You can find my original blogpost por the Bitprime blog here.
In recent years, there have been a lot of projects coming into the light, some of them great, others not so much, and many of them were a direct scam.
In 2017, we experienced the boom of the ICO’s (Initial Coin Offering) which propelled the platform forward, lots of money was thrown into these projects backed only by the promises of a whitepaper and a team. Nevertheless, there have been some great projects that have come out of the ICO “bubble”. One of the use cases that survived the ICO boom was the creation of “stable coins”. These are cryptocurrencies that are pegged 1:1 to a so-called “strong” FIAT money like the US Dollar. Examples of these stable coins are Tether (USDT), TrueUSD (TUSD) and USD Coin (USDC). Most of these coins are backed by companies (e.g. USDC is a Coinbase exchange currency) which means that they are not entirely decentralised. These coins backed by companies use blockchain technology, but there is a centralised component which needs to be trusted that it’s going to keep the issuance and balance of the money in place.
In 2019, there has been a rise of a new type of DApps that make use of a new breed of stablecoins. Decentralised lending and borrowing protocols powered by Ethereum’s smart contracts can use decentralised stablecoins, such as DAI (or SAI), which achieves stability against the US dollar by over-collateralising enough ETH before minting new coins.
Traditional Financial Industry
The financial industry, as we know it is fully centralised. The power to manage and regulate the flow and supply of currencies, stocks, bonds, debt and interest is in the hands of a few institutions. Banks and financial entities have control over money and also dictate who can or cannot have access to financial services. Access to financial services is not open to everyone, and when someone can access them, they have to pay fees just for the right of using them. We are putting our money into banks, which they invest, keep the gains, and charge us fees for holding it. Besides, there are no guarantees banks will give back our money if they are in trouble. For example, experiences like Argentina’s default in 2001, there wasn’t any money for the population to make withdrawals of their money; or more recently, banks in Turkey froze three million accounts because they were in financial trouble.
Bitcoins and altcoins decentralise the issuance and storage of money, as well as the legitimation of financial transactions. Still, there’s more room for disruption in the finance industry with Blockchain technology.
What is DeFi
DeFi stands for Decentralised Finance, and its primary goal is to give everyone access to traditional financial services by providing a borderless, permissionless and uncensored financial service ecosystem based on blockchain and smart contract technologies.
The traditional financial use cases like trading, lending, borrowing, payments and insurance can be coded into smart contracts and used by DApps to create a peer-to-peer financial network.
With DeFi, people have full access to financial services and complete control of their assets and the decisions over them. Also, as most of the code of these DApps are in Ethereum smart contracts, the logic behind it is accessible by anyone who knows how to read it. Furthermore, some of the governance aspects of these DApps are decentralised as well, giving more power to the people and more automation to the process.
The typical use case for DeFi is: users deposit their crypto into a smart contract, and when someone else borrows the money, they earn interest. The smart contracts connect borrowers and lenders and also distributes the interest. Some of them, like MakerDAO, allows for token holders to vote on a variety of risk parameters, such as what collateral can be used, how much debt can be issued, and the fees charged.
How it Works
Most of DeFi services are web-based interfaces that interact with Ethereum blockchain on the backend through smart contracts.
There is a variety of use cases for DeFi services — borrowing and lending being the most popular one. Lenders locking cryptocurrency in smart contracts, and borrowers taking loans from these DApps, are propelling the industry forward.
Custodial & Non-Custodial Services
Something to consider about the many types of DeFi services is the difference between custodial and non-custodial. A custodial service demands users give away their private keys to a company that manages them, so it means losing total control of your money and fully trusting the third party. Whereas non-custodial services mean that the funds are locked in a smart contract which has already set rules for locking and releasing funds, so there’s no human or third-party intervention in the management of the funds.
Let’s take MakerDAO as an example, as it’s the most popular platform with the highest amount of money invested in it. As at the time of writing this article, $476.1M USD is locked in the MakerDAO platform.
MakerDAO is a DApp powered by a set of smart contracts on which users can borrow money by creating new DAI tokens that are pegged 1:1 to the USD dollar. Users create these coins by creating a “Collateralised Debt Position” (CDP) or ”Vault”, meaning users have to lock a certain amount of ETH as collateral to get the coins. This is a loan scheme, on which when users payback the loan, they get the collateral back.
Since November 18th, 2019 MakerDAO provides two stablecoins called DAI and SAI:
DAI is now a multi-collateralised asset, meaning users can lock other cryptocurrencies besides ETH as collateral in their Vaults.
SAI is now the single collateralised asset, meaning users can only use ETH to collateralise their Vaults.
Collateralisation Ratio & Stability Fee
The way MakerDAO coins (SAI or DAI) achieve stability is by over-collateralising with another crypto asset, the amount we want to borrow. Each Vault or CDP has a collateralisation ratio, which means how much collateralised is an amount of DAI/SAI. There’s a minimum collateralisation ratio (usually 150%, but it’s subject to vote) at which the Vault gets liquidated. If the price of the collateral asset fluctuates downwards and reaches the 150% threshold, the borrower won’t be able to pay back the loan, so it’s liquidated, and the collateral is lost. There’s also a stability fee that needs to be paid when the loan is paid back, this stability fee is meant to be collected by the Smart Contract and used to buy more DAI/SAI in the open market to burn it.
DeFi democratises access to financial services. The current finance sector forbids access of services to certain people that don’t meet the traditional parameters such as financial status, geographic location, currency, income, age or profession. This poses tremendous inequality and helps increase the gap between the “wealthy” and “poor”.
DeFi offers decentralised financial services, censorship resistance and worldwide participation regardless of social or financial status. Furthermore, the blockchain-based infrastructure allows for relatively fast and low-cost transactions, trustless interactions and security. Most of the projects have governability features, on which the token holders can vote on different aspects of the services. Also, the fact that smart contracts cut out intermediaries lowers the fees and could lead to an increase in the interest ratios, making the whole process more profitable.
The Current State of DeFi
DeFi industry is in its infancy, as the whole blockchain industry is. We could say that it’s still in an experimental stage, even when we already have 834.3M USD locked in DeFi platforms. Nevertheless, it’s the fastest-growing area in decentralised services with more than 40,000 monthly users and an increasing number of projects starting.
MakerDAO dominates the other lending category, although projects like Compound are growing at a faster pace. As stated earlier, the lending category is the most prominent use case of DeFi, but it’s not the only use case. Decentralised exchanges are another use case, where there was lots of growth in 2019; Uniswap platform being the one with the most significant trading volume last year, at $390 M.
Overall, DeFi use cases are still confined to the crypto industry and have not reached massive adoption. It is expected that the projects and the industry keep growing and attract individuals and capital beyond the scope of the existing crypto-industry.
The Future and Challenges of DeFi
The industry still has a lot to improve on. One of the main challenges of lending platforms is that products are over-collateralised, meaning users cannot access the capital they don’t have, as there’s currently no credit scoring or shared collateral. This means that lending/borrowing use cases are reduced.
Between the many challenges that DeFi faces, having all the logic in smart contracts and every transaction being irreversible on the blockchain won’t help if fraudulent users want to exploit bugs on the platforms. To avoid this, there is an increasing number of firms auditing DeFi smart contracts and providing insurance if the contracts fail for whatever reason.
Another caveat of using a blockchain platform, Ethereum in particular, is transactional costs, such as gas fees. Every time we send ETH or any ERC20 token to an address, whether it’s a wallet or a smart contract, we need to pay the gas fees of the Ethereum platform. Although these fees are not even near what users may pay in traditional finance, it’s still something to consider when operating on these type of platforms.
DeFi and blockchain platforms, in general, must overcome the knowledge barriers of asymmetric cryptography understanding, meaning the general public needs to understand that they are the real owners of their money by holding their private keys. This ensures a better understanding of how any blockchain-based platform works, making the experience less daunting for first-time users.
Overall, there is a bright future for DeFi, especially for the people it can help. Once DeFi has overcome the barriers of user experience design and overall trust of the general public, we will see these protocols as an integral part of the Internet. Much like TCP/IP is the network communications protocols, DeFi will be for peer-to-peer finance protocol. Decentralised digital cash and access to uncensored financial services will become the new standard.