Introduction to Decentralized Finance
This article is the first issue of a DeFi Series which represents a strand of research actitivities aimed at understanding 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.
The digital era has brought to the integration of new technologies into every social and economic aspect of our lives. Technology has disrupted almost all industries, forcing players to fit new market requirements and accommodate the entry of new technologies at any operational layer. Focusing on the financial industry, the standard paradigm has evolved towards the so-called fintech (i.e., financial technology), which refers to the innovation and technology aimed at challenging traditional methods used in the financial services industry [1].
As reported by the Global Fintech Report Q2 2019 [2], the fintech market share was, as of the first half of 2019, slightly over 1% of the global financial industry (i.e., around 187 billion U.S. Dollars). Moreover, according to the findings provided by IndustryARC’s market analyst estimates, the demand for fintech services is expected to grow with an astonishing CAGR of 25% to 30% during the forecasted period of 2019 to 2025 [3]. As a matter of fact, however, fintech does not represent a new industry, but an evolution and, in particular, a digital transformation of the pre-existing financial services industry. Consequently, even if fintech has allowed moving towards a more efficient financial ecosystem, it has not been able to involve paradigmatic shifts with respect to the traditional system under some fundamental aspects: centralization, commission costs, intermediation, innovation without permission, bureaucracy burdens.
The conception of the blockchain technology in 2008, with the publication of the paper “Bitcoin: A Peer-to-Peer Electronic Cash System” by Satoshi Nakamoto marks a total change of game rules [4]. Among others, blockchain introduces decentralization, eliminating intermediaries and proposes a trustless and transparent framework, allowing permissionless access to the network. The blockchain technology application to the financial services industry gave birth to the so-called Decentralized Finance (DeFi) that dates back to 2014 with the first execution of smart contracts within the Ethereum blockchain. In particular, this article aims at presenting the last and most innovative evolution of the financial industry towards a decentralized reality, defining its main characteristics and delineating the relationship with the traditional paradigm.
“The blockchain technology application to the financial services industry gave birth to the so-called Decentralized Finance (DeFi) that dates back to 2014 with the first execution of smart contracts within the Ethereum blockchain.”
According to DeFi Pulse, the DeFi ecosystem has reached a peak of more than 8.7 billion U.S. Dollars of capitalization [5], only considering the market cap reached by the most prominent dApps within the decentralized environment. However, the real attention that DeFi has gained in terms of capital in recent years has a dramatically higher value. Indeed, if we consider the entire value locked in cryptocurrencies (or better, digital assets), which are used to execute financial services in the dApps, the total capitalization is much higher [6]. In particular, we are talking about all the financial tools that fall within the decentralized environment, backed by blockchain technology, issued on platforms that pursue innovative financial objectives.
The continuous increase of DeFi capitalization since the first application of smart contracts shows an impressive shift from centralized solutions towards decentralized alternatives. In particular, the emergence of the blockchain technology has led to the spread of digital assets, paving the way for the creation of decentralized applications (dApps) able to exploit the multivalent nature of tokens to build an entire decentralized financial environment. The result is a rich ecosystem of dApps that offer exciting opportunities for both users and developers.
So, what is DeFi?
DeFi is a decentralized financial system composed of dApps, developed upon permissionless or (public) permissioned blockchains like Ethereum and Eos, that grant access to a wide variety of financial services through the execution of smart contracts.
“DeFi is a decentralized financial system composed of dApps, developed upon permissionless or (public) permissioned blockchains like Ethereum and Eos, that grant access to a wide variety of financial services through the execution of smart contracts.”
And, how does DeFi differ from the standard paradigm?
As DeFi is based on blockchain technology, it is characterized by a set of fundamental principles often in contrast with the standard financial paradigm. Among others, DeFi benefits, with respect to Centralized Finance (CeFi), include transparency, autonomy (i.e., non-custodial management of assets), financial inclusion and tradability (i.e., no requirements to commit to entire high-value investment at once) [7].
Notably, DeFi leverages public blockchains making available to all the users the same transaction data stored on the ledger, enhancing transparency. All the operations carried out on the blockchain do not need third party interventions, granting autonomy through the non-custodial nature of dApps. Therefore, no specialized institution is entitled to make financial and commercial decisions regarding assets belonging to customers [8]. DeFi also enhances financial inclusiveness, only requiring an Internet connection and a smartphone to access these financial services. In addition, financial inclusion is also incentivized by the possibility to conduct transactions that involve portions (even minimal) of digital assets (i.e., micropayments).
Besides, blockchain platforms ensure censorship-resistance since central authorities cannot interfere with the on-chain operations. Indeed, the blockchain is increasingly seen as a valid alternative for individuals who suffer unstable economic conditions due to untrustworthy institutions. Two prominent examples of this phenomenon are the Bitcoin trading volumes registered in Venezuela [9] and Argentina [10] in the last years to contrast the hyperinflation conditions caused by ongoing presidential crises and lack of trust.
In addition, given the absence of intermediaries, DeFi allows performing cross-border payments faster and cheaper. Indeed, transactions intermediated by central authorities (e.g., private banks) can take days to execute. Within blockchain infrastructures, payments execution time generally ranges between seconds (e.g., Eos, Stellar blockchain) and 1–1.5 hours (e.g., Bitcoin blockchain) [11]. On the other hand, the average global remittance fee in the CeFi can reach 7%, while DeFi often offers to operate below 3% [12].
While performing transactions, blockchain platforms grant high-security levels thanks to two main aspects of their infrastructures. The first one relates to the concept of consensus, which rules how to find an agreement within the on-chain community on new data entries (i.e., validating transactions). The second one concerns the immutability of this data allowed by the blockchain’s ability to prevent alteration of transactions that have already been confirmed since its decentralized nature [13].
Summing up, the advantages proposed by DeFi with respect to CeFi are:
- Full accessibility on transaction data by all users; transparency is granted.
- Users do not need third party interventions to compute financial operations.
- Only an internet connection is required to operate on dApps regardless of personal status and geographical positioning.
- No central authority can neither invalidate user transactions nor manage their assets.
- Consensus and immutability provide security for the data held on blockchain frameworks.
- Central authorities cannot interfere with the transactions conducted on-chain.
The DeFi ecosystem is vibrant!
Although when we hear about DeFi generally the attention is all catalyzed by the Ethereum blockchain, the DeFi ecosystem is much more than that. Indeed, even though there exists a path dependency linked to Ethereum since its first-mover advantage obtained thanks to strong network effects consolidated over time, DeFi has also evolved in a transversal and cross-chain way. New players have emerged, proposing higher scalability opportunities with respect to Ethereum and characterized by different design choices in terms of governance [8].
“Indeed, even though there exists a path dependency linked to Ethereum since its first-mover advantage obtained thanks to strong network effects consolidated over time, DeFi has also evolved in a transversal and cross-chain way.”
DeFi applications in the financial industry are numerous as well as the services offered. In this framework, we propose a classification of financial services based on five categories that encompass the largest portion of services carried out on dApps: borrowing & lending, exchange/trading, deposit/asset management, derivatives, stablecoin issuance.
It follows a brief explanation of these categories:
- Borrowing & Lending — users have access to P2P lending platforms, where borrowers can obtain funds over-collateralizing (generally at 150%) a loan by blocking (not selling) their digital assets — examples: Oasis (Ethereum blockchain) and Vigor (Eos blockchain).
- Exchange / Trading — users can exchange tokens (even of different blockchains) not only for utility reasons but also to take advantage of rising and decreasing prices — examples: Uniswap (Ethereum blockchain) and Switcheo (Neo blockchain).
- Deposit / Asset Management — users can access non-custodial dApps to manage funds and digital assets, monitoring their investments directly — examples: TezBox (Tezos blockchain) and Daedalus (Cardano blockchain).
- Derivatives — users can invest in synthetic tokens whose value is anchored to the underlying asset’s price through dApps that allow tokenizing every kind of asset — examples: WBTC (Ethereum Blockchain) and Chintai (Eos blockchain).
- Stablecoin issuance — users can exploit the issuance of tokens characterized by minimal fluctuation rates, that are generally fiat-backed or crypto-backed — examples: WBTC (Ethereum blockchain) and AnchorUSD (Stellar blockchain).
What will finance be like in 10 years?
DeFi is still in its early stages. Its growth potential has no limits, considering the capitalization achieved and the expansion of the ecosystem experienced in the last years. However, since the strict dependence of the world economic system on centralized institutions such as Central Banks, private banks, insurance companies and stock exchanges, it is not credible to forecast a thorough future shift from a centralized to a decentralized financial system in the short-medium term.
Instead, the real opportunity for the DeFi lies in its complementarity with CeFi, maximizing the strengths of the relative ecosystems and minimizing the respective weaknesses. Indeed, exploiting the two systems’ communication gateways and the absence of interferences among the two, users worldwide can take advantage of both systems’ benefits, avoiding operational bottlenecks. In this sense, DeFi also represents an opportunity for risk diversification in the wealth management context.
Moreover, the coexistence of the two realities is opening and will open new opportunities for incumbents and new entries. Incumbents can exploit their market power to experience a (partial) paradigm shift, fostering efficiency and increasing transparency. On the other hand, new entrants can take advantage of the lower barriers to entry and the new tools to gain attention and funds (e.g., ICO and IEO).
[1] Fintech Magazine, 2020, “What is Fintech?”, Retrievable at link.
[2] Global Fintech Report Q2 2019, Retrievable at link.
[3] IndustryARC, “Fintech Market Overview”, Retrievable at link.
[4] S. Nakamoto, 2008, “Bitcoin: A Peer-to-Peer Electronic Cash System”, Whitepaper, Retrievable at link.
[5] https://defipulse.com/ — updated 17/09/2020.
[6] https://coinmarketcap.com/ — accessed 17/09/2020.
[7] Elev8, 2020, “Centralized vs. Decentralized Finance | How Does DeFi Stack Up?”, Retrievable at link.
[8] Moncada R., Ferro E., Favenza A. and Freni P. (2020), “Next Generation Blockchain-Based Financial Services”, In: Future Perspectives of Decentralized Applications (FPDAPP) 2020.
[9] Cointelegraph, 2019, “Bitcoin Trading Reaches All Time High in Venezuela Amidst Ongoing Economic Collapse”, Retrievable at link.
[10] Nasdaq, 2019, “Economic Uncertainty, Restrictions in Argentina Show Power of Bitcoin”, Retrievable at the link.
[11]https://support.kraken.com/hc/en-us/articles/203325283-Cryptocurrency-deposit-processing-times
[12] Medium, 2019, “DeFi — The Rise of Decentralized Finance Community”, Retrievable at the link.
[13] Binance academy, “What Makes a Blockchain Secure?”, Retrievable at link.
Please cite as:
Moncada R., Ferro E., (2020) Introduction to Decentralized Finance, Overtheblock Innovation Observatory, https://medium.com/overtheblock/introduction-to-decentralized-finance-916f7bcd9043
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.
