DeFi — An Introduction
DeFi or decentralized finance is a collective term for financial products and services that are open to everyone and minimize one’s need to trust and rely on central authorities.
Current financial services are controlled by a central party. Whether it’s basic money transfers, asset purchases, or lending, you need to go via an intermediatory. DeFi on the other hand connects peer-to-peer and allows basic financing easier and affordable.
DeFi market experienced explosive growth beginning in 2020. As of now almost the total value in DeFi is over 100 billion dollars.
Defi is arguably a zero to one innovation. Unlike FinTech companies, it deployed on principles seldom seen in current financial architecture. It democratizes finance and levels the playing field for anyone in the world to build a finance company/protocol. The goal of this document is to give a better understanding of DeFi.
DeFi is a general term for decentralized applications providing financial services for everyone. To achieve this DeFi relies on the power of cryptography, decentralization, blockchain, and smart contracts.
Historically, intermediaries have played essential roles within financial markets, serving as agents and brokers of trust, liquidity, settlement, and security. Since the 2008 Global Financial Crisis, there has been increased attention on inefficiencies, structural inequalities, and hidden risks of the intermediated financial system.
DeFi makes it possible for sellers, lenders, buyers, and borrowers to interact directly rather than seeking institutional help for transaction administration.
Not every application of blockchain technology is a form of DeFi. A DeFi protocol, service, or business model has the following four characteristics:
1. Financial Services or Products
Processing or directly enabling the transfer for value among parties.
2. Trust Minimized Operation and Settlement
Transactions are executed and recorded according to the explicit logic of DeFi protocol’s predetermined rules. These do not require trust in the counterparty of a third-party intermediary.
3. Non-Custodial Design
Assets issued or managed by DeFi services cannot be unilaterally altered by parties other than the account owner, even those providing intermediation and other services.
4. Programmable, Open, and Composable Architecture
There is the broad availability of the underlying source code enabling service composability. Widespread use of open-source code allows participants to view and verify protocols directly, and to create derivative or competitive services by forking code.
DeFi Building Blocks
DeFi takes advantage of various technologies developed in the blockchain sphere. All have applications outside of DeFi but do play essential roles within the DeFi ecosystem.
Distributed ledgers serve as the settlement layer for transactions. Currently, most DeFi services operate on the Ethereum network, due to its capabilities and developer adoption. DeFi activity is growing on and across other blockchains as well.
Tokens represent value that can be traded or transferred within a blockchain network. Bitcoin and other cryptocurrencies were the first blockchain-based digital assets. Others have a range of intended functions beyond payments.
Software interfaces for users to manage assets stored on a blockchain. With a non-custodial wallet, the user has exclusive control of funds through their private keys. With custodial wallets, private keys are managed by a service provider.
Blockchain-based software code that carries out, controls, and documents relevant events and actions according to predefined terms and rules. Smart contracts are immutable as they reside on the blockchain.
Software applications built out of smart contracts, often integrated with user-facing interfaces using traditional web technology. Decentralized Application (DApp) refers to an application built on top of Ethereum blockchain using smart contracts. DeFi is the fastest-growing category of DApp. DeFi DApps are vastly different from their traditional bank counterparts:
- Not managed by an institution and its employees — instead, the rules are written in code (smart-contract)
- Code is transparent on the blockchain for anyone to audit, and thus build a different kind of trust with users
- Transactions are pseudonymous, and transaction activity is public to view
- DApps are global and available to anyone with an internet connection
- Permissionless to create, permissionless to participate
- Flexible user experience — smart contracts are like an open API that anyone can build an app for
- Applications can be composed by combining other DeFi products like lego pieces
Software-based mechanisms that manage changes to smart contracts or other blockchain protocols, often based on tokens that allocate voting rights to stakeholders.
Decentralized Autonomous Organizations (DAOs)
Entities whose rules are defined and enforced in the form of smart contracts.
Digital assets whose values are pegged to a fiat currency, a basket of fiat currencies, or other stable-value assets.
Data feeds that allow information from sources off the blockchain, such as the current price of a stock or a fiat currency, to be integrated into DeFi services.
Ethereum network is certainly the most popular for building various blockchain-based applications and is mostly used for DeFi due to its smart contracts and its ability to execute transactions when certain conditions are met. Due to their programmability and composability, the possible configurations of DeFi services are nearly endless. However certain core functions can be identified. Below are the most popular use cases — using value locked in as a yardstick.
One of the most popular use cases of DeFi is lending and borrowing. MakerDAO is the most popular lending DApp that allows you to lock in ETH for a stablecoin called DAI, a token pegged to USD. Dai provides a way for token holders to access liquidity at the cost of an annual interest rate.
Aave is a non-custodial protocol to earn interest on deposits and borrow assets. It is permissionless and takes minutes to take out a loan. It’s used to build any third-party service or application to interact with the protocol and enrich your product.
Maker is a decentralized credit platform on Ethereum that supports Dai, a stablecoin whose value is pegged to USD and backed by digital assets as collateral.
InstaDApp is a DApp built on the Ethereum network that integrates DeFi protocols into one platform for easy asset monitoring and management.
Compound is an open-source money market protocol on Ethereum that lets users lend or borrow assets against collateral. Compound contract automatically matches borrowers and lenders and adjusts interest rates dynamically based on supply and demand.
Decentralized exchanges or DEX are smart contracts that allow users to buy, sell or trade cryptocurrencies or tokens. Exchanges operate without a central authority. Trading on a DEX reduces some risk because you keep your ETH and tokens in your wallet instead of placing them in someone else’s control. Trades are made by transacting with the DEX’s underlying smart contract and the only time your funds leave your account is to execute a trade.
Curve is a decentralized exchange liquidity pool on Ethereum designed for extremely efficient stablecoin trading.
Uniswap is a fully decentralized on-chain protocol for token exchanges on Ethereum that uses liquidity pools instead of order books. It uses a mechanism called Automated Market Making (AMM) to automatically settle trades near the market's price. In addition to trading, any user can become a liquidity provider, by supplying crypto to the Uniswap contract and earning a share of the exchange fees.
SushiSwap is an automatic market maker (AMM) DEX based on a Uniswap fork.
Derivative markets in DeFi trade nearly any asset on the blockchain using synthetic pricing.
dYdX is a non-custodial trading platform on Ethereum geared toward experienced traders.
Synthetix is a decentralized platform on Ethereum for the creation of Synths: on-chain synthetic assets that track the value of real-world assets. It lets users create and exchange synthetic versions of assets like gold, silver, cryptocurrencies, and traditional currencies like the Euro. The synthetic assets are backed by excess collateral locked into the Synthetix contracts.
Nexus Mutual is a decentralized insurance platform where people can share risk particularly against smart contract bugs, failure, or other black swan events
The payments category is largely dominated by layer 2 payment channel networks. These networks are built on top of existing blockchains like Ethereum or Bitcoin, aka. layer 1. Payment networks allow two parties to create instant transfer payment channels. As you may know, blockchains are only able to handle so many transactions in a timely manner. And so, layer 2 solutions allow users to trade a bit of the security and decentralization of Layer 1 for the convenience of speed. Ultimately, these qualities make layer 2 payment channels ideal for smaller, frequent payments like those found in commerce.
Flexa is a payment network that enables merchants to accept digital currencies without the risk of fraud or volatility through off-chain collateralization.
Tornado Cash is a fully decentralized protocol for private transactions on Ethereum.
Sablier is a real-time finance protocol built on Ethereum that enables continuous, autonomous, and trustless payroll.
Tokenized assets and asset management is a quickly growing sector of DeFi. Existing financial assets deployed to the blockchain as tokens fit nicely into DeFi protocols which extend their utility. Asset management protocols allow investors to put their money in the hands of smart contracts or fund managers which manage their portfolios. Other asset management protocols, such as Set Protocol, employ automated strategies such as periodic rebalancing or following technical indicators.
Yearn Finance is a collection of community-led & developed yield farming vaults, yield-aware money markets, easy swapping tools, and pooled insurance coverage.
Vesper is a DeFi ecosystem and growth engine for crypto assets, providing a suite of yield-generating products.
Badger is DAO (decentralized autonomous organization) with a single purpose: build the products and infrastructure necessary to accelerate Bitcoin as collateral across other blockchains.
DeFi v/s Traditional Finance
One of the best ways to see the potential of DeFi is to understand the problems that exist today.
- There’s a premium to financial services because intermediatory institutions need their cut
- Some people aren’t granted access to use financial services
- Hidden charge of financial services is your personal data
- Centralized institutions can close down markets at will
Below are the highlights of how the two compare.
You hold your money
You control where your money goes and how it’s spent.
Transfers of funds happen in minutes.
Transaction activity is pseudonymous.
DeFi is open to anyone.
The markets are always open.
It’s built on transparency — anyone can look at a product’s data and inspect how the system works.
Your money is held by companies
You have to trust companies not to mismanage your money, like lending to risky borrowers.
Payments can take days due to manual processes.
Financial activity is tightly coupled with your identity.
You must apply to use financial services.
Markets close because employees need breaks.
Financial institutions are closed books: you can’t ask to see their loan history, a record of their managed assets, and so on.
Unlike a traditional bank, there isn’t a regulation on your money when you use DeFi. Though DeFi loans are collateralized with other crypto assets, borrowers using DeFi protocols cannot be held accountable otherwise if they are unable to effectively pay back a loan. Many of today’s DeFi loans are overcollateralized, but the black swan for DeFi is contract vulnerabilities. If a hacker finds and exploits a bug in the open-source code for a DApp, millions could be drained in an instant.
Applying a risk-mapping framework, the risks can be categorized as below:
Depletion of funds due to transactional behavior of fellow users concerning the digital assets in the DeFi service
- Market risk
- Counterparty risk
- Liquidity risk
Failures of the software systems supporting transaction execution, pricing, and integrity.
- Transaction risk
- Smart contract risk
- Miner risk
- Oracle risk
- Software bugs in DApps
Failures of the human systems for key management, protocol development, or governance
- Routine maintenance and upgrades
- Key management
- Governance mechanisms
- Redress of disputes
Use of DeFi to engage in illicit activity or to evade regulatory obligations
- Financial crime
- Fraud and market manipulation
- Regulatory arbitrage
Macro-scale crashes or undermining of the financial system due to the interaction, scaling, and integration of DeFi components
- Dynamic interactions
- Flash crashes or price cascades
Within and beyond the categories described here, DeFi is evolving rapidly. Developers are experimenting with new services, business models, and combinations of DeFi protocols. Technologies are maturing. Services are moving to decentralized management and governance of protocols. Tools are emerging to simplify the user experience on and across DeFi services.
The first generation of DeFi DApps relies heavily on collateral as a safeguard. Traditional unsecured borrowing and lending will need to rely on an identity system.
The first generation of DApps was built by blockchain enthusiasts for blockchain enthusiasts and didn’t prioritize usability. The latest iterations of DeFi apps are prioritizing design and ease of use in order to take it to a wider audience.
Ethereum in its current form is slow and suffers from high transaction fees, known as gas prices. Other blockchains such as Algorand, Avalanche, Binance Smart Chain, Cosmos, EOS, NEAR, Polkadot, and Solana are trying to attract DeFi-focused developers and users with promises of higher throughput and lower fees. However, better scalability at the base layer may come at a cost in the degree of decentralization or other attributes. The Ethereum Foundation promises significant scalability improvements in the upcoming Eth2, while Ethereum developers have been building a variety of Layer 2 solutions, such as sharding or “rollups,” that offload computation execution, but keep some transaction data on-chain. Eth2 is also scheduled to replace proof-of-work mining, which has been criticized for intensive energy usage, with a proof-of-stake system.
DeFi is a new, fast-growing area. DeFi has the potential to transform global finance. In addition, the very flexibility, programmability, and composability that make DeFi services so novel also exposes new risks, from hacks to unexpected feedback loops among protocols.
Retail investors, professional traders, institutional actors, regulators, and policy-makers will need to temper enthusiasm for the innovative potential of DeFi with a clear understanding of its challenges. Developers are actively working to address vulnerabilities and introduce new mechanisms to manage risks efficiently, but the process is ongoing. DeFi will ultimately succeed or fail based on whether it can fulfill its promise of financial services that are open, trust-minimized, and non-custodial, yet still trustworthy.