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What is Decentralized Finance (DeFi)?

The financial world has changed in revolutionary ways over the years. With the emergence of cryptocurrencies since Bitcoin’s history started in 2009, new instruments in the form of digital assets introduced a wide variety of purposes.

Alongside the traditional financial markets, cryptocurrencies brought new advancements in the field of digital finance. As 2017 signaled the boom of initial coin offerings (ICO), 2019 has paved the way for the decentralized finance (DeFi) movement.

Due to the inefficiencies of the current global financial system such as cybercrimes that caused financial loss and data exploitation, as well as lack of access to basic financial services, crypto, and blockchain-based solutions, seem to be an economical answer.

Early Stages of DeFi

The historical evolution of DeFi began in 2018, with the teams behind Set Protocol (automated crypto asset management), 0x (DEX), Dharma (decentralized P2P lending), and DyDx (DEX) started working together to build an alternative financial system.

According to a ConsenSys SEO consultant, Google searches for “decentralised finance” surged 273% in 2019 compared to 2018. As a new decade started, in the early 2020s, DeFi’s total market value had risen to ~US$500M.

Meanwhile, Bitcoin and Ethereum are the pilot DeFi applications. Yet, the DeFi market within the blockchain and crypto industry continues to expand; and the now billion-dollar worth of ventures work towards achieving open-source interoperability, collaboration, and transparency.

Introduction to DeFi

Open finance — or decentralized finance — refers to the technological shift from the closed financial system towards an open financial ecosystem based on public blockchains.

Mainly utilizing the Ethereum blockchain as the core infrastructure, DeFi is based on smart contracts, forming programmable open protocols and decentralized applications (DApps).

World Bank revealed that approximately 1.7 billion adults worldwide still don’t have access to a bank account. Despite the goal of financial inclusion on the rise, the gap remains to be there. Hence, this is where DeFi comes into play.

The goal of DeFi is to reconstruct the banking system worldwide in a more secure and permissionless way through the use of blockchain technology.

Similar to forming LEGO block structures, an interconnected financial network combines DApps together. DeFi intends to restructure financial use cases like trading, lending, investing, asset management, payments, and insurance.

Powered by smart contracts working alongside each other, the open financial economy aims to be interoperable, programmable, and composable. With DApps as the gateway tool, anyone with a smartphone can access financial services easily at a much cheaper cost.

Key Components of DeFi

Source: Token Economy
Source: Token Economy

What makes DeFi capable of addressing the issues of the current financial system is the primary features that blockchain has. As smart contracts operate in this distributed ledger, its features benefit the protocol created for each project.

Permissionless. Everyone can access a public network openly. In this case, regardless of location or status, a person can avail of the services offered.

Decentralization. With thousands of computers maintaining the whole network, there is no single point of failure. As a result, all participating nodes control the transactions.

Trustless. Eliminating the middleman, direct transactions between one another are conducted through blockchain. Subsequently, no double spending and authenticity are ensured by the network.

Transparent. All transaction records can be viewed and monitored by network participants. This also reduces any cases of manipulation as the whole community will be informed.

Censorship-Resistant. Any person can transact on the network as long as they follow the rules of the protocol. Once a transaction is done, it cannot be detached from the network.

Programmable. Depending on the conditions set, smart contracts deploy automatically. This reduces the time processing and possibilities of human errors.

Interoperability. Removing the limitations of making transactions, open finance allows platforms to work together, complementing each other for maximum efficiency.

Composability. This refers to the concept that other protocols (typically based on Ethereum) can be selected and assembled in multiple combinations without any problem.

Core Benefits of DeFi

As mentioned, DeFi is built on top of a blockchain. It can be viewed as a cluster of secondary layers consisting of the DApps and its underlying open protocols. This is only made possible as the blockchain itself is decentralized in nature.

Otherwise, if you look at it from a centralized point of view, it defeats the purpose of establishing an open financial economy for all.

Therefore, the core benefits of decentralized finance are shared with the core benefits of blockchain. These include the following:

Speedy and low-cost transactions/settlement. Various payment DeFi protocols aim to provide instant and affordable transactions to crypto users on a daily basis.

Immutability of the financial contracts. Once a contract has been deployed, its conditions must be strictly followed and any transactions within the contract cannot be modified.

Contract automation. Enhancing efficiency of transactions, smart contracts are automated and computer-generated. This allows quick processing and turnaround time.

Non-custodial system. DeFi puts full control of the economy and transactions to the community. Therefore, it is the user’s responsibility to keep their private keys secure at all times.

Increased ecosystem transparency. In a traditional setting, financial infrastructure tends to have loopholes and discrepancies. Decentralization seeks to promote transparency for all.

Price and market efficiency. Depending on the use case, DeFi involves putting a collateral amount of crypto to get a specific token in return. This can result in price stability in the market.

Minimal principal-agent risks. Due to the decentralized nature of smart contracts, any moral hazard and conflict of interests among the community members is avoided.

Top Blockchain Platforms for DeFi

1. Ethereum

Startups and companies have recognized the potential of open-source networks to change and decentralize economic activities. Notably, DeFi projects have mainly used Ether (ETH) as the base asset and primary source of collateral.

The Ethereum platform, by far the largest blockchain-based smart contract ecosystem, enabled the evolution of DeFi. It enables developers the ability to create DApps, leading to an open financial system with little to no involvement from financial institutions.

With this, the fate of the adoption of DeFi is tied to the scalability and usability of Ethereum. Basically anyone capable of writing smart contracts is able to create DeFi applications. Given that, the majority of DeFi protocols utilize this platform.

2. Bitcoin

The good-old Bitcoin blockchain is also a popular choice for DeFi developers as the Lightning Network layer allows the creation of dApps and deployment of smart contracts.

As a matter of fact, Bitcoin offers an alternative and stable architecture for DeFi. Indeed, the simplicity of using this platform makes some developers comfortable with Bitcoin Core’s security. It has proven to work well and very securely throughout the years.

Moreover, despite the scalability of Ethereum, guaranteed base-layer security is also one of the factors why developers are building “Layer 2” smart contract protocols on Bitcoin.

3. EOS

DeFi is also a primary element within the EOS ecosystem. As it crossed its $5 billion market cap mark, EOS has shown great potential in delivering decentralized financial services.

Though fairly underrated compared to the abovementioned blockchains, EOS is among the most scalable and best-performing blockchain in the industry that is capable of supporting DeFi DApps and protocols for mainstream adoption.

DeFi Use Cases

DeFi is a progressive system of open, permissionless, and interlocking financial products. In practice, DeFi is an overlapping network of DApps and smart contracts built on a specific blockchain.

Based on DeFiprime, there are more than 200 DeFi projects existing up until the Q3 of 2020. More than 80% are built on top of Ethereum (197), followed by Bitcoin (24) and EOS (22).

Source: DeFiprime.com
Source: DeFiprime.com

DeFi is proving that cryptocurrencies are more than just digital assets exclusively used and created for facilitating decentralized (P2P) payments or speculative trading.

Crypto Lending & Borrowing

The two largest DeFi DApps by market cap — MakerDAO and Compound Finance — are lending platforms. Thus, these products are the hottest apps in the DeFi market.

Decentralized lending platforms provide loans to businesses and individuals without any intermediaries present. On the other hand, DeFi lending protocols enable everyone to earn interest on the cryptocurrencies they will lock their investments on.

Derivatives

A derivative is a contract that relies its value on an underlying financial asset such as bonds, commodities, currencies, interest rates, market indexes, and stocks.

Traditional derivatives have no value, but it supports the long-term growth of any asset class Within the crypto industry, examples of derivatives commonly include futures contracts, forward contracts, options, swaps and warrants.

Asset Management Tools

In DeFi, you are the only custodian of your own funds and assets. Ranging from user-friendly crypto wallets and easy-to-navigate dashboard, users can easily manage their cryptocurrencies and other digital assets.

Decentralized Exchanges

The DeFi wave has also benefited decentralized exchanges aka DEXs. Dune Analytics data revealed that trading volumes on DEXs set an all-time high of $4.3 billion in July 2020. It is gaining traction due to its non-custodial nature and enhanced liquidity and security.

Stablecoins

Value of real-world assets or commodities back stablecoins’ prices. This allows its value to be less volatile and more stable than the traditional monetary system. More so, crypto-collateralized stablecoins are on the rise with the idea of fewer risks and more profit in the long-term run.

Payments

Included in DeFi’s most common applications are payment apps, protocols, and solutions. Global trade and international transactions are made to be easier and accessible to the people who cannot open their own banks or go to a physical retail store or exchange.

Aside from these main DeFi use cases, various projects also fall under these categories:

  • Staking
  • Infrastructure & Dev Tooling
  • DAOs
  • Alternative Savings
  • Analytics
  • Insurance
  • Margin Trading
  • Asset Tokenization
  • Prediction Markets
  • KYC & Identity
  • Marketplaces

Top DeFi Projects

DeFi is one of the active contributors to the cryptocurrency scene. Over the past three months (90 days), the market has seen an upsurge of $1 billion worth of total value locked up in June 2020 to $4 billion during early August 2020.

This is due to the increasing appeal of migrating financial services onto a decentralized platform, signaling more opportunities to make favorable profits.

Source: DeFi Pulse
Source: DeFi Pulse

The following protocols triggered DeFi market trends in 2020:

  • Compound

Compound is a money market protocol that lets users earn interest or borrow collateralized assets. As one of the first DeFi projects, its native governance token (COMP) has skyrocketed in value as it allows holders and delegates to vote on important protocol decisions.

  • MakerDAO

Among the most recognized names in the DeFi list is MakerDAO. It is a decentralized credit platform that supports DAI, a stablecoin pegged to USD. Within the platform, anyone can lock in crypto as collateral and generate DAI based on the locked amount.

  • Synthetix

Synthetix is designed to be a decentralized synthetic asset issuance protocol. The protocol’s synthetic assets (Synths) are collateralized by the SNX token. Minting, holding, and trading various derivatives such as fiat, commodities, and stocks are available on the platform.

  • Aave

Aave offers the most diverse range of DeFi collateral (uncollateralized loans, rate switching, flash loans, etc.) among the lending protocols on the market. Leveraging its native token (LEND), it provides holders with discounted fees and stable interest rates.

  • Uniswap

Uniswap provides users with incentivized liquidity pools instead of order books. By providing liquidity on the platform, users receive rewards. In addition, the permissionless DEX allows Ethereum-based tokens trading via web 3 wallets.

  • Bancor Network

Bancor is another DEX that aims to incentivize users to provide liquidity by sharing a percentage of their trading fees. Its native token (BNT) serves as an intermediary between pools in the network and other blockchains.

  • Set Protocol

Set Protocol is an open finance project that aims to provide a platform for custom-built tokens that adapts to different trading strategies. Through its Tokensets marketplace, non-technical traders can buy and sell native tokens (Sets) in a few clicks.

  • Curve

Curve is one of the most popular DeFi platforms which allow users to trade between stablecoins with low-fee algorithms. Consequently, it is an early proponent of yield farming as it offers pools where users can stake stablecoins to earn rewards.

  • Balancer

Balancer is an asset management platform that serves as a great solution for DeFi users who want to earn passive income on Ethereum-based assets. At the same time, it acts as an automated portfolio manager and liquidity provider, powered by its native governance token (BAL).

Risks and Limitations

Despite being a billion-dollar worth sector within the decentralized landscape, risks and limitations are present within the DeFi market. This could affect its mainstream adoption.

  • Poor smart contract audits.

Smart contract audits play a critical role in evaluating the technical risks associated with DApps. As a relatively new form of code, the standards for software audits of smart contracts have still room for improvements.

  • Centralized price feeds.

Oracles serve as the technology that connects external data sources and APIs to the blockchain. These control the input data in smart contracts, therefore controlling the operation of the smart contract as it responds to the input data.

During late 2019, DeFi player Synthetix reportedly suffered market manipulation attacks on its platform. For that reason, solutions that must reduce the complexity and implementation of multiple oracles at a time should be there to build more robust DeFi DApps.

  • Network congestion.

As more users rely on the Ethereum blockchain for transactions, the platform has experienced few clogging issues. If the network continues to be congested, a transaction can remain pending (unless higher GAS fees are paid). Later on, this can lead to information delay and inefficiency.

  • Interoperability between protocols.

Undoubtedly, DeFi poses a potentially systemic risk from the interdependencies between DeFi protocols. This is arguably the most critical limitation as the elements of infrastructure within DeFi relies highly on oracles and stablecoins. In reality, the market is yet to prosper to undermine the instability of cryptos.

CoinQuora Staff

CoinQuora is an online publication that aims to educate about news, exchanges, and markets in the cryptocurrency and blockchain industry

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