What is decentralized finance (DeFi)?
What is decentralized finance (DeFi)?
Cryptocurrencies have exploded into a trillion-dollar industry today, sparking a wave of worldwide financial disruption.
At the heart of cryptocurrencies is a remarkable history of innovation that goes back to the 1980s, with advancements in cryptography. Since then, a series of events have shaped crypto space; the first cryptocurrency, Bitcoin, being the most prominent. Despite its spectacular growth in the past 12 years, financial services have very slowly appeared 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 to plan any investment accurately.
Things change quickly in the crypto space, and decentralized finance (DeFi) is a current trend — it's an exciting space to be, undoubtedly. If you're still unaware, let’s dig a little deeper into DeFi and learn more about it.
Decentralized finance (DeFi) explained
Short for decentralized finance, DeFi is an umbrella term for a variety of applications and projects in the public blockchain space geared toward disrupting the traditional finance world. Inspired by blockchain technology, DeFi is referred to as financial applications built on blockchain technologies, typically using smart contracts. Smart contracts are automated enforceable agreements that do not need intermediaries to execute and can be accessed by anyone with an internet connection.
DeFi consists of applications and peer-to-peer protocols developed on decentralized blockchain networks that require no access rights 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 needing a centralized intermediary. Blockchain’s ability to capitalize on smart contracts has made them ideal platforms to choose when building out financial applications.
How did DeFi get its start?
Humans bartered initially for goods and services. But, as humans evolved, economies evolved: We invented currency to make it easier to exchange goods and services. Subsequently, coins helped usher in innovations and created better levels of economies. However, progress comes at a cost.
Historically, central authorities have issued currencies that underpin our economies, which eventually gave them more power as more people began to trust them. However, trust has been broken from time to time, which makes people question the centralized authorities' ability to manage said money. DeFi was developed based on the idea of creating 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, which was the first p2p digital money built on top of the blockchain network. Through Bitcoin, the idea of ushering transformation in to the traditional financial world using blockchains became an essential next step in the decentralization of legacy financial systems. The launch of Ethereum and, more specifically, smart contracts, in 2015 made it all possible. The Ethereum network is a 2nd generation blockchain that first maximized 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 brought a plethora of opportunities to bring about a transparent and robust financial system that no single entity controls. But the turning point for financial applications started in 2017, with projects facilitating more functionalities in addition to just money transfer.
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 the risk and control at the center of these systems.
Historically, we’ve seen bankers and institutions failing to see risks in the market, as seen in the 2008 financial crisis. 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, up until the emergence of smart contracts and that enabled DeFi.
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 $30 billion are currently locked in DeFi ecosystems, making it one of the fastest-growing segment within the public blockchain space.
Here's an overview of the most popular DeFi use cases and protocols available in the market today:
DeFi lending and borrowing
DeFi gave finance a new direction by enabling lending and borrowing. Widely regarded as ‘Open Finance’, decentralized lending offered crypto holders lending opportunities to gain annual yields. Decentralized borrowing allowed individuals to borrow money at a specific interest rate. The aim of lending and borrowing is to serve financial service use cases while fulfilling the needs of the cryptocurrency community.
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 to borrow against collateral. The Compound protocol makes this possible by creating liquidity for cryptocurrencies through interest rates set using computer algorithms.
How does Compound work?
Users of Compound earn interest by depositing cryptocurrencies. Here's a list of cryptocurrencies that can be deposited on the protocol, along with the expected Annual Percentage Yield (APY). Once cryptocurrencies are supplied on the Compound platform, users can use them as collateral for loans.
Compound token: $COMP
$COMP, the governance token for Compound protocol, is a token used by its holders to suggest and implement development changes to Compound protocol. Changes include:
Selecting which digital assets to support.
Adding modifications to how $COMP tokens are distributed.
Adjusting collateralization factors to the platform.
Decentralized exchanges
Decentralized Exchanges (DEx) are one of the essential functions of DeFi, with the maximum amount of capital locked compared to other DeFi protocols. 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. The extra cost on each transaction is another negative aspect of CExs, which DExs address.
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 grants from multiple capital ventures, including the Ethereum Foundation. UniSwap automated transactions between cryptocurrencies through smart contracts.
How does it work?
UniSwap today offers three functionalities: Swapping tokens, adding liquidity, and removing liquidity.
Swapping tokens
Users are required to create an account on Metamask to utilize this service.
Once a Metamask account is created, users can select tokens they own to swap for another type of cryptocurrency.
Adding liquidity
To provide liquidity, users deposit an equivalent value of tokens into the token's associated exchange contract
Once you have tokens for liquidity, you can add them to a “pool" on the UniSwap interface.
Users who provide liquidity on UniSwap earn exchange fees, calculated per the value of tokens offered for liquidity.
Removing liquidity
You can remove the liquidity on UniSwap by merely choosing the 'Remove Liquidity' option from a drop-down menu.
UniSwap token: $UNI
$UNI is the governance token of UniSwap, meaning the token holders have a say in the protocol's development and treasury. The token was launched in September of 2020 and was awarded to anyone who has used Uniswap.
Stablecoins
Stablecoins are a viable solution to volatility issues surrounding cryptocurrencies and are helping DeFi gain prominence. The name says it all — stablecoins' value is tied to a relatively stable asset, like gold or the US dollar, to keep its price consistent. Stablecoins became useful during risk-off moments in the crypto space, providing a safe haven to 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 and DExs.
MakerDAO
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 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 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 will enables the ability to take $DAI at a specific collateralization rate.
Suppose the price of $ETH drops in the future. In that case, the CDP of a user will automatically be 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 back by paying back the amount, with the addition of a small fee.
Maker protocol tokens: $DAI and $MKR
The project requires two kinds of tokens to work: $DAI and $MKR
$DAI is created by locking a cryptocurrency in the Maker protocol. $DAI is used like any stablecoin: trade it against other digital assets or use it to make purchases.
Unlike $DAI, MakerDAO's $MKR token is volatile and isn't pegged to any asset. $MKR tokens are used in voting on proposals that affect how $DAI can be used. Holders of $MKR tokens are benefitted when the token increases — however, when the system fails, they take the largest hit in price.
Prediction markets
Predictions markets are platforms where individuals can make predictions on the realization of future events, ranging from sports bettings or politics to predictions on stock prices and more. 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. The DeFi platform August 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 you two primary actions:
Market creation: Users can create an Augur market by spending some amount of 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 goes up. 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, purchase participation tokens, or dispute an outcome. As the name suggests, $REP represents token holders' reputation in the market. For any action that requires tokens, users stake their reputation.
Asset management
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 to enjoy hyper-customization of portfolios, and trustless to allow access to historically illiquid assets and manage their investment regardless of location.