacy financial systems. The launch in 2015 of Ethereum and, more specifically, smart contracts made it all possible. The Ethereum network is a second-generation blockchain that maximizes the potential of this technology within the financial industry. It encouraged businesses and enterprises to build and deploy projects that formed the ecosystem of DeFi.
DeFi created many opportunities to create a transparent and robust financial system that no single entity controls. In 2017 projects reached a turning point and began to go beyond just money transfers.
Challenges within centralized finance
Financial markets can enable great ideas and drive the prosperity of society. Still, power in these markets is centralized. When people invest in the current financial system, they relinquish their assets to intermediaries, such as banks and financial institutions. This keeps risk and control at the center of these systems.
Historically, we’ve seen bankers and institutions failing to manage risks in the market. The 2008 financial crisis was a catastrophic illustration of this. Undoubtedly, when central authorities control money, risk accumulates at the center and endangers the system as a whole.
Bitcoin and early cryptocurrencies, which were initially developed to give individuals complete control over their assets, were only decentralized when it came to issuance and storage. Providing access to a broader set of financial instruments remained challenging — until the emergence of smart contracts that made DeFi possible.
DeFi protocols and how they work
DeFi has grown into a complete ecosystem of working applications and protocols that deliver value to millions of users. Assets worth over $239 billion were locked in DeFi ecosystems as of April 2022, making it one of the fastest-growing segments in the public blockchain space.
Here's an overview of the most popular DeFi use cases and protocols available today.
Certain decentralized applications require that real-world data be connected to the blockchain. For example, prediction markets treat real-world events, such as elections, as financial products and require the real-world data to be stored on-chain for funds to be released to those who predicted the results.
An oracle connects the blockchain to the outside world. They are often used to send real-world data to the blockchain but can also send data from the blockchain to the real world. In most cases, software oracles that connect to public APIs are used. In some cases, hardware oracles with physical sensors are used to determine things like wind speed.
To weed out “bad data,” protocols often utilize consensus oracles. These oracles aggregate data from various sources and use a consensus mechanism to reach a single data point.
DeFi lending and borrowing
Decentralized lending lets users lend cryptocurrency to others to gain annual yields. Decentralized borrowing allows individuals to borrow money at a specific interest rate. Unlike traditional finance, these DeFi protocols enable peer-to-peer lending, removing the need for intermediaries.
Because DeFi lending protocols use an automated smart contract code to enable loans, users don’t have to wait to get their funds. These protocols also remove the need for credit checks and enable users to borrow cryptocurrency regardless of location. Some decentralized lending platforms offer rate-switching features that let borrowers switch between variable and stable interest rates to protect themselves from volatility.
Although DeFi lending is an ideal solution for many users, it isn’t without risk. Many lending protocols require users to lock their funds in a liquidity pool, making them susceptible to impermanent loss. Flash loans, a type of loan in which funds are borrowed and returned within the same transaction, also can be problematic. They allow DeFi users to borrow large sums of cryptocurrency that might be used to manipulate token prices.
Top DeFi lending and borrowing platform: Compound Finance
Launched in 2018, Compound Finance is the brainchild of Rober Leshner. The project is a lending protocol developed on the Ethereum blockchain that allows users to gain interest by lending out assets or borrowing against collateral. The Compound protocol makes this possible by creating liquidity for cryptocurrencies through interest rates set using computer algorithms.
Numerous blockchain-based insurance policies cover real-world scenarios like farming, disasters, and more. Many blockchain-based insurance policies utilize a parametric insurance model in which claims are paid to the party involved as specific parameters are met. These parametric insurance policies often use hardware and software oracles to determine when disbursements should occur. With smart contract technology, disbursements happen automatically rather than relying on a centralized entity to trigger the payment.
Decentralized insurance policies offer numerous advantages over centralized policies. For example, if you had a centralized hurricane insurance policy and a hurricane caused property damage, you would have to go through a lengthy claims process before receiving the funds needed to repair your home. On the other hand, a decentralized policy could utilize smart contracts to pay the total value owed as soon as the damage occurred.
DeFi Insurance also refers to insurance that covers blockchain-related activity. This type of coverage is ideal for those with significant amounts of crypto assets on an exchange. A DeFi insurance policy can cover losses incurred from an exchange hack. Additionally, DeFi insurance can offer security for stablecoin investors in the event of a price crash.
Decentralized Exchanges (DEX) are one of the essential functions of DeFi. DEXs allow users to exchange or swap tokens with other assets without a centralized intermediary or custodian. Traditional exchanges (centralized exchanges) offer similar options, but the investments offered are subject to that exchange's will and costs.
Top decentralized exchange: Uniswap
Founded in 2018 by Hayden Adams, UniSwap is the largest automated token exchange by trading volume deployed on the Ethereum blockchain. The project was launched after receiving support from venture capitalists and the Ethereum Foundation. UniSwap automated transactions between cryptocurrencies through smart contracts.
UniSwap today offers three functionalities: Swapping tokens, adding liquidity, and removing liquidity.
Derivatives allow users to interact with assets without buying them, although, in some cases, the user has the option to buy the underlying asset. Lock derivatives are contracts where traders are bound to agreed-upon terms throughout the contract’s life, whereas option derivatives let holders buy or sell the underlying asset before expiration.
Many DeFi derivatives are tied to cryptocurrency tokens and other DeFi products, although they can also track the value of traditional assets. Defi derivatives marketplaces that deal with real-world assets usually allow users to create synthetic assets pegged to underlying real-world assets. Most DeFi derivatives marketplaces allow traders to use leverage to increase their potential returns, although this also increases their risk.
DeFi derivatives may lead to regulatory issues down the line for exchanges that haven’t properly registered with the SEC. The SEC has sent numerous subpoenas to cryptocurrency projects selling tokens that resemble investment contracts.
Yield farming is a popular way for cryptocurrency traders to earn passive income on their tokens. Yield farm protocols use smart contracts to lock users’ tokens and pay interest rates on their locked assets. Users who lock tokens on yield farm protocols earn interest based on transaction costs if their funds are used for liquidity and loan interest if their funds are used for DeFi loans.
The rewards paid to traders exist to offset potential risks associated with locking their tokens. Risk exists primarily in the form of impermanent loss, although token volatility and rug pulls are of concern as well.
Sometimes, the pool’s creator manually decides the annual percentage rate. In other cases, the yield farming protocol determines and alters the APR with smart contracts.
Stablecoins are a viable solution to volatility issues surrounding cryptocurrencies and are helping DeFi gain prominence. The name says it all. Stablecoin value is tied to a relatively stable asset, like gold or the US dollar, to keep its price consistent. Stablecoins became useful during risky moments in the crypto space, providing a haven for investors and traders. Stability makes them a reliable collateral asset. Stablecoins also play an important role in liquidity pools — an integral part of the DeFi ecosystem.
Founded in 2015 by Rune Christensen, MakerDao is an organization-building technology for savings, borrowing, lending, and a stable cryptocurrency on the Ethereum blockchain. The project was one of the earliest DeFi protocols. Instead of conducting an initial coin offering (ICO), the project privately sold $MKR tokens to fund the development over time. $DAI, Maker's stablecoin, was launched in 2018 and has experienced significant traction.
How does MakerDAO work?
The protocol for this decentralized autonomous organization works like this:
A user can send or deposit $ETH to a smart contract on Maker's protocol and create a Collateralized Debt Position (CDP). This enables users to take $DAI at a specific collateralization rate.
- If the price of $ETH drops, the CDP of a user is automatically closed to ensure the network has enough capital locked against the borrowed tokens.
This can be prevented by putting in more $ETH or taking out less $DAI in the first place.
$ETH can be claimed by paying back the amount, with the addition of a small fee.
Prediction markets are platforms where individuals can make predictions on the realization of future events. The markets cover things like sports betting, politics, and predictions on stock prices. DeFi opens these markets for participation. The concept of decentralized prediction markets has long been touted as a possibility through smart contracts.
Top prediction market: Augur
Augur is a decentralized prediction market platform that utilizes the collective prediction of the masses. It uses Ethereum to harness the "Wisdom of the Crowd" to create real-time predictive data. The first version of Augur was released in 2015, and its mainnet was released in 2018.
How does Augur work?
Augur offers two primary actions and uses an ERC-20 token:
Market creation: Users can create an Augur market by spending some Ethereum. When creating a market, users need to set the taker fees and maker fees, which should be low enough to incentivize people to bid and high enough to cover the Ethereum cost.
Trading events shares: Users can buy or trade shares that represent the odds of the occurrence of a market event. Traders can make money by buying positions at a low cost and selling them when the price increases. People who predict an event correctly will also receive rewards when the market closes.
Augur token: $REP (reputation token): $REP is an ERC-20 token used on the Augur platform to create a prediction market, buy participation tokens, or dispute an outcome.
Another class of service offered by DeFi is asset management. It intends to make investing faster, less expensive, and more democratized. Aspects of the DeFi ecosystem play very favorably for Asset Management, including transparency, composability, and trustlessness.
Transparency promises to make information accessible and secure. Composable allows users to enjoy hyper-customization of portfolios. Trustless provides access to historically illiquid assets.
Launched in 2020 by Evan Kuo, Ampleforth aims to provide a non-collateralized digital asset that helps traders and investors diversify their crypto portfolios. Ampleforth is an asset-management protocol of DeFi designed to be a smart commodity, synthetic money. "Synthetic" because they're created by humans but aren't raw materials like gold.
How does Ampleforth work?
Ampleforth adjusts its tokens' supply daily to match the market demand using a smart contract. These smart contracts use Ampleforth's and Chainlink's price oracle to get real-time data from Bitfinex Exchange and KuCoin Exchange. These decentralized price feeds help determine if the token's price is within the equilibrium range (0.96-1.06 USD). Suppose an $AMPL token price is lower than $0.96 — the supply decreases. If it is greater than $1.06, Ampleforth increases the supply.
The future of DeFi
We’re observing a quantum leap in the new possibilities of the functionalities of money through the innovation of distributed ledger technologies. For the first time in history, a global financial system for a worldwide population is being shaped by that same population. Anyone can participate in DeFi protocols' governance and get a seat at the table where the world of decentralized finance is actively created.
The DeFi space is gradually catching up with the traditional financial system. Despite some of the obstacles that come with operating on the bleeding edge of innovation, the world of decentralized finance is on the path to prosperity. When Defi and fintech map and merge, we'll have an inflection point where nascent financial technology is just part of a new financial system — one that realizes the dream of being fast, secure, available, and egalitarian.