DeFi is short for "decentralized finance", an umbrella term for a variety of financial applications geared toward disrupting financial intermediaries. To achieve trust DeFi relies heavily on cryptography, blockchain and smart contracts. Smart contracts are the main building blocks on DeFi – they permit trusted transactions and agreements to be carried out among disparate, anonymous parties without the need for a central authority, legal system, or external enforcement mechanism. As this form of agreement between buyer and seller is directly written into lines of code. The code controls the execution itself, and transactions are trackable and irreversible.
Pretty much, all of DeFi projects are built on Ethereum, once probably because of its fairly robust programming language called Solidity and its developed ecosystem across all the smart contract platforms with thousands of developers, building – in a continuous manner – new applications.
One of the first innovators that shaped the Decentralized Finance movement was MakerDAO which was founded in 2014 in Santa Cruz, California. The platforms allows its users to lock in collateral, such as ETH and generate DAI. DAI are stablecoins that – by using certain incentive – follow the price of the US dollar. DAI can be also used for trading, borrowing and saving on MakerDAOs Oasis platform – which recreates one of the pillars of the financial system.
There are a few other important DeFi projects. Another key player in the lending category is Compound. Compound was founded in 2017 and is headquartered in San Francisco, currently received Series-A funding (backed by e.g. a16z, BainCapital Ventures, Draper Capital, Polychain Capital etc.) with a total funding amount of US$ 33.2M. With around US$ 630M worth of assets locked in the protocol. Compound is an algorithmic, autonomous, interest rate protocol that allows users to supply assets like ETH, BAT, 0x or Tether and start making interest. Supplied assets can also act as collateral for borrowing other assets.
Aave is also worth a mention in the lending category. Their protocol enables users to lend and borrow a diverse range of cryptocurrencies using both stable and variable interest rates. Unlike Compound, Aave includes notable distinguishing features such as uncollateralized loans, "rate switching", Flash Loan and unique collateral types.
The company also received an Electronic Money Institution license from the United Kingdom Financial Conduct Authority. Lately the company launched its Aavenomics proposal to reward both liquidity providers and AAVE holders who are taking part in the risk position and keeping the protocol safe.
In fact, DeFi is trying to create the whole new financial ecosystem in a permissionless and open way. While lending and borrowing is only one part of this ecosystem. Some of the other important pillars are stablecoins, decentralized exchanges, derivatives, margin trading and insurance.
There are multiple collateralized stablecoins like USDT (Tether), USDC (USD Coin) or Paxos Standard (PAX). The main problem with them is the fact, that they are centralized as there is a company behind them that is responsible for holding the equivalent of the value of stablecoins in e.g. US$. Each token is backed on a 1:1 ratio by money held in the bank accounts. So these companies only issue new stablecoin units when they receive the equivalent value in fiat currency.
Some stablecoins are pegged to other cryptocurrencies (crypto-backed stablecoins) instead of fiat or commodities, and these are often referred to as crypto-collateralized stablecoins. The peg of these coins is maintained through over-collateralization and stability mechanisms. A prominent example is again DAI.
Non-collateralized stablecoins, on the other hand, make use of algorithms to control the supply of tokens in order to keep the price fixed at a predetermined level. The goal of these coins is to maintain a stable value by algorithmically expanding and contracting its circulating supply in response to market behavior. As an example the Carbon Protocol makes use of supply decreasing by issuing Carbon credit through an auction. Users and token holders can bid for Carbon credits in order to burn CUSD, which offers them a discount as the token expands and helps maintain the price. As the token changes value, Carbon sells tokens to readjust the price.
DEXs (Decentralized Exchanges) – in opposite to standard centralized crypto exchanges like Coinbase or Binance – allow for exchanging crypto assets in a completely decentralized and permissionless way. This is mainly important because centralized exchanges come with their own inherent risks – namely those of custody.
Some of the most notable aspects of DEXs include:
- Non-custodial – Ownership of the underlying assets is never revoked.
- Automated – With no intermediaries, DEX trading is instantaneous so long as there is sufficient liquidity.
- Cost-Efficient – Many DEXs have minimal trading fees, allowing users to swap assets at little to no cost
- Globally Accessible – Most DEXs do note require any sign-ups, and largely come with no counterparty risk.
- Intuitive – Newer trends have evolved DEX trading from order books to simple point and click swaps.
- Pseudo-anonymous – Users simply connect a wallet of their choice to start trading. No profile or background information is required.
There are two main types of DEXs, on the one hand side the liquidity pool based, and the order book based ones. Liquidity pool based examples are Uniswap, KyberSwap, Balancer and Bancor. Loopring Exchange and IDEX are examples of the order book based ones.
Similar to traditional (centralized) finance derivatives are contracts that derive their value from the performance of an underlying asset. The main DeFi application in this space, Synthetix, which is a decentralized platform that provides on-chain exposure to different assets. A user puts collateral in the form of SNX tokens to create a synthetic asset. Now the user can exchange or swap one synthetic asset for another i.e. reprice the collateral through a price oracle. There is no direct counterparty involved in the process. Synthetix employs a pooled collateral mechanism and hence, the SNX stakers collectively take on the counterparty risk of other users' synthetic positions.
Derivatives built on DeFi have some inherent benefits which will incentivize a share of the traditional derivatives market to decentralized derivatives:
- Decentralized derivative markets are inherently more accessible. They can be used by anyone with an internet connection and an Ethereum wallet — no matter their location or social status.
- Creating a custom derivative on DeFi is easy, cheap and can be done by anyone as well. In the traditional financial system, the process for creating and listing a new derivative is very complex and costs involved are close to a million US$. Because of this, most derivatives are created by large financial services institutions. As only example the Opium Protocol, allows the user to create a derivative contract from scratch in a few minutes by combining an on-chain derivative recipe with a price oracle recipe (cf. later on this article I will talk about blockchain oracles).
Within the DeFi space, Future derivatives are essential for traders to hedge positions and reduce the risk of crypto’s price volatility. Various derivatives allow traders to gain from the price fluctuation of Bitcoin and major altcoins – for instance buy now at a lower price and sell at a higher price later.
DeFi Margin trading again has a lot of similarities to the traditional (centralized) finance space. It is basically the practice of using borrowed funds to increase a position in a certain asset. The main DeFi apps in the margin trading space are dYdX and fulcrum.
dYdX takes the approach that all assets on the platform have an interest rate for borrowing and for supplying. In other words, there is no distinction between three different wallets. If you simply deposit ETH, USDC, or DAI to the platform, you begin accruing interest immediately. If you deposit ETH and then buy ETH/DAI, you would then begin receiving interest on the additional ETH you bought and pay it on the DAI you borrowed.
On other protocols, such as Augur or Gnosis, users wager on the outcome of events. With Augur, users can create and exchange "shares" representing a portion of the value of outcomes like election results or sports results.
There is a huge difference between a RFQ approach (Request for Quote) which gives a supplier the opportunity to sell the most products at an appropriate price point, taking variables in product, volume, and region into account. dYdX takes another approach towards rates where there is theoretically no bid-ask spread, because all assets are eligible for interest there will always be a spread. For instance, on ETH there is a large amount supplied but very little demand to borrow it. Consequently, a small amount of interest must be spread across a large pool of suppliers.
The advantages of this pool-to-pool style of margin trade:
- Supplied assets can be used to initiate margin trades while still getting paid interest. There is no need to move funds into a funding wallet where they must remain unencumbered to receive yield.
- There is a verification getting paid the correct amount of interest by the protocol and that nothing has been taken away.
- For bearish like minds while the rest of the market is bullish (aka the market is willing to pay a high interest rate to borrow e.g. USDC and DAI against ETH), the user will receive the appropriate amount of interest for being willing to short ETH/USDC and ETH/DAI. In contrast, a margin short on a centralized exchange for the same pair would only incur interest but not pay the user any.
- Does not require account sign-up or sharing of user personal information with other parties.
- The assets must be available in the protocol or nearby. Without a centralized party to facilitate the initial liquidity or on an adhoc basis, there is a chicken and egg situation. Composability is likely important to be able to access the assets sitting on other DeFi protocols and make them available for margin traders.
- Rates can fluctuate drastically based on utilization. A few big trades can quickly push up rates for existing borrowers.
- Liquidations are more expensive, as positions get liquidated into currently a less liquid spot market.
Insurance is yet another part of traditional finance that can be reproduced in DeFi. The providers guarantee e.g. a compensation for specified loss, damage, illness, or death in return for payment of a premium. An immediate use case is the protection against smart contract failures and protection of deposits. DeFi insurance borrows some of its objectives from the traditional insurance market. It protects people and institutions from financial losses due to fraud, theft, or unanticipated infrastructure failures. DeFi insurance can provide a valuable hedge if you’re uncomfortable with the amount of risk you assume in the DeFi space. Popular defy projects in this space are Nexus Mutual and Opyn Protection.
Nexus Mutual aims to take "the power away from large insurers and give it back to the individual". They are different from traditional insurance companies in that they are member-driven. And Nexus incentivizes its members to participate in Governance, Claims Assessment, and Risk Assessment. With Nexus Mutual, anyone can purchase coverage. They provide a risk-sharing pool that provides users simple, transparent protection against their financial risks.
Nexus has already had to perform payouts. This is due to the attacks on bZx which is a flash loan provider. The bZx exploit occurred after a bug was found in its smart contract. Fortunately, the funds of the people who bought cover were safe. In this "trial by fire", Nexus was able to overcome any doubts in the DeFi community as to whether their community would vote to distribute payouts.
Blockchain Oracles & DeFi
Another really important – although not strictly limited to finance – part of the DeFi ecosystem are Blockchain Oracles that focus on delivering reliable data feeds from the outside world into the smart contracts. This data could be an asset’s price, election results, supply chain information or even which team won a football game.
Typically this is a third party service or something that is done manually — both of these are usually centralized. Obviosuly a centralized method for oracles defeats the entire purpose of building a DeFi product. If for instance the oracle was corrupted, it could game the system and manipulate that data or choose to censor it for its own financial gain. Decentralizing this process through which off-chain data gets used on-chain is critical to having a secure contract.
Since we talked about MakerDAO before – the company utilizes an oracles module to determine the real-time price of assets. The module is composed of whitelisted addresses of oracles and an aggregator contract. The oracles send periodic price updates to an aggregator that determines a median price, which is then used as a reference price on the platform.
On the other hand side Compound uses oracles to gather price information that is then forwarded to its price feed, which is managed and controlled by "administrators" that are holders of Compound’s native token, COMP.
The most popular project in this space is Chainlink. Chainlink is currently valued at US$ 4.475B. In contrast, Band Protocol, the second largest oracle project in the market, has a valuation of US$ 257M. They currently power most of the DeFi protocols such as Aave (LEND), Synthetix Network (SNX), Kyber Network (KNC), Loopring (LRC), Ampleforth (AMPL) and Bancor (BNT). Additionally Chainlink announced that Google was integrating Chainlink into their approach to smart contract adoption on how users could use Chainlink to connect to BigQuery, one of Google's most popular cloud services. LINK is their digital asset token used to pay for services on the network.
Stablecoins, decentralized exchanges, derivatives, margin trading and insurance are pretty much all the main pillars of the DeFi ecosystem. They can surely be combined together in multiple, various ways. Think about them as LEGO bricks that can be built on top of the existing blocks.
Let us compare the main differences between DeFi and CeFi:
|Censorship-resistant||Can be censored|
|Blockchain based||Legacy systems|
And lastly look at the potential risks:
One of the main risks are bugs in smart contracts and protocol changes that can affect the existing contracts. Even though that DeFi insurances can lower risk (but surely not eliminate).
Secondly, it has to be proven how decentralized a DeFi provider really is. What is for instance the shutdown procedure if something goes wrong? Is there an "adminkey" – if yes, who is is that and can this person shutdown the protocol? All that goes along with systemic risk that might arise. For example, asset prices, sharply losing their value, which may result in a cascade of liquidations across multiple DeFi protocols. Network fees and congestion.
DeFi is lately a high-risk and high-reward "game". DeFi is probably closest to truly disrupt the traditional financial industry. Most of the financial products can be only created by banks. DeFi is open, permissionless and enables cooperative work in a similar manner then the internet itself.
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