Decentralized Finance Ecosystem: A Cross-Chain Study
This article is the second issue of the DeFi Series which represents a strand of research related to an extensive and ongoing effort to understand and map the innovation potential of Distributed Ledger Technologies (DLTs) in the financial field carried out by Overtheblock.io, a permanent observatory on Blockchain technology powered by LINKS Foundation.
This article also represents an extract of the paper titled “Next Generation Blockchain-Based Financial Services” (Moncada et al., 2020) presented within the 3rd International Workshop on Future Perspective of Decentralized Applications (FPDAPP 2020).
In a changing world, governed by centralized institutions that control most of society’s fundamental pillars, Decentralized Finance (DeFi) is determining the shift of one of these pillars towards a reality with no or reduced intermediation. The traditional financial system provides access to financial services to citizens and private companies through the close interaction among governments, Central Banks (CBs), private banks, insurance companies and stock exchanges, to name a few. In this context, DeFi represents an ecosystem of financial applications developed on top of blockchain infrastructures [1]. In particular, blockchain technology grants a transparent and trustless framework, departing from the traditional financial system’s paradigm, allowing permissionless access to a variety of financial services, provided that an Internet connection is available.
Decentralization often leads to a fragmentation of information, making it difficult to get a clear and complete idea of the phenomenon and its state of evolution, also due to the community’s dissolution into detached tribes. Within this framework, the post aims at clarifying what DeFi is and how it relates to the existing system, highlighting its importance as an innovative strand of the current financial industry. This discussion relies on a cross-chain analysis offering a cross-sectional representation of the infrastructure’s ecosystem to identify DeFi progress and its future trends.
DeFi ecosystem functioning and implications
With respect to the centralized system, the decentralized nature of DeFi allows solving three critical issues present in the traditional financial paradigm. Firstly, decentralization eliminates the necessity of trusted third parties, i.e., intermediaries disappear. Secondly, transparency is granted, since all users have access to data concerning all transactions carried out on the blockchains while maintaining privacy (at least for public blockchain infrastructures). Thirdly, DeFi grants access to banking services for those strata of the population who are today unbanked for various reasons: ethnicity, financial conditions, geopolitical positions, etc. The resulting framework is an open finance ecosystem where users have access to a prosperous network of financial services that is in continuous expansion thanks to the possibility for new entrants to build on top of decentralized applications without the need to request permission.
For the DeFi system to exist, there must be a circulating medium of exchange that we define as currency in the traditional system while in the DeFi context, we call cryptocurrency. If, on the one hand, fiat money is generally under the monopolistic control of CBs, on the other, cryptocurrencies represent a "form of unregulated digital money" [2] that is consensually accepted by the community members of the blockchain. New transactions, in turn, are performed through the implementation of a consensus mechanism that leverages a cryptographic algorithm to secure the ecosystem. Hence, it is on the community and algorithm that DeFi bases its functioning. Indeed, since decentralization implies the disappearance of a trusted third party, trust automatically flows among all the community members who, in turn, share their own with the whole system. As a result, institutional trust is replaced by cryptographic trust. Consequently, by design, any blockchain platform becomes more secure as its community gets larger since every additional node of a blockchain represents one more node to tamper in order to hack the system. Therefore, a vast blockchain community makes the DeFi applications reliable, in terms of system security, and more appealing since generally, more capitals generate more profits.
“Hence, it is on the community and algorithm that the DeFi bases its functioning.”
However, the argumentation provided above may still not be enough to answer the question, "why do we need DeFi?". Therefore, we must take another step forward in the discussion, going back to the origin of the DeFi. As explained above, DeFi applications take advantage of the blockchain technology implemented, for the first time, by Satoshi Nakamoto, who contextually provoked the issuance of the first cryptocurrency: the Bitcoin [3]. However, despite the massive innovative contribution brought by Bitcoin's creation, the birth of DeFi dates back to a later time. Indeed, most financial services' implementation needs the execution of smart contracts [4], firstly developed on the Ethereum blockchain, which automatically trigger self-enforcing actions arising from an agreement between two or more parties.
Where does DeFi come from?
The creation of Bitcoin occurred in response to a crucial historical-economic event: the 2008 financial crisis. Once again, centralized institutions demonstrated to be strongly interdependent at a global level, allowing an economic crisis that broke out in the United States to spread widely all over the world with severe consequences that we still drag on today. The blockchain leverages decentralization to avoid the domino effect that characterizes the standard financial paradigm since it outsources risks. In the blockchain infrastructures, the game rules are fixed, and users can only sit at the table and participate in the business, eliminating bureaucracy burdens.
In the context of the Euro area, the Coronavirus disease (COVID-19) pandemic is causing a series of critical economic consequences that have led to decelerated planning of monetary policy interventions by the European Central Bank (ECB). Besides, the bureaucracy needed to find and implement joint policy measures is lowering Europe's reactivity in counteracting the harmful effects of the virus. These issues add up to the health context heavily under stress, favoring economic uncertainty and fear of citizens. On the other hand, the blockchain world has simply continued to work as before, already recovering a considerable part of what has been lost during the first days of March 2020. No bureaucracy is needed; only the community counts together with the decentralized system's trust, which does not require reaction plans. Other prominent examples are represented by the hyperinflation conditions still being experienced by Argentina [5] and Venezuela [6], which forced citizens to seek refuge in alternatives to the national currency and, in particular, towards digital options.
There is no way of knowing whether the digital system will substitute the standard paradigm in the future. Nevertheless, since the first implementation of smart contracts, the DeFi ecosystem has experienced relevant improvements, attracting more and more attention and capital, not only by users but also by developers. Indeed, despite the high volatility of these tools, looking at the principal cryptocurrencies' market capitalization, the ecosystem has achieved significant aggregated volumes, i.e., about 300 billion US dollars [7].
Considering DeFi’s detached position with respect to the centralized system and the increasing trend of its aggregated value, its main impacts on the financial industry are twofold. Firstly, DeFi represents an opportunity for investment differentiation to those already involved in financial activities and those who have never had access to them (as a matter of choice or lack of opportunity). Secondly, DeFi also allows reducing the risks deriving from international economic crises, promoting an improvement in the efficiency of the standard financial system, since neither of the two ecosystems has direct control over the other one. As a consequence, the two financial environments can be seen as complementary instead of opponents.
“The two financial environments can be seen as complementary instead of opponents.”
As mentioned above, the growth experienced by the DeFi ecosystem since the first implementation of smart contracts has attracted the attention of new developers. In recent years many blockchain platforms have been created with the capability not only to execute smart contracts but also to develop decentralized applications called dApps. One of the most fertile fields in terms of dApps development is DeFi, through the conception of applications able to offer standard financial services, often taking a step forward to propose innovative solutions to old-time needs. Blockchain technology also allows deploying dApps conceived with a lego-like approach, which enables the combination of multiple financial services without creating bureaucracy limitations for their interconnection.
DeFi ecosystem analysis
Eight blockchain projects, which host the most promising DeFi applications, are presented in the table below. The selection criteria of the blockchains are essentially three. The first one concerns the market capitalization of the blockchain's native tokens, while the second one has to do with the platform's nature. In particular, the sampling concentrates on permissionless and public permissioned platforms where DeFi has developed the most. Finally, the third one regards the objectives of the blockchains. Indeed, the analysis focuses on platforms that aim at reshaping the financial industry from multiple perspectives.
Valuable information about the functioning of these infrastructures is contained within the table. In particular, as mentioned above, all these blockchains are public and, therefore, everyone has access to the data of transactions. The consensus mechanism represents the set of pre-defined rules according to which community members can validate new transactions. In addition, this mechanism also determines the token issuance method of each blockchain platform. The table also provides information about the uses of the blockchains, starting from a simple transaction platform, as in the case of Bitcoin, to get to more complex infrastructures like, for instance, Tron and Tezos.
In terms of financial services, the transition from the traditional financial paradigm to DeFi is not straightforward. In moving from a centralized ecosystem to a globally inclusive financial system, not all the features remain constant. Numerous changes happen, creating a new network, characterized by elements more or less disruptive concerning the standard environment. The principal financial services considered in this article are borrowing & lending, exchange, deposit/asset management, derivatives and stablecoin issuance. Particularly, the categories of financial services have been designated in such a way as to encompass most of the financial operations carried out both in DeFi and CeFi.
In the context of the eight blockchains considered, the figure below shows the DeFi ecosystem in terms of services provided within each blockchain platform. As mentioned above, most of the financial services offered by DeFi require the implementation of smart contracts, as well as specific protocols generally performed by dApps. In this framework, the Bitcoin blockchain is the only one, among the eight platforms analyzed, that does not include the implementation of smart contracts and, in turn, the development of dApps. However, given its importance in terms of network effects, which caused its considerable appreciation since 2012, the Bitcoin blockchain represents one of the DeFi ecosystem’s cornerstones.
Within the set of categories of financial services selected, payment gateways were not mentioned since they are generally seen as a standard integration of deposit service granted by traditional financial institutions like private banks. However, in the case of DeFi that principally makes use of cryptocurrencies, conditions may change. Indeed, since their price tends to fluctuate, it is difficult to think of these tools as widespread means of payment. Instead, they should be conceived as assets and, therefore, as digital assets used by users to take advantage of the financial services made available by DeFi applications.
Within the DeFi ecosystem and in the borrowing & lending context, dApps grant access to P2P lending platforms that use the money deposited by users to finance borrowers without substantial restrictions, as in the case of standard private banks, provided that borrowers can over-collateralize their loan (generally at 150%) with digital assets. Besides, these on-chain projects allow potential borrowers also to become margin traders by virtue of the collateral that they have to provide to apply for a loan. Fulcrum and Nuo represent two examples of borrowing & lending dApps developed on top of the Ethereum blockchain, which also offer margin trading services.
When it comes to exchanging activities, they can be considered the alter ego of trading in the Centralized Finance (CeFi) context. Indeed, thinking of cryptocurrencies as digital assets, the exchange among native tokens of different blockchains represents an investment choice to take advantage of rising and decreasing trends in the various digital asset markets. Moreover, as also seen before, many dApps provide more than one financial services. For instance, the aforementioned Nuo grants also access to exchange activities. Another interesting example is Tokenlon, which is not only an exchange platform built on top of the Ethereum blockchain, but it also issues the token imBTC that is a derivative pegged to BTC’s value.
The dApps that deal with deposit and asset management are applications that allow managing funds and digital assets. Indeed, differently from the CeFi context, in the DeFi ecosystem, dApps are generally non-custodial, which means that there is no specialized institution entitled in making financial and commercial decisions regarding assets belonging to customers. Moreover, payment activities can be considered as part of this category. In this context, Instadapp is a very interesting dApp, developed upon the Ethereum blockchain, that grants access to asset management activities and connects many DeFi protocols allowing users to interface with a series of financial services. MakerDAO, Compound and Uniswap are three relevant examples of interconnections made available by Instadapp.
DeFi derivatives represent another exciting field of this growing financial ecosystem. In the CeFi context, derivatives are contracts among two or more parts whose value depends on the underlying financial assets upon which the parts have an agreement. As such, derivatives can be viewed as secondary securities, since they have no intrinsic value. Instead, in the DeFi environment, derivatives represent synthetic tokens able to reproduce the fluctuations of the underlying assets. Chintai is a dApp built on top of the Eos blockchain, allowing businesses to issue, manage and trade tokenized assets. Another example of this category is Digix, a dApp based on the Ethereum blockchain that issues tokens pegged to the value of gold (i.e., 1 DGX = 1 gram of real gold). Moreover, also the Tezos blockchain is entering the world of digital derivatives through the issuance of wrapped BTC tokens, named tzBTC.
The last DeFi category concerns stablecoin issuance. In particular, stablecoins are fiat-backed (e.g., U.S. Dollar) or crypto-backed (e.g., USDC, TUSD) tokens characterized by minimal fluctuation rates. In this context, DAI represents the first stablecoin issued through the borrowing & lending platform of MakerDAO, developed on top of the Ethereum blockchain. Examples of fiat-backed stablecoins are SDUSD, provided by the Neo blockchain through the dApp Alchemint, and ANCT, issued by AnchorUSD and built upon the Stellar blockchain. On the other hand, instances of crypto-backed stablecoins are EOSDT issued by the Eos blockchain and USDx provided by dForce developed on top of the Ethereum blockchain.
Finally, the following table summarizes what has been presented so far, showing the DeFi development areas of the individual blockchains concerning the financial services analyzed. Therefore, whenever a box that connects a financial service with a blockchain is colored, at least one dApp provides that specific service upon the related infrastructure.
[1] Binance Academy, “Decentralized Finance (DeFi)”, Retrievable at link.
[2] European Parliament (R. Houben and A. Snyers), 2018, “Cryptocurrencies and blockchain”, Policy Department for Economic, Scientific and Quality of Life Policies, Retrievable at link.
[3] S. Nakamoto, 2008, “Bitcoin: A Peer-to-Peer Electronic Cash System”, Whitepaper, Retrievable at link.
[4] Binance, “Smart Contract”, Retrievable at link.
[5] Nasdaq, 2019, “Economic Uncertainty, Restrictions in Argentina Show Power of Bitcoin”, Retrievable at link.
[6] Medium, 2019, “How Bitcoin Is Helping Venezuelans Survive Hyperinflation?”, Retrievable at link.
[7] https://coinmarketcap.com/ — accessed 08/04/2020.
Please cite as:
Moncada R., Ferro E., Freni P. (2020), “Decentralized finance ecosystem: a cross-chain study”, Overtheblock Innovation Observatory, https://medium.com/overtheblock/decentralized-finance-ecosystem-a-cross-chain-study-a7d9ededa30d
OverTheBlock is a LINKS Foundation’s initiative carried out by a team of innovation researchers under the directorship of Enrico Ferro. The aim is to promote a broader awareness of the opportunities offered by the advent of exponential technologies in reshaping the way we conduct business and govern society.
We are chain agnostic, value-oriented, and open to discussion.
