Everything you need to know about decentralized finance (DeFi) — Part 2

DeFi makes finance available to anyone with internet access. The ecosystem consists of decentralized platforms controlled by the community. Read about decentralized stablecoins, synthetic assets, yield farming, and other ways to use DeFi.

Decentralized Stablecoins

Stablecoins are cryptocurrencies whose value is tied to an underlying asset (e.g., the USD). Stablecoins are backed by fiat currencies, baskets of currencies, cryptocurrencies (such as ETH), physical assets (such as gold), or a combination of these assets.

Stablecoins backed by the USD represent the right to claim fiat collateral from a centralized custody. The value of dollar-linked stablecoins is secured by the issuer itself, and their use often involves AML/KYC procedures. There have already been cases where the accounts of stablecoin holders have been frozen and closed.

For instance, the MakerDAO project offers a different model of stablecoin. It is a smart contract platform based on Ethereum, which is the ground of the decentralized stablecoin Dai.

The Dai issuance scheme is analogous to the issuance of gold-backed money. The difference is that Ether cryptocurrency is used instead of gold. The user sends some amount of ETH or other ERC-20 tokens (such as BAT) to a smart contract, which issues the token. This type of smart contract is called a Collateralized Debt Position (CDP).

These Dai tokens represent a collateralized debt to MakerDAO (a decentralized issuance system).

MakerDAO uses two tokens — beyond Dai, also a Maker utility token (MKR) is used. Similar to “gas” in Ethereum, MKR is a “fuel” that is used to pay off smart contract fees. MKR tokens are “burned” after fees are paid, thus supporting demand.

MKR has a governance function — the token is used to vote on a key aspect of the project’s survival and functioning, such as risk management, as well as the platform’s business logic. Every MKR holder has the right to vote and the opportunity to create a new proposal, and the proposal with the highest number of votes automatically receives the status of “important”, affecting the further development of the project.

Non-custodial lending protocols

One popular use case for DeFi is to obtain loans without a trusted party or intermediary in the form of a bank or corporation. Non-custodial lending protocols use smart contracts to reduce counterparty risk and lower transaction costs.

MakerDAO is one of the first applications of this model. It was followed by other protocols such as Compound, Fulcrum, Aave, etc. Compound and Fulcrum create capital pools and allow users to lend or borrow crypto assets, including Dai, USDC, ETH, and more.

When you choose a protocol, you should consider not only the interest rate but also other factors, such as the risk of certain smart contracts, the security of the loan, and the liquidity of the pool.

Decentralized Exchanges (DEX)

It is a blockchain-based exchange that doesn’t store user funds or personal data on its servers and acts solely as a matching platform for orders to buy or sell assets. DEXs offer a new model of trading and exchange of assets. This model eliminates the passage of KYC procedures, dependence on one intermediary, and oligopoly (a market with a limited number of major players).

One of the most successful decentralized exchanges, which is developing rapidly is Uniswap. It combines trading and lending options.

Other popular DEX and protocols are IDEX, 0x, AirSwap, Bancor, Kyber, Paradex, Radar Relay, Loopring, etc.

Peer-to-peer prediction markets

Prediction markets are platforms that allow you to bet on the results of events, games, elections, etc. Many jurisdictions prohibit gambling and betting on certain events, including elections, sporting events, the outcome of trials, and other controversial events.

Prediction market platforms and applications rely on the “wisdom of the crowd” to determine the likelihood of certain outcomes. Evidence from contemporary scientific research supports the notion that large numbers of people (“the crowd”) always predict the consequences of particular events with greater accuracy than do individual experts.

Augur is a platform for creating peer-to-peer prediction markets where anyone can place bets. The Augur protocol allows you to buy and sell shares of potential profits.

The Numerai platform is a hedge fund that uses AI to find the most efficient ways to trade securities. The fund’s employees are data scientists and analysts. They create algorithms to predict trades and bet on their predictions using NMR tokens. The amount of remuneration is determined by the accuracy of the prediction and the amount of the bet.

Synthetic assets

Today, platforms are creating protocols for issuing synthetic assets and derivatives through smart contracts.

UMA (Universal Market Access) is developing a derivatives platform to provide financial products with standardized contracts.

The Synthetix team is developing a protocol to enable the creation and release of synthetic assets.

Security Token Offering (STO)

The traditional financial system requires investment banks to create and issue securities. The equivalent of the securities market in DeFi is the security-token market.

STO issues tokens in full compliance with securities laws. This ensures a higher degree of investor protection and reduced regulatory risk for issuers.

These tokens are backed by assets or the right to receive a portion of the profits of the issuing company. They can be an investment or debt instrument, a derivative, or a digital asset share. These tokens are usually recognized as securities.

The advantage of security-tokens is the ability to divide the underlying asset into smaller units. This makes it more liquid and accessible to investors. For example, instead of investing in the purchase of an apartment for subsequent rental, an investor can buy a token that represents a share in such an apartment and entitles the investor to receive a proportionate share of the income from its rental. Moreover, despite the low liquidity of real estate as an underlying asset, the liquidity of tokens can be high.

Several platforms provide users with tools for issuing tokenized securities and validating subsequent transactions, an interface, and functionality for investor relations and corporate events. These are Polymath, Tokeny, Harbor, Securitize, etc.

Asset management

The asset management segment of DeFi is relatively small compared to TradFi. But there are some significant projects here. For example, Melon. Its users can manage their own and others’ assets in the form of ETH and ERC-20 tokens. The management of Melon Protocol is also decentralized — it is done by the community, not the board of directors.

Another investment solution is Set Protocol, which allows the creation of Sets, of ERC-20 tokens representing a set of underlying assets. This model resembles the ETF investments in TradFi.

DeFi escrow

An example of a DeFi escrow project is Arwen.

An Arwen user can trade on centralized exchanges without depositing any funds. Arwen offers traders secure access to the liquidity of centralized exchanges. At the same time, users have no reason to worry about the threat of hacker attacks.

Where can you track the key indicators of the DeFi sector?

Check the following portals:

• defipulse.com — the volume of blocked funds in DeFi protocols.
• defimarketcap.io — market capitalization of DeFi protocols tokens.
• defiprime.com — interest rates in DeFi protocols.
• dappradar.com — data on decentralized applications.
• defillama.com — the DeFi TVL (Total Value Locked) aggregator.
• l2beat.com —researches about Ethereum layer two (L2) scaling.

What is yield farming in DeFi?

Yield farming is the process of obtaining native tokens through any form of interaction with DeFi protocols. Such as providing liquidity to lending protocols or decentralized exchanges (liquidity mining), taking loans, and participating in votes.

Theoretically, such encouragement is intended to stimulate user activity, but practically, it leads to market manipulation reminiscent of the ICO bubble in 2017. A good example is the YFI token from the Yearn Finance project, which rose from $35 to $4500 in just one week since its launch.

Which DeFi protocols provide liquidity mining and profitable farming opportunities?

• Synthetix distributes SNX tokens for providing collateral to the platform.
• Compound distributes COMP tokens to users who lend or borrow.
• Balancer distributes BAL tokens to whitelist liquidity pool creators.

Similar programs are offered by mStable, BZX, Ampleforth, and Curve.

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