Drixx Academy/What is Decentralized Finance (DeFi) and What Makes it SO Exciting?/

What is Decentralized Finance (DeFi) and What Makes it SO Exciting?

Edwin Munyui
Content
March 22, 2021

DeFi is an abbreviation for Decentralized Finance, a financial product suite that is built on the Ethereum blockchain. This upcoming cryptocurrency niche features financial services and products that are offered in today's market ecosystems - however, DeFi takes a decentralized approach which means that it is not controlled by a single entity or central source.

In traditional finance, the market dynamics are controlled by central authorities through monetary policy amongst other tools. Money circulation is facilitated by financial institutions such as banks who act as the middlemen in most economies. While this model has been sustainable for over a century, traditional finance still faces multiple challenges - DeFi tries to tackle some of these by introducing a decentralized financial ecosystem.

The fundamentals of DeFi are based on blockchain technology, this is the same tech that Bitcoin is built on. Ideally, blockchain introduces the aspects of decentralization, verifiability, immutability and permissionless ecosystems. Take for instance the Bitcoin blockchain, anyone can view or track transactions on this public network - such is not the case for traditional finance where most databases are private or shared between specific players.

DeFi Fundamentals

Can DeFi set the stage for a new financial ecosystem that is decentralized and lives on the internet? Only time can tell whether this nascent market could live to such potential. Meanwhile, let's take a look at some of its fundamentals to better understand the inspiration of DeFi as a futuristic ecosystem - maxis believe that it could actually be the future of finance!

Ethereum Logo

source: https://en.wikipedia.org/wiki/Ethereum

As we have highlighted, most DeFi applications are currently built on the Ethereum blockchain. This network was invented by Vitalik Buterin - it is now the leading blockchain platform when it comes to decentralized applications (DApps). A number of DeFi protocols ranging from decentralized exchanges, derivatives, stablecoins and lending innovations already run on the Ethereum network.

The technical underpinnings of DeFi innovations are based on smart contracts and Ethereum's programming language, solidity. Developers leverage smart contracts to build intelligent decentralized applications that can automatically execute a function based on the on-chain data available or off-chain data relayed by oracles. Solidity programming language facilitates the creation and deployment of these smart contracts.

For a more practical example, let's assume that a particular DeFi protocol relies on external weather data to trigger smart contract execution. This means that the smart contract would have pre-coded conditions such as 'executing when the temperature rises above 70 degrees Fahrenheit'. In this case, any position on the DeFi protocol will be closed once the pre-coded condition is met - hence the whole idea of coding rules within smart contracts.

Another interesting fact about the DeFi infrastructure is that it assumes a 'money legos' like model. Basically, it is possible for anyone to create a DApp from scratch, build on an existing DeFi protocol or link their applications with ready products - all this without permission. In fact, the industry has evolved to a point where the existing DeFi innovations are combining synergies to build all-rounded financial service platforms.

DeFi Use Cases

Though still considered to be in its early stages, DeFi has already shown it could be the future of finance or largely dictate how the industry will grow. Some of the products featured by DeFi protocols are an exact replica of traditional finance products - it is actually evident that DeFi borrows a lot from traditional finance.

However, there is a clear disparity when it comes to the mode of governance and accessibility of the two market ecosystems. DeFi is more relaxed in both cases given that it follows a decentralized architecture and can be adopted by anyone, unlike its counterpart where KYC hurdles remain a challenge. That said, here are some of the main DeFi applications:

Decentralized exchanges (Dexes)

Uniswap swap interface

Source: Uniswap

Just like the name suggests, these are decentralized platforms that facilitate the trading of cryptocurrencies - they can be compared to stock exchanges where traders and investors buy and sell securities. With Dexes, crypto users only need a metamask wallet to start trading their preferred crypto assets. Some of the popular decentralized exchanges include Uniswap and Sushiwap - each has a total value locked (TVL) of over $4 billion as of press time.

Lending and Borrowing platforms

DeFi lending and borrowing platforms are a solution to the traditional credit model where banks dominate the game. These protocols offer lending style products with more lucrative interest rates compared to traditional finance. On DeFi lending protocols, the annual yield could go as high as 8% - a better alternative than the 4-5% offered on U.S junk bonds. Notably, these applications can be accessed by anyone across the globe. The earliest lending and borrowing protocol is known as MakerDAO, but the industry has evolved to feature other platforms such as Compound and Aave.

 MakerDAO, Compound and Aave on DappRadar

Source: DappRadar DEFI

Derivatives

As we have expounded in a previous article, derivatives are market instruments whose value is determined by an underlying asset. This potential market is now finding its way into the DeFi ecosystem through protocols like Synthetix and Nexus Mutual. Initially, only centralized crypto exchanges provided derivatives trading - a narrative that has changed since DeFi went mainstream.

Synthetix on DappRadar

Source: DappRadar

Stablecoins

Stablecoins: DAI, USDC, TUSD, USDT,sUSD, BUSD, GUSD on AAVE

Source: AAVE

Stablecoins also exist within the DeFi ecosystem - the most popular being DAI which is backed by Ether on a 1.5:1 basis. This means that for every DAI stablecoin that is minted, an ETH collateral worth 1.5 times the stablecoin value is deposited with the providers vault. In DAI's case, this process is facilitated by the MakerDAO protocol - users can further leverage this platform to earn interest or take out a loan against their crypto or stablecoin holdings.

DeFi vs Traditional finance

The DeFi ecosystem is fundamentally and technically different from traditional finance - the former is a futuristic version of the latter, although still largely experimental. Some of the major differences between these two ecosystems include:

Decentralization

At the very core, traditional financial products follow a centralized model since they are controlled by central authorities and offered by financial intermediaries. On the other hand, DeFi products assume a decentralized model which means that no one controls them. To put into perspective, anyone with a metamask wallet can take out a loan on Aave or Compound as long as they have enough collateral. In traditional finance, some players are left out of the system due to cumbersome KYC requirements and minimum capital provisions.

Anonymity

DeFi is particularly famous for its anonymity features - users can only be identified like digital addresses as opposed to their real identification. One could actually carry out millions of transactions without ever revealing their identity. As for traditional finance, tough KYC requirements force financial service providers to collect the personal identifiable information of their clients.

Accessibility

DeFi was built to solve the problem of financial inclusion - over 1.5 billion people are not part of the world's financial network. With DeFi, they can now access financial products regardless of their location or whether they meet KYC requirements. Currently, there is over $44 billion locked in DeFi protocols - a sign that more people are joining this permissionless market.

Trust factor

We all want to be part of a trustworthy and transparent financial ecosystem, something that DeFi is trying to achieve by building on blockchain. The DeFi ecosystem is touted as a transparent one since all transactions are recorded on the Ethereum public chain - anyone can view them or track the movement of funds. As for traditional finance, all trust is placed in the hands of third parties who handle the transactions or decide on policies that may have an effect on financial markets.

Challenges in DeFi

Though quite promising, the DeFi ecosystem is not short of challenges - in fact, it is among the most risky markets globally. A million dollars could quickly turn to ten and vice versa, just the way things move in this volatile market. Let's take a look at some of the major challenges that DeFi is still facing:

Regulatory risks

Up to now, there is still no regulation on DeFi products - it is basically the wild wild west of today's market. This poses a huge threat to its future as well as that of the market participants. Should radical regulations be introduced in the coming years, some DeFi protocols may not survive while participants are likely to find themselves at loggerheads with authorities.

Technological risks

The smart contracts that are used to build DeFi applications are not perfect tools in their current state. A lot still has to be done to make them more secure before they can be adopted on a mainstream level. It is interesting to note that over half of the crypto hacks in 2020 were DeFi affiliated. Clearly, this promising niche still has a long way to go in terms of industry-grade security.

Liquidity risks

DeFi carries a significant liquidity risk - this is the possibility of losing your value as a result of insufficient market liquidity. A large fund inflow or outflow within a DeFi protocol could result in massive price variations. Notably, this is very common in a market where whales still dominate most of the operations.

Operational risks

Being built on Ethereum, the DeFi ecosystem faces operational risks that can be attributed to scalability issues. The fact that Ethereum is still developing scalability solutions has exposed DeFi applications to operational risks ranging from high fees to network congestion. While Ethereum diehards are optimistic of a solution, it might actually take a few more years before operations on this network are smoothened out completely.

Conclusion

Decentralized Finance (DeFi) is one of the most revolutionary innovations since the invention of the internet. This ecosystem will likely challenge the dominance of traditional finance - however, it may take some time. Going forward, more DeFi protocols with tangible solutions will emerge to solve the existing challenges in traditional finance. It is also likely that we will see multiple integrations across the DeFi ecosystem as the industry grows bigger.