Decentralized Finance, or “DeFi,” is a catchall term for blockchain-based financial services that rely on smart contracts to complete transactions on a peer-to-peer basis rather than third-party intermediaries, like banks, brokers, or exchanges. This enables participants to borrow, trade, and lend globally on an open and transparent network, while relying on the security of the blockchain to protect their transactions and thwart external interference.
Key to the appeal of DeFi is its elimination of central authorities and middlemen in financial transactions (“non-custodial”), instead operating entirely on the blockchain network. This reduces transaction costs, imbues market participants with anonymity, and ensures security through the use of computer code and algorithms rather than the intervention of banks and financial authorities.
We cover the mechanics of DeFi, its current applications, and its implication for the future.
How Does DeFi Work?
DeFi is built on blockchain networks, with the majority of current DeFi protocols built and operating off of the Ethereum blockchain as decentralized applications, or “DApps.” This is due, in large part, to the unique programmability of Ethereum’s blockchain through “smart contracts.” Smart contracts allows developers to code functionality into the blockchain rather than functioning exclusively as a platform for value exchange.
|Pro Tip: Bitcoin (BTC) vs. Ethereum (ETH)|
While Bitcoin is the incumbent blockchain as far as cryptocurrency is concerned. Ethereum takes it to the next level by building programmability into its core functions. This makes it a hotbed for developer activity with new applications and features being explored today.
The smart contracts that embody the Ethereum blockchain enable DeFi applications to largely eliminate the role of third-party intermediaries in financial transactions. In the current financial system, all transactions require the participation of a gatekeeper:
- Credit card transactions: a credit card company needs to clear the transaction
- Electronic funds transfers: a bank or credit union needs to update its ledger
- Insurance contracts: an insurance company needs to process your claim
The value proposition of DeFi is that it eliminates the need for third-party intermediaries in financial transactions, instead, eschewing traditional finance in favor of fully peer-to-peer transactions, verified entirely through the blockchain. This builds on the basis of cryptocurrencies at their core, which was meant to provide an independent method for transacting between peers. DeFi expands that concept to other financial transactions, including lending, investing, insurance and beyond.
What are the Essential Components of Defi?
The components that make DeFi possible are smart contracts, stable value currencies, and a diversity of use cases. Without the components above, DeFi applications would face serious difficulty maintaining sustainable growth. These are the traits of DeFi that enable and incentivize the global developer community to actively build out the capabilities of DeFi.
Smart contracts enable functions and covenants to be coded into DeFi transactions without the need for outside enforcement. Smart contracts ensure that transactions only execute if the specified parameters originally programmed into the exchange are met. Any transactions that fall short of those parameters will automatically fail based on the underlying code.
While simple in concept, smart contracts allow DeFi, NFTs, and other decentralized applications (“Dapps”) to scale massively, as they can be built out or combined to function simultaneously or in-sequence, much like lego blocks.
|Pro Tip: Ethereum and Smart Contracts|
The programmability that accompanies Ethereum’s smart contracts has contributed to its dominance in the field of decentralized finance. Other blockchains that experiment or plan to experiment in smart contracts include NEO, NEM, Cardano, and Hyperledger Fabric.
Stable currencies increase trust and ensure transactions can be completed while mitigating price slippage and reducing the possibility of failed transactions. Participants are most likely to complete their end of the bargain if the value of the underlying currency retains the preponderance of its value from the beginning of a transaction to its end.
One of the shortcomings of using non-stable currencies in DeFi transactions is that a major dip or rise in the value of an underlying cryptocurrency may incentivize participants to fail to perform. Much like standard currencies in circulation, a stable value helps encourage commerce and a functional economy.
|Pro Tip: How Stable are Cryptocurrencies?|
One of the first objections raised to this point are the massive value fluctuations we’ve seen in cryptocurrencies over the past decade, with huge booms and busts happening in 2017 and 2018. While these do pose a concern, DeFi applications such as “Stablecoins” and cryptocurrencies pegged to the value of real world assets like gold and fiat are being built to address these concerns.
Diversity in Use Cases
A variety of use cases are what allow abstract digital protocols to be converted into consumer-facing applications. It’s what encourages developers to continue to experiment on blockchains, develop novel new DeFi applications using blockchain technology, and create the wide range of decentralized end-user experiences that currently exist, including Decentralized Exchanges (“DEXs”), Trading Decentralizing Applications (“Trading Dapps”), and decentralized money markets (“Yield Farming”).
The multitude of use cases contributes towards the appeal of blockchains like Ethereum as growth investments. The global community of developers experimenting with DeFi applications over time and the resulting use cases for end users, will likely continue to contribute to DeFi’s growing appeal over time.
Where did DeFi come from?
There’s a lot of dialog on where DeFi originated from. Some would argue that Satoshi Nakamoto’s rollout of the blockchain and the mainstream acceptance of bitcoin serves as the launching point for DeFi; still other sources cite a 2018 Telegram chat between Ethereum developers as the original source of where the term “DeFi” was coined.
In either case, both the Bitcoin and Ethereum blockchains have been vital to the rise of DeFi as a rising subsector of the blockchain. We cover both cryptocurrencies in relation to DeFi as well as DeFi’s contrast to traditional finance.
Bitcoin as DeFi
The “first” DeFi platform to arise in the crypto universe might be attributed to bitcoin, which pioneered the global peer-to-peer transfer of digital currency on an open and secure basis. Bitcoin helped provide one of the first blockchain networks with immutable rules that wasn’t subject to the whims of banks or government institutions.
This “decentralization” ensures that a blockchain network could not be impacted by arbitrary market shutdowns, nor would it be subject to the whims of government actions, like inflationary money printing or account seizure. That all of bitcoin’s “rules” were written directly into the underlying code ensured that none of it could be changed by participants, while its open source nature still allowed for all who wished to partake.
Fast forward to today, and bitcoin is the most well-known and highest valued of any cryptocurrency traded on the market, with some media outlets dubbing it “liquid gold.” It’s establishment has begun to be accepted by the mainstream, with large corporations like Square and Tesla embracing it and making large investments in the blockchain.
As for where Bitcoin might traverse next, consider the new concept of “Wrapped” bitcoins (WBTC), which allows the value of bitcoin to be embodied onto the Ethereum blockchain and transacted on a system outside of the original Bitcoin blockchain. In theory this allows for holders of bitcoin to retain its value while also allowing them to harness the unique benefits of Ethereum’s DeFi collection.
While it’s debatable whether Bitcoin may continue to grow and evolve beyond its current phase, or whether it eventually cedes hegemony to another blockchain contender, this is certainly something to keep an eye on as this market continues to evolve.
Ethereum and DeFi
The Ethereum platform represents the next step in the line of technological progress beyond what the bitcoin blockchain has already established. Expanding on immutability and global adoption, Ethereum introduces the concept of smart contracts, which confers participants and developers with a programmable functionality that goes beyond the simple storage and transaction of value coined by Bitcoin.
Whereas bitcoin helped provide the first widespread use case for widely exchangeable digital currencies, Ethereum expands the use case for cryptocurrencies from value exchange to other financial exchanges like lending, investing, and borrowing. It essentially forms the underpinning of DeFi as we know it today.
Applications programmed through the Ethereum stack allow developers to combine many programmable assets into financial suites that mix multiple programmable functions. The underlying Ethereum protocol that unites all Ethereum applications is what enables this “building block” functionality. This makes way for a much greater variety of use cases and exciting growth opportunities down the line.
The combination of smart contracts and their stackability has played a large part in Ethereum’s ability to scale. The majority of mainstream DeFi applications are built and live on the Ethereum blockchain as of the day of this writing; this has given rise to new technologies like NFTs and the myriad of DeFi applications that currently exist. Thanks to its widespread success, it’s likely that other blockchains will attempt to replicate Ethereum’s core features in coming years.
DeFi vs. Traditional Finance
Decentralized finance is the emerging peer-to-peer financial network that runs on top of any existing blockchain. By contrast, traditional finance is the existing financial establishment that relies on centralized institutions to intermediate all transactions. Where the two systems differ is in the presence of centralized intermediaries; decentralized finance, by definition, removes the presence of any centralized institution to broker, mediate, or otherwise effect the transaction.
The simplicity of a decentralized system expands the universe of eligible participants, as users aren’t subject to hurdles like credit checks, background checks, or minimum deposits that might otherwise preclude them from participating in the traditional banking system. Anyone with access to the blockchain and who owns a wallet can theoretically partake in DeFi.
Whereas banks and financial institutions have know-your-counterparty requirements that often mandate that the identities of all parties involved be disclosed, DeFi largely eliminates this requirement. When you partake in a DeFi transaction, all parties involved are only identified via their respective “keys” on the blockchain, which are simply anonymous collections of code.
All DeFi transactions are conducted peer-to-peer without the need for an intermediary, which means that you can complete transactions at all hours (including weekends and holidays). The fact that those transactions are validated by the blockchain within minutes, can cut hours or days off compared to standard financial transactions, like funds transfers or stock trades.
In theory, DeFi is faster, more cost-effective, and more convenient, when compared to the infrastructure required for traditional finance. Its lack of custodians and reliance on a shared global ledger, bars it from third-party interference, while providing the type of security that’s inherent to blockchain networks.
Some proponents of DeFi tout that it has the potential to unseat the global financial system as we know it. Even at a more moderate level, it’s not inconceivable for DeFi to co-exist with pre-existing financial systems as a viable alternative to more traditional methods of finance.
There’s no doubt that DeFi still has a long way to go before it can compete on the scale of traditional banking institutions; doubtful investors should bear in mind that the S&P 500 index itself has only existed for less than a century.
We don’t profess to know what the future for DeFi holds, as it’s technically still being written. As the past decades have shown, the market for disruptors is far-reaching and unexpected. At the least, DeFi and blockchain technology is something that prospective investors should continue to monitor as it matures.
What can you do with DeFi
The majority of DeFi applications exist on the Ethereum blockchain thanks to its smart contract capability. There exist a multitude of use cases for DeFi, some of which were even outlined by Ethereum’s founder Vitalik Buterin, in his original white paper prior to the launch of the project in 2015. We’ve highlighted and reviewed a few of the most popular DeFi applications below.
At its core, DeFi approaches lending in a similar way to traditional creditors; a lender offers a borrower a lump sum of money in exchange for repayment, plus an appropriate interest rate.
However, the mechanics of how these transactions are arranged differs slightly in DeFi.
First, the interest rates, payment streams, and collateral on these contracts are programmed directly into the smart contracts that underpin these transactions. This takes the place of the complex covenants that accompany traditional loans. Additionally, all funds exchanged or collateralized take the form of cryptocurrencies.
Lenders have the option of either:
- Depositing their funds into a centralized finance institution, similar to how customers deposit their funds into a bank, and the bank lends the funds out while providing the original depositor with a steady stream of interest, or
- Supplying their funds into a decentralized finance protocol, essentially a pooled money market fund consisting of cryptocurrencies, and earning a market-determined rate of return based on how many borrowers are utilizing the coins within the pool at a given time.
Generally speaking, most of the borrowers partaking in the activities above are overcollateralized, making this a relatively low-risk activity for lenders who partake. However, a riskier form of uncollateralized lending, known as “flash loans,” exists for lenders who want to significantly push the yield on their investment. Still in its speculative phase, flash loans in themselves are a novel experiment into what might one day be accepted in lieu of traditional credit-based systems.
|Pro Tip: Why would anyone need an overcollateralized loan?|
From a borrower’s perspective, an obvious question comes to mind as to why one would even need a loan, if they already have that amount ready as collateral?
Depending on the individual, there are many reasons why someone would choose to incur a loan rather than sell their tokens outright. This can include avoiding a capital gains liability, not wanting to miss out on future appreciation potential on the underlying tokens, or even using the loan as a form of leverage to purchase other investments.
Decentralized exchanges (DEXs) allow you to trade different tokens at any time. Unlike traditional trading exchanges like the NYSE, DEXs never close and are globally accessible, which improves liquidity at all hours of the day. DEXs help domestic traders reach international counterparties that otherwise would have been inaccessible, or extremely difficult to reach without the help of an expensive intermediary.
DEXs also provide a private and non-custodial way for crypto traders to gain access to liquidity across a diverse range of cryptocurrencies at a low cost. Keep in mind that DEXs also differ from more established, centralized exchanges for cryptocurrencies like Coinbase. DEXs do not require users to relinquish control of their private keys nor do they require you to disclose your identity. This allows users to remain relatively anonymous in all their transactions and reduces the level of information asymmetry between bigger players and small retail investors.
In their current state, DEXs are still a widely developing network with multiple exchanges splitting the market, which limits the liquidity of any exchange that fails to develop sufficient scale and leads to increased trading costs in the form of slippage. DEXs may also be limited in scope based on the technological capacity of their underlying networks. This problem of access is further hampered by the fact that DEXs are generally not set up to exchange currency in traditional fiat, which adds another barrier to entry for more traditional investors who don’t currently own cryptocurrency.
While many of these concerns may be hurdles for growth, we’ve even seen advanced DeFi trading protocols for limit orders and margin trading develop to address problems like slippage and lack of scale. Regardless of which DEXs end up building enough scale to become market leaders in their own right, the market for DEXs continues to gain traction with veteran cryptocurrency traders who prize their reduced costs and anonymity over the benefits offered by centralized crypto exchanges.
DeFi stablecoins are cryptocurrencies that are designed to maintain a steady valuation, unlike classic cryptocurrencies, alt-coins, and meme-coins like DOGE. While volatility has defined the crypto market for much of its existence, stablecoins may hold the key to advancing the crypto market beyond a speculative asset class, towards a reliable and established standard for financial transactions.
Stablecoins are typically tied in value to a mainstream currency, like US dollars (USD), underlying precious metals, or even more established cryptocurrencies like ETH (as is the case with DAI). Currently, the majority of stablecoins are issued on the ethereum blockchain and see global usage, with over $1 trillion in stablecoins changing hands in 2020. DeFi stablecoins have slowly gained traction in mainstream society, with the US Department of the Treasury releasing guidance on holding stablecoin reserves in October of 2020.
The market for DeFi stablecoins will likely continue to expand alongside the development of other DeFi applications, as many DeFi applications rely on these currencies to underpin their use cases. Key to the future success of stablecoins will rest largely on whether they can continue to maintain their pegs to their respective reserves in a transparent manner, as this has proven to be a sticking point for both government authorities and investors alike.
DeFi investing applications have replicated many of the traditional capabilities and services provided by brokers and mutual funds, and transformed them into blockchain equivalents that transact cryptocurrencies. This gives crypto traders greater control over their entry/exit prices on trades, as well as a way for many investors to gain diversification and greater market exposure through index products.
The DeFi Pulse Index is currently the best-known product for tracking the broad market capitalization of all of the top actively traded DeFi tokens. It incorporates many of the traits of traditional indexing, including automatic rebalancing and reconstitution of coins within the index; additionally, investors who buy into the index can actually redeem their shares directly for the underlying basket of tokens.
The above-mentioned index product is among the first of its kind, but represents a big step in DeFi investing applications.These capabilities will likely expand with future experimentation by blockchain developers. In theory, blockchain-based indices can be established for sectors beyond DeFi coins and may grow to encompass other crypto-assets like NFTs, or even more traditional investments like stocks, bonds, and real estate.
Is Investing in DeFi Safe?
DeFi’s meteoric rise has coincided with the growth of other budding blockchain technologies like NFTs. While there’s arguably value beneath the underlying technology, investors should be cautious as there’s likely to be significant risk and volatility when it comes to investing in DeFi, as is typical of all new technologies.
Price volatility and liquidity risk are two of the most salient risks that accompany DeFi lending. If you do plan on lending your cryptocurrencies out, or you plan on staking your cryptocurrencies (yield farming), keep in mind that you’re essentially giving up liquidity on your investment in exchange for an agreed-upon return. During these lock-up periods, your assets will not be available to exchange, significantly hampering your ability to sell. Additionally, liquidity risk can be compounded during times of extreme market volatility.
Another risk is the risk of both digital manipulation and obsolescence. DeFi is built on smart contracts and their underlying blockchains, this means that your DeFi investment will be exposed to whatever weaknesses the underlying blockchain basis may exhibit. If the developers who built the capacity for these technologies failed to account for a technological loophole, this may leave your assets vulnerable to exploitation by hackers. Additionally, if the underlying application falls out of favor, fails to live up to its valuation, or otherwise becomes obsolete, your investment’s value is likely to suffer as well.
Finally, there’s a material risk that the full roster of market participants in DeFi exchanges has yet to shake out. Much like the 2001 dot com bubble, the crowded market of DeFi applications likely consists of a variety of contenders, including applications that offer value and applications that seek to profit off the “hype” and irrational investor exuberance. While the bull market leading up to the 2001 dot com bubble did give us winners like Amazon and Google, remember that it also gave us colossal failures like Pets.com.
As with all new speculative investments, investors should conduct their own thorough due diligence on their target DeFi investments and fully understand the risks that accompony emerging technologies.
The Current State of DeFi and the Future
DeFi has caught fire in recent years, giving rise to an entire alternative market of globalized, accessible blockchain-based financial services. This market continues to grow exponentially, as new decentralized applications are built, refined, and tested. According to DeFi Pulse, a site that actively tracks the amount of money invested into smart contracts within the Ethereum blockchain, almost $60 billion USD has been deposited into all Ethereum-based DeFi applications alone (as of April 2021).
The current state of decentralized finance and its upwards growth trajectory has enabled developers to essentially replicate almost every type of financial transaction on the blockchain, including lending, currency exchange, and even investing.
However, there are still a number of obstacles out there that DeFi will need to adapt to, including things like cryptocurrency volatility and over-collateralization of DeFi loans. Additionally, the fractured market of decentralized exchanges will likely need to see some form of consolidation before the winners can truly begin to scale. Decentralized finance is still very much in its infancy, and the true market leaders in this space may yet evolve.
There also exists the issue of governance and acceptance by authorities. Whether DeFi moves in the direction of being governed by some form of monetary authority, like a Decentralized Autonomous Authority (DAO), or concedes to receive oversight from established government entities remains to be seen.
It’s clear that DeFi has taken the concept of “digital currency” to the next level and is the next proverbial step in the ladder to a full “digital economy.” Prudent investors will want to monitor developments closely as this market continues to shake out. Undoubtedly, there will be room for both opportunity and risk, should the market for DeFi and blockchain continue to evolve.