What Is Decentralized Finance (DeFi)? Where is it built? How does it improve upon traditional finance?
Decentralized (DeFi) refers to the next generation of finance (therefore it’s instruments) being built on distributed ledger technology (DLT), especially, blockchain. It is founded on the principle of censorship-resistance, transparency, trustlessnes, equal opportunity to participate, lack of centralized control, fast processing and lego-like composability.
Enthusiastically termed as “going bankless”, DeFi has eight core categories. Those are stablecoins (pegged valued), lending and borrowing, exchanges, derivatives, fund management, lottery, payments and insurance services. Owing to the compatible and composable nature of DeFi, they are integrated with each other heavily.
How Is DeFi Built?
DeFi can be built on any compatible smart contracts blockchain platform. However, it is currently majorly and almost exclusively found on the Ethereum blockchain. This can be explained by the fact that Ethereum is the most used blockchain network in the world, dwarfing every other platform of similar kind.
Furthermore, the infrastructure and the network effects of the Ethereum blockchain are highly conducive to Decentralized Finance (DeFi). This is also helped by the community ethos of experimentation, inclusiveness, practical approach, and libertarian nature. Ethereum has a DeFi market exceeding $10B+.
How Does DeFi Improve Upon Traditional Finance?
The number of people who are unbanked is estimated to be 1.7B by the most recent data, this means that a large percentage of the world’s population has no access to modern financial services and is at a disadvantage. This can be attributed to high barriers to entry, trust issues, accessibility, service costs, and even outright discrimination.
On the other hand, DeFi offers a vast improvement over the traditional financial system. It does so by offering easy access to anyone with an internet connection and personal computing device/smartphone. This ensures that nearly all people have access to DeFi, significantly lowering the barriers to entry.
The fees are also nearly a fraction of that found in the centralized financial services. Furthermore, DeFi is censorship-resistant and trustless by design, thereby allowing for indiscriminate operation without reliance on any third-party. For these reasons, it can help improve the lives of those living in poor regions and grant them equal participation opportunities.
History Of DeFi
Though, the basic idea of DeFi is almost as old as the blockchain tech itself. However, it wasn’t until the advent of smart contracts on the Ethereum blockchain that it started to take shape. The first true DeFi product is widely regarded to be Bancor – the automated market making platform which allows for seamless conversion of tokens. This was followed by the top heavyweights today such as Maker, Compound, Aave, and Synthetix.
DeFi Core Services
There are eight core DeFi services in total, these are:
Stablecoins – Pegged value tokens issued and managed with crypto-assets collateral backing. Overcollateralized (holding more in collateral than the issued token) and operating on decentralized ledgers, can be audited by anyone.
Borrowing And Lending – Allows the creation of liquidity markets by enabling people to borrow assets by providing collateral and borrowers to provide assets for lending in lieu of yield.
Exchanges – Decentralized exchanges are necessary for exchanging tokens with each other, in a non-custodial and generally risk-free manner. There is no trust involved and the exchange’s solvency isn’t an issue.
Derivatives – A derivative is a contract whose value is derived from another underlying asset such as stocks, commodities, currencies, indexes, bonds, or interest rates.
Fund Management – The service for managing funds and arranging them in order to generate positive returns on investments
Lottery – A form of gambling which allows people to pool money together to eventually go to a few winners chosen at random. DeFi enables no-loss lottery services by allowing yield on pooled money to be distributed as prize, with the base capital remaining intact and returned at the end of the gaming period.
Payment Services – Decentralized and trustless transfer of value between parties
Insurance – A risk management strategy which provides protection or reimburses against financial losses, obtained by paying a premium for the safety umbrella
Top 5 DeFI Protocols
1. Maker Protocol – Decentralized Multi-Collateralized Stablecoin
Maker is the decentralized overcollateralized stablecoin with peg-assuring mechanisms. It operates through MKR and DAI tokens. The former MKR is a governance token required for opening vaults and voting on parameter changes. The latter DAI is the actual stablecoin, which is pegged to 1:1 with United States Dollars (USD) and is generated by depositing collateral assets (ETH, BUSD etc.) in Maker vaults.
What comes from within is debt issued in the form of the DAI multi collateral stablecoin, which ensures it’s value through multiple deposited assets. It can be thought of as accessing a line of credit without having to liquidate the assets. For conversion back to the deposited asset or collateral, a user needs to return all of the borrowed DAI and the interest owed to the vault maintainers.
2. Wrapped Bitcoin – ERC-20 Token Backed by BTC
Wrapped Bitcoin (WBTC) – a Layer 2 solution has rapidly gained adoption and usage as collateral in DeFi services. It is an Ethereum based ERC-20 token, which is backed 1:1 by Bitcoin (BTC). It allows the usage of Bitcoin on the Ethereum blockchain, which isn’t possible otherwise. WBTC is maintained by a Decentralized Autonomous Organization (DAO) and verifiable proof of reserves. It is minted by supplying BTCs and can be redeemed back by burning WBTCs.
3. Compound – Automatic Lending And Borrowing
Compound is an automatic lending and borrowing protocol, which is governed by the community. It allows for borrowing against collateral or lending for interest. Further, it allows for compounding interest by supplying crypto-assets for long term. The COMP token is used for making governance proposals and voting on changes.
4. Aave – Automatic Lending And Borrowing
Aave is again a decentralized non-custodial protocol enabling automatic lending and borrowing. It’s salient feature is the flash-loan facility, which allows users to borrow extremely large amounts of money without providing much collateral (severe under-collateralization) with one condition – the borrowed amount must be returned by the end of the transaction or in one block.
5. Uniswap – Automated Market Making (AMM) Protocol
The wildly popular non-custodial decentralized exchange, which recently gave it’s users the famed UNI airdrop. Uniswap is powered by multiple smart contracts and operates on the Ethereum blockchain. It allows for automatic exchange of tokens without any order book or direct counterparty, by allowing users to create liquidity pools and employing an automatic fair price determination mechanism.
Despite being introduced not so long ago, DeFi has gained wide acceptance and usage in a relatively short period of time. It’s popularity is enhanced by the open nature of the community and the protocols, which anyone can fork and experiment with. Also, it offers considerable advantages over traditional finance.
Though, DeFi faces challenges from the degree of decentralization of it’s protocols and the security of the smart contracts on which they are based. However, the field is maturing with each passing day and lessons learned from the past. It is likely to gain more ground and lock more value in the coming days, as the infrastructure improves further.