What is DeFi (Decentralized Finance) and Which Types of DeFi Product available in Market
The economy of the world is the cluster of a number of financial services and trading technologies. we all have heard the word finance but further, it splits into two basic types
- Centralized finance
- Decentralized finance (DeFi)
Crypto has always been speculative in the crypto world. There are numbers of the technological aspect which makes crypto so accessible. Blockchain is one of them and it is the best technologies that are changing how different sectors work.
Finance is no different. In this article, we are going to discuss decentralized finance and how it is going to change how financial firms work. Crypto is driving financial institutions to take steps for the future. They are now looking at blockchain and crypto as their next technology for solving critical problems within the finance sector.
What is Decentralized Finance?
Decentralized Finance (DeFi) is the movement that leverages decentralized networks to transform old financial products into trustless and transparent protocols that run without intermediaries. DeFi is all about monetary systems using public blockchains. It is a new monetary system and hence is one of the hot topics among the industrialist, blockchain experts, and learners like you!
At the core, the term “public” is important here. It can be equated similar to that of Ethereum public blockchain. In the public blockchain, there is no place for centralized authority.
Why: Issues With Traditional Finance?
The need for DeFi comes from the fact that financial services are not available to everyone around the world. Almost 1.7 billion people all around the world have no means and access to financial services. The financial institutes are also not able to provide the necessary infrastructure to make people more access to money. The existing infrastructure is huge, but it does lack when it comes to reaching everyone out there.
Luckily, technological developments and their rapid adoption make this the right time for a new decentralized financial system to emerge as today we have,
The Internet: Around 4 billion users by the end of 2019
The proliferation of smartphones: Two-thirds of the unbanked have mobile phones
Digital banking: over 2 billion users by end of 2019
Bitcoin and Blockchain: the emergence of a new public blockchain.
How Defi will help?
With decentralization, the current infrastructure failures are solved. It removes the failure point and ensures that the records can be stored and shared among different nodes across the network.
It can work on a peer-to-peer network without any centralized authority. For the current infrastructure to work, there is an over-dependence on the centralized authority. Without its governance, rules, regulations, and reach, it is not possible to implement in some areas, especially in places where wealth generation and distribution is less or inadequate. Also, centralized authority holds the power to delete accounts or block them if they deem so. The censorship might be needed in some cases, but in most cases, it is restrictive and make the users suffer.
Another key element of the DeFi is the decentralized apps(dApps). DApps enable the financial institutes to create functional apps on the public blockchain and ensure that anyone can interact with them with minimal cost per interaction.
DeFi is offering you control of your own assets. Though many new-age banks and fintech firms promise to provide more control to the users, in reality, you are still trusting in them to manage your funds. The objective of DeFi is to give you full control of your assets, and it can because of decentralization and blockchain technology. Also, many developers of financial apps are adopting open-source protocols for trading through decentralized exchanges.
The fact that all protocols are open-source allows anyone to build new financial products on top of them. Developers across the globe can collaborate with each other to create new products leading to faster innovation and a secure network.
Anyone can store, trade, and invest their assets in blockchain securely and earn a much higher return than from the traditional financial system. Since there no intermediaries handling your asset, you have complete control over your investments.
Types of Decentralized Finance Products.
In order to understand DeFi in-depth, it is important to understand its products. One thing is common between all the products — they are based on blockchain-powered open protocols. Most of the existing products are based on the Ethereum blockchain, except for one that is on the Bitcoin blockchain. Let us look at some DeFi product categories.
- Lending -In Lending, users can borrow one asset by giving another asset as collateral. The collateral is usually ETH, and the borrowed token depends on what the firm is offering. The debt has an accruing interest which is to be paid off when along with principal interest.
Maker, a lending DeFi product, offers its USD-backed stable coin DAI, when ETH is given as collateral. The value of the collateral is always higher than the value of the loan to ensure that in the case of a non-repayment of the loan, the collateral can be used to cover up the lender’s loss. In the case of Maker, users can borrow up to 66% of value in DAI on the collateral they lock-up.
In case the value of the collateral falls below the stipulated rate, then the lender may impose a penalty on the borrower and even liquidate their collateral in the open market. Maker charges a 13% penalty if the value of the collateral falls below the 150% collateralization ratio and also sells the collateral at a 3% discount in the open market.
Giving Maker strong competition is EOS’ stablecoin initiative for crypto lending. The USD-backed stablecoin, EOSDT, leverages EOS’ collateral to add to the liquidity in the market. A user can simply lock up their digital assets to issue EOSDT. The level of collateralization is 130%, lower than other lending products in the market.
There are several DeFi lending products in the market which follow a similar model of lending. Compound allows users to supply assets to its liquidity pool and earn compounding interest on that. From this pool, it lends assets to borrowers at interest. dYdX allows borrowers to take leveraged long positions of up to 4x their collateral value or leveraged short positions of up to 3x of their collateral value.
Derivatives
Derivatives are another class of DeFi products –derivatives can range from asset-backed tokens to alternative insurance to decentralized oracles or p2p protocols for prediction markets.
For example, Synthetix is a decentralized platform that allows for the creation of Synths -assets based on fiat currencies, commodities and crypto-assets. Ethereum-based Nexus Mutual allows members to pool and share risk through a community-owned insurance alternative called a discretionary mutual. Augur is a decentralized, p2p protocol that allows users to create a market around the outcome of any event and bet on it.
Dexes
Dexes are open protocols, which, instead of relying on order books, use liquidity pools for token exchange. In simple terms, they facilitate the exchange of crypto assets using smart contracts deployed on the blockchain using liquidity pools. The trading rules are coded into smart contracts deployed on the Ethereum blockchain.
Uniswap is an example of a DEX which allows anyone to create a market or a liquidity pool by providing an equal value of ETH and an ERC20 token. The exchange rate is initially set by the creator of the market, but it keeps changing as trading takes place and the liquidity of one asset compared to the other gets reduced. The arbitrage opportunities presented by these changes promote more trading.
Bancor, like Uniswap, also uses pooled liquidity instead of order books for token exchange. Bancor uses “smart tokens”, which can be considered as tokens that hold the monetary value of other cryptocurrencies. In other words, smart tokens hold the reserves of other ERC20 tokens and are linked to smart contracts. On the exchange, smart tokens are used internally for converting from one asset to another depending on reserves of the tokens.
Kyber is another on-chain liquidity protocol that facilitates token exchange with the help of reserves. Users can create token reserves, which will exist as smart contracts on the Kyber network. When a user wants to exchange a token, Kyber will check across all reserves and show the best price.
Assets
Assets are another class of DeFi products. In this category, there are different types of product offerings — sets of tokens as an investment, tokens backed by other tokens and decentralized asset management.
Set Protocol offers tokens that represent other underlying assets or sets of tokens, for example, ETH and USDT, clubbed together in a specified proportion. Consumers can buy TokenSets based on different strategies — trend trading, range-bound, and buy and hold. For e.g. in Trend trading, if you are holding a token representing ETH and USDT which rebalances according to the 20-day moving average, then your token set will be 100% ETH is the price of ETH is above the 20-day moving average, and it will rebalance to USDT if the price goes below the 20-day moving average. The process of rebalancing will be governed by a Smart Contract.
WBTC is an ERC20 token backed by BTC in 1:1 which can be traded on DEXes which support ERC20 tokens. The idea behind looking at Bitcoin and Ethereum together is to bring Bitcoin’s vast liquidity into Ethereum. The token is helping in the expansion of both the networks. For example, this token helps in utilizing DEXes for trading BTC.
Melon Protocol facilitates decentralized asset management. It enables anyone to create their own asset fund whose rules are coded into the smart contract, thus, lowering the barriers to entry into asset management. It also helps investors evaluate different asset funds available in the Melon network and invest in them at a fraction of the cost of what they would pay to traditional asset managers.
Payments
Payments are an interesting use-case of decentralized finance with products that utilize both Bitcoin and the Ethereum blockchain. In the payments sector, DeFi products have tried to make micro-payments more efficient and inexpensive, thereby improving the scalability of blockchain networks.
Lightning Network is a product focusing on Bitcoin blockchain which induces efficiency in smaller transactions by taking them off-chain. In the Lightning Network, two or more network members who want to transact can open a channel by depositing funds. They can perform as many transactions as they want without exceeding the amount of the funds deposited. All transactions will be recorded off-chain, and when the channel is closed, the most recent state of the off-chain ledger will be updated on the blockchain.
Connext is another DeFi product related to payments. Like the Lightning network, it too uses an off-chain solution for fast, low-cost micropayments. Connect requires it users to set up a Dai card that hosts an Ethereum wallet. The Dai card can be loaded for up to $30 with ETH or DAI. The Dai cardholder can then send micropayments to any other user with a Dai card.
xDAI Chain is a payment solution with a 5-second block time and very gas fee. It an Ethereum sidechain that uses the Proof of Autonomy (POA) consensus algorithm. In POA consensus algorithm, only US public notaries can become validators and are managed by a Decentralised Autonomous Organisation (DAO). In the xDAI network, xDAI tokens, backed by DAI in a 1:1 ratio, have the same role as ETH does in the Ethereum network. so these all were the products of Decentralized Finance. Let’s have a look on pro and cons of DeFi.
The Advantages of DeFi are many as below.
- Autonomy
The money and assets that you own in a DeFi ecosystem are yours and yours alone. There is no centralized authority, such as a bank, with the ability to freeze your account, seize your assets, or block your transactions.
- Accessibility
If you’ve been active in the digital assets industry for some time, you’ve likely heard about the 1.7 billion unbanked people around the world. Unable to access bank accounts, these people are at a disadvantage to pursue many financial opportunities.
Unfortunately, centralized financial institutions don’t have an incentive to target this population. The revenue they would receive from providing services to the currently unbanked simply doesn’t justify the costs of reaching them. Because DeFi apps operate without expensive intermediaries, they can afford to reach those people.
- Tradability
Synthetic assets, aka tokenized assets, are another aspect of DeFi bringing immense value. By creating tradeable tokens that represent, say, a portion of a real estate investment, you open up the investment for people who previously couldn’t afford it, to potentially having access from anywhere in the world.
Similarly, DeFi enables investors to trade more efficiently because they aren’t required to commit to an entire high-value investment at once. Instead, they have the option to buy or sell just a portion.
- Transparency
DeFi data is publicly available, enabling you to keep service providers honest. For instance, you can easily check the reserves of a DeFi bank, shop around for accurate loan rates, or even track the transactions of public figures.
The Disadvantages of DeFi
DeFi does have a significant number of benefits, but it’s not without its faults.
Giving individuals complete control of their money and assets is risky. Lost private keys, forgotten passwords, mistyped addresses — the list of ways you can lose your cryptocurrency goes on and on.
According to the Wall Street Journal, over one-fifth of all bitcoin are currently missing. With further adoption, we can expect this figure to grow.
Additionally, the complexity of smart contracts opens the potential for attack vectors that don’t exist in traditional financial systems. Looking through history, you can find a nearly endless number of examples that demonstrate how less-than-stellar smart contracts have led to a host of people losing their cryptocurrency. (Remember the DAO attack?)
Finally, the DeFi regulatory landscape is still ambiguous at best. Although many government entities are making headway, much of the law and DeFi classifications are still uncertain. Therefore, most businesses are hesitant to jump in fully.
DeFi Statistics — How Big is This Market Presently?
according to DeFiPulse.com, a total of $643M is locked in the DeFi market presently. There are a total of 20 DeFi products belonging to different categories — Lending, Derivatives, Dexes, Assets, and Payments. MakerDAO is the largest DeFi product with a market share of over 52.95% and funds worth $340.47M locked in. Synthetix and Compound are the second and third largest products with locked-in funds worth $89.2M and $78.8MM respectively.
Future of Defi
The future of DeFi looks bright for sure. DeFi is still at an early age — its size is a tiny fraction of the size of the crypto market. However, it has stirred the interest of the crypto community and it is evolving — one step at a time. From $4 in August 2017 to over $680 MM in June 2019, DeFi has shown massive growth in just 2 years. As the crypto industry grows and gains adoption, DeFi is also likely to see an increase in value with more participants moving to DeFi.
In fact, the DeFi movement is already adding more blockchain networks. EOS has established itself as a major player with EOSDT. Tron has also joined the DeFi movement, as it announced its partnership with the Loom Network in September. With the help of Loom Network’s solutions, it will be able to deploy MakerDAO’s DAI stable coin on the Tron blockchain.
Given the rapid developments and the growth in the world of DeFi, and the mainstream adoption of crypto, it is a possibility that DeFi may overtake traditional finance in the future.
The BitsShadow also supports the DeFi terms and also committed to always be with a positive change in cryptography.
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