DeFi: the open, free and global financial system (Article 12):
DeFi (Decentralized Finance) brings financial services and independence to everyone, removing the need for banks and financial institutions and taking power out of the hands of those preventing others from exercising their financial rights.
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Bitcoin and other decentralized cryptocurrencies were developed to eliminate the need for a trusted third-party that authorizes transactions. However, financial services also include other activities, such as lending, borrowing or savings, for example. Just like Blockchain technology removed the dependency on banks and financial institutions through the offer of decentralised payments, it can provide decentralization to these other financial services as well.
Payments are a fairly simple process to facilitate. This is not the case for more advanced financial services, as those are more complex and cannot be facilitated or performed using only layer-1 blockchain solutions. To be able to perform complex financial operations, the use of layer-2 protocols and Dapps is required. Dapps built on layer-2 protocols that provide financial operations are called DeFi.
The goal of DeFi is to democratize financial services through decentralization, so that it is not a single entity or just a selected few that control the system. In DeFi, communication between the individual parties is peer-to-peer (P2P), thus removing the need for a trusted third party in the middle, and it is also automated through the use of smart contracts, which additionally saves costs. The financial services provide liquidity to the market by making the currency that lenders pour into the market available to borrowers. The Smart contracts which automate liquidity-providing do so via the use of applications called “Automated Market Makers” (AMM).
AMM are Dapps that facilitate financial services and simplify the process of providing the opportunity to everyone to be a liquidity provider/borrower through easy-to-navigate GUIs (Graphical User Interface). DeFi Dapps allow users to lend, borrow and invest cryptocurrencies.
DeFi tries to solve the problems present in the current centralized financial market by:
- Providing access to financial services to everyone without the need for third-parties intervening as to who can and cannot participate. DeFi Dapps are accessible to anyone with internet connection.
- Eliminating most of those costs of financial transactions that are associated with third-party fees. Although mining fees still need to be paid, these are usually minimal — especially in comparison to bank fees, for example.
- Ensuring privacy by decoupling your physical identity from your blockchain identity. All your transactions are tied to a wallet ID, not your personal ID.
- Provide around-the-clock financial markets since the services are coded in smart contracts that live on the blockchain.
- No authority can shut down the market since DeFi is decentralized.
- Global, equal and fair service; no borders, no boundaries, no exclusions — the only requirement is access to the internet.
- Interoperability between different blockchains, which makes money transfer almost instantaneous, since clearance time between different banks and across borders is eliminated.
- Flexibility: a Dapp adds functionality and an easily understandable user interface to one or more smart contracts. As long as a smart contract is deployed to the blockchain, anyone can develop a Dapp that suits their own preference to interact with it.
DeFi applications cover most of the traditional financial services: payment, lending, borrowing, investing, insurance, and so on. And for this to be possible, crypto-wallets, which are capable of interacting with the blockchains, were developed. Crypto-wallets are encrypted-on-blockchain digital wallets, where cryptocurrencies and other crypto-assets are stored (wallets will be covered in a later article). A wallet address is your identity on the blockchain, through it you can engage in several financial activities and also other decentralized applications (such as gameFi).
For the peer-to-peer transaction system of blockchain to work, both parties need to have a connection in the real world. If you remember the bitcoin-pizza transaction from the ‘Bitcoin evolution’ article, Laszlo Hanyecz probably had to meet the pizza delivery guy in person to get his pizzas after sending the pizza guy 10,000 bitcoins as payment. It is the same with cash transactions — while you don’t need to know the other person, you need to have a situation where you are sure that the transfer of goods will happen once the payment is done. And because this is not possible between parties that are separated by long distances or over the internet, a trusted third-party was needed. Although blockchain removes the need for trusted-third parties to confirm and allow transactions, there is still the need for a type of ‘guarantee’ — something akin to a mutually agreed upon and mutually trusted contract — when engaging in financial activities. The trusted third-party in the case of blockchain is a code in the form of a Dapp. The Dapp holds the funds from 2 or more parties and performs the financial operation once all involved parties sign the agreement laid out in the Dapp’s smart contract.
Dapps that perform currency exchanges are called DEX (Decentralized Exchange). DEX guarantees that you will receive the right amount of ether (Ethereum currency) for the amount of bitcoin you pay, for example. DEXs are a form of Automated Market Makers (AMM), and at present, two of the famous DEXs are Uniswap and Sushiswap.
Another financial application is Investment. Investment products that pay interest go by the name ‘Yield Farming’ in the decentralized (crypto) world. To engage in this activity, you commit your cryptocurrency to a financial service and receive returns on it. Yield farming (sometimes also called ‘yield harvesting’) is possible through:
- Lending: you lend your cryptocurrency and earn interest on them for it.
- Borrowing: this is similar to arbitrage trading, where you borrow cryptocurrency then lend it out and gain the difference in interest rate. Financial markets usually encourage arbitrageurs as they provide liquidity and facilitate transactions. This decentralized arbitrage (like centralized arbitrage) is also known as ‘flash loans.’
- Providing liquidity: This is when you deposit a pair of cryptocurrencies in a pool on a DEX as a liquidity provider so that others can exchange currencies. DEXs charge a fee for their services, and the liquidity provider likewise enjoys a cut of it.
- Staking: Staking your cryptocurrency to increase the security of a blockchain or a protocol doesn’t go unrewarded. You earn a percentage on your staked cryptocurrency from mining rewards, fees, or both.
If you are paying attention to the cryptocurrency field, you will probably notice that cryptocurrencies are insanely volatile. These huge swings in the cryptocurrency price make yield farming a very risky investment. One example of such risks is what is called ‘impermanent loss’. Impermanent loss is when you provide liquidity to a liquidity pool and then the value of your coins depreciates. As long as you don’t withdraw your funds, the loss is not realized and can be recovered in the future if the value of your coins recovers. To save against volatility, DeFi has introduced the concept of stablecoins.
Stablecoins are crypto-tokens with a value pegged against an asset or a fiat currency. Tying the value of stablecoins to a less volatile asset (money is an asset; this will be covered in a later article) ensures stability of the stablecoin, and also ties it to a certain economy. There are also crypto-pegged stablecoins. The value of crypto-pegged stablecoins is tied to a major cryptocurrency, such as bitcoin or ether. The reason for this is that in the world of cryptocurrency, major coins (bitcoin and ether) are considered a measure of other currencies’ price (while non-major coins that are nonetheless well-established are known as ‘alternative coins’ or ‘alt-coins’). Fiat-pegged and crypto-pegged stablecoins are collateralized using the underlying asset, and the supply is tied to an existing asset in the same way the US-dollar used to be collateralized by gold.
A third type of stablecoins is algorithmic stablecoins. Algorithmic stablecoins are not pegged to an asset, but they are tracked by an algorithm (smart contract) that adjusts the supply based on the demand to stabilize their price in relation to the asset they track. Ampleforth and UST (UST collapse will be covered in a later article) are examples of algorithmic stablecoins. Additionally, a hybrid-form of pegged and algorithmic stablecoins also exists and which even allows for soft-pegged stablecoins.
The most important metric when exploring the DeFi space is ‘total value locked’ (TVL), which is the total amount of cryptocurrencies deposited, staked, loaned or used on a DeFi platform. TVL can either represent the sum of a single currency on a DeFi platform, or the sum of all different cryptocurrencies for a specific service on a DeFi platform.
DeFi is not just part of the future of blockchains, it is already an integral part of them, with an established/deep-rooted history. Wallets, payment, Lending, liquidity providing, insurance, stablecoins, NFT marketplaces and many more are all examples of DeFi Dapps. DeFi has proved to be very successful and the outlook is promising. However, DeFi goes with many risks attached, among them:
- The risks associated with Dapps.
- Hacks: blockchains are almost impossible to hack as they are decentralized. However, DeFi Dapps can include other components which are susceptible to hacks.
- Exit scams: are usually referred to as a ‘rug pull.’
- No safety back-door: funds on blockchains are stored in wallets, so there is only one key to unlock the funds. If this key is lost, there is neither a replacement method nor a back-door to access the funds.
- No consumer protection: since blockchains are not regulated, no authority can protect against fraud, scam or incompetent service providers. When engaging with DeFi services, protecting your privacy comes at the cost of insurance and legal protections.
- Volatility and adoption: since cryptocurrencies are at present only adopted by a tiny minority of the global population, most of the time cryptocurrencies need to be converted into fiat currency to engage in financial activities. Due to the high volatility of cryptocurrencies, people can incur losses in value during this exchange.
DeFi is built on two main pillars, blockchain technology and finance. While blockchain technology is pretty mature and robust enough to allow for the implementation of both existing and proposed DeFi services, and while the financial concepts are well established and have been tried and tested over decades, the union between blockchain technology and finance is still in its infancy. Many questions still need to be answered, many scenarios still need to be anticipated and prepared for, and many legal and social aspects still need to be considered before DeFi can completely replace centralized finance. The one thing that is for sure is that once DeFi proves its might, banks and financial institutions will need to convert their centralized systems to decentralized ones, or become fossilised remains of an outdated system.
