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The how, what, and why of DeFi

DeFi has been at the center stage for some time now in the world of blockchain and crypto. However, with increasing usability improvements simultaneously with increasing distrust in centralized finance, the value locked into DeFi has sky-rocketed in recent months. At the time of writing, a staggering amount of $55.91 Billion is locked into DeFi apps and protocols.

This article will cover what DeFi stands for, why it has emerged, and what projects and companies make up the ecosystem.

DeFi is short for decentralized finance. It aims to create an alternative, better system than the existing financial system, in contrast to centralized finance, financial services provided in DeFi function without a central authority. DeFi services are built on smart contract platforms such as Ethereum. Smart contracts allow developers to automate a transaction between multiple parties once a particular set of pre-defined conditions is met.

How financial services in DeFi work is entirely encoded into the platform in line with the idea that “Code is Law.”

Apart from the infrastructure (smart contract platforms), DeFi needs a stable currency to attract users. After all, who’d want to use financial services where the value of your savings could drop at any time.

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Several stablecoins exist, the most prominent example being Tether. However, USDT issued by Tether is backed by US-Dollar in their treasury, which introduces an element of centralization. And more importantly, it requires traders to trust in the company behind USDT. Since DeFi aims to offer a trustless system, it’s sensible not to rely on a currency like that.

Fortunately, with DAI, we’ve seen the advent of a reasonably stable currency backed not by real-world assets but by cryptocurrency. Without going too deep into the workings of DAI, it’s kept stable by ETH held in collateral and use of an innovative governance mechanism. To re-cap, DeFi requires infrastructure in decentralized smart contract platforms and a stable store of value: DAI.

Before getting into the participants making up the DeFi landscape, let’s quickly cover the rationale behind DeFi.

Flaws of the existing financial system

As covered previously, our centralized financial system, while it has arguably positively contributed to growth, is far from perfect. The 2008 financial crisis illustrated how the development of increasingly complex financial instruments could bring the world economy into trouble. It also highlighted the interconnectedness of different financial institutions that represents a significant point of vulnerability. Like dominos, just one bank needs to have a substantial fall-out, and others will tumble. Additionally, due to wrong incentivization and moral hazard, risk-assessments are skewed, and events like the fall-out of Archegos Capital causing Credit Suisse a $4.7 billion loss result.

Despite issues arising from centralization and greed, the financial system fails more than a billion people worldwide. Estimates put the number of unbanked people: citizens without access to essential financial services at 1.7 billion. Not having a safe place to store money introduces uncertainty and vulnerability into those people's lives and often keeps them from improving their living standards.

Even the idea of microfinance aimed at helping the poor escape from poverty by providing them with microloans has grossly failed. What’s worse, it has damaged many developing countries' sustainable growth, mainly driven by microfinance banks' commercialization.

Enter DeFi

https://gph.is/g/EG7nPyd

Decentralized financial services are accessible and open to everyone. There is no one central authority checking if someone fulfills a set of requirements. The only thing an individual needs to access DeFi services is an internet connection. DeFi is non-custodial, allowing users complete control over their own funds.

Another benefit of DeFi is stablecoins. Those have already provided citizens of countries suffering from high inflation with an alternative store of value. Often in these cases, the governments will put capital controls in place, preventing citizens from storing all their money in a foreign currency such as the US-Dolla Stable. It’s not a coincidence that Google Searches for Bitcoin spiked when the Turkish government fired their head of the central bank, who had been running a program to keep inflation in check. In Southamerica, cryptocurrencies have flourished as well, and with the advent of cryptocurrency-based stablecoins, citizens have yet another trustless option to store their worth.

Currently, the decentralized Finance ecosystem is made up of the following:

  • DEX & Liquidity Providers
  • Lending and Borrowing Platforms
  • Synthetic Assets
  • Liquidators

DEX & Liquidity Providers

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Like the existing financial system, DeFi needs exchanges to enable users to switch and trade between different assets. Those exchanges are called DEX (decentralized exchange) and make up a big part of the DeFi landscape. The most prominent example is Uniswap which has occasionally even surpassed Coinbase in trading volume.

What differentiates decentralized exchanges from their centralized counterpart is the way trades are executed. When trading on a DEX, traders interact with a protocol that swaps tokens for them without relying on an orderbook that matches traders.

While centralized exchanges employ market makers that stack orders at different price points to ensure liquidity, decentralized exchanges use liquidity pools. The exchange holds tokens in these pools to ensure that traders can trade at any point. These liquidity pools mostly rely on a mechanism called “Automated Market Making,” which attempts to mirror market-making in the real world. However, liquidity is basically pre-funded on DEX.

The tokens held in liquidity pools are provided not only by the DEX but mostly by liquidity providers. Any trader who decides to lock their tokens in a liquidity pool is a liquidity provider. Liquidity providers receive a portion of trading fees earned by the liquidity pool rewarding them for their contribution.

Some challenges with the Automated Market Making approach are impermanent loss, increasing ERC-20 asset exposure, and low capital efficiency.

Impermanent loss refers to the loss traders incur by depositing their tokens in a liquidity pool vs. simply holding their assets. As most automated market-making algorithms can’t adjust prices to price outside of the liquidity pool, it can happen that the tokens inside a liquidity pool trade at a lower value.

ERC-20 exposure results from liquidity providers requiring traders to deposit two different tokens to supply liquidity on both sides of a trade. This increases their exposure.

Low Capital efficiency is another criticism of AMM-based liquidity pools. They often require a substantial amount of capital to achieve a slippage similar to the slippage on centralized orderbooks.

Despite these challenges, DEXs enjoy growing popularity. Countless developers are working on addressing the existing known problems of AMM liquidity pools. For example, Uniswap now allows any ERC 20 token pooled with any other, while Bancor V2 uses an oracle to adjust prices inside the liquidity pool to prices outside of it.

Lending and Borrowing platforms

DeFi Pulse

The lion's share of tokens locked in the DeFi ecosystem is locked into borrowing and lending protocols. Like peer-to-peer lending, which has increased in market cap over the last years, decentralized lending and borrowing platforms allow individuals to access loans and lend their cryptocurrency for an interest rate payment.

The vast majority of lending platforms are built on Ethereum, allowing any ERC-20 token to be put into them. It’s important to note that whatever is locked into a lending platforms’ platform is not controlled by the company behind the platform. The whole idea of decentralized lending is to make it trustless and enable self-custody.

To borrow funds in a DeFi lending platform, you won’t have to pass a credit check as in traditional finance. However, collateral is required, and due to cryptocurrency’s volatility, loans need to be overcollateralized. That means, to take out, for example, a $1000 loan, a borrower has to deposit at least $1500 as collateral when the ratio is 1,5.

This makes DeFi pretty useless for financing major purchases. As of today, most DeFi lending is fuelled by traders looking to borrow to leverage their trades without having to sell their assets. On the other side of the platforms, lenders benefit from interest rates on their stablecoins that citizens with a normal savings account can only dream of.

Some lending protocols have started giving governance tokens to anyone lending crypto on their platform, which became very profitable in several cases. To mention one, Compound distributed their governance token COMP initially at a $64 value which is now trading at $470. That’s a nice reward for simply lending.

With DeFi evolving, we might see borrowing and lending platforms that won’t require over-collateralization in the future. With users building up a transaction history on-chain, this could be used to evaluate their creditworthiness—other projects such as Bird.Money is looking into connecting real-life transaction data with on-chain borrowing allowing borrowers to access higher loans.

Liquidators

Let’s talk about the nasty side of lending platforms for a minute.

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Lending platforms wouldn’t survive if it weren’t for liquidators who liquidate positions where collateral has fallen below the collateralization ratio. To illustrate this, in Maker, the DAI stablecoin relies on sufficient collateral held in custody to ensure the soft-peg against the US-Dollar. If the ETH price decreases drastically within a short time span, many loans will fall below their ratio of 1,5. As soon as this happens, liquidations are triggered, the ETH deposited as collateral is sold on the market.

Liquidators are specialized in seeking out liquidation opportunities to take advantage of them. Since successful liquidations are crucial for lending platforms to survive, they award liquidators with a “liquidation bonus” that can amount to 3–5% of the loan value. Liquidators act as market makers for liquidations and are therefore essential for DeFi platforms' well-being relying on fast execution of liquidations.

While liquidations can be highly profitable, they’re capital-intensive, resource-intensive, and highly unpredictable. Currently, with the ongoing bull market, liquidators won’t be making much profit. However, once prices start dropping, they will have a chance of earning rewards. Some DeFi projects, such as KeeperDao, are aiming to allow individuals to be part of liquidations and the profits earned by making them more accessible.

Synthetic Assets

Lastly, synthetic assets are another important part of the decentralized finance space. Synthetic assets are part of derivatives. Therefore, they derive their value from an underlying asset.

Synthetic assets allow traders to access and benefit from an asset without having actually to hold that asset. For example, traders can gain exposure to oil without having to touch the actual commodity. While normal synths are positively correlated with the underlying asset, inverse synths are negatively correlated with the underlying asset.

One example of synthetic assets in DeFi are wrapped tokens like wrapped BTC or WBTC. Wrapped Bitcoin is running on Ethereum and is 1:1 pegged to Bitcoin. This allows BTC holders to access passive income opportunities in the Ethereum ecosystem without having to give up on holding BTC.

All in all, the DeFi ecosystem is a fast-moving space with innovation happening daily. While it currently still isn’t offering a complete set of services for use-cases outside of trading — stablecoin usage put aside — , with ongoing development and growing awareness of cryptocurrencies, this might soon change. It’s definitely an exciting time to be involved.

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Naomi Oba

Naomi Oba

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Writer in Crypto — passionate about financial education, blockchain, books, and food.