Introduction to Decentralised Finance
Decentralised Finance (DeFi) is one of the fastest growing areas in the digital assets space. It describes the replication of various financial applications on decentralised platforms such as Ethereum where no central counterparty must be trusted. It also removes the need for multiple middlemen, thus introducing efficiency and cheaper fee models.
The sector’s growth and fast adoption rates can be displayed in the total value locked (TVL) in DeFi applications. The TVL refers to the USD equivalent of tokens that are locked in the smart contracts of DeFi applications. While in June 2020 the TVL was around USD 1 billion it rose to currently USD 60 billion in June 2021. Currently the largest DeFi sectors are lending and borrowing services followed by decentralised exchanges, with asset management, decentralised insurance, payments, and asset creation also showing promise.
Open by design
DeFi is characterised by its open-source nature and interoperability. Due to the nature of its decentralised basis DeFi applications share many of the same characteristics of public blockchains such as inclusiveness, immutability, and transparency.
DeFi applications are open source which means that the source code is public to the community and users. This allows users to check if the applications function as promised and if there are any improvements to make. Once developed the founding teams gradually hand over the control of the application to its community mostly with governance tokens which allow to vote on new proposals and makes the application decentralised.
The money Lego
As the code is open source it is very simple to either copy an existing application and add a new feature to it or leverage certain parts of it. This enables a rapid pace of growth as innovation is not hidden behind walled gardens as in traditional finance. DeFi is therefore often called the money Lego due to its open-source nature which allows different applications to be connected to each other –like joining Lego pieces to each other — and creating new applications. This plug-in feature into different apps is one of the central characteristics of DeFi. Currently, most DeFi applications are built on the Ethereum blockchain due to its smart contract functionalities. While there are several other protocols such as Polkadot, Cardano, Binance Smart Chain and Tezos that would allow the programming of DeFi applications, it can be expected that Ethereum will dominate for the next years especially after the Ethereum 2.0 update which will solve the scalability and high network fee issues.
Currently there are three main limitations in the DeFi sector: smart contract risk, user friendliness and scalability. As the application code is public there is the threat that a hacker can detect a bug in the code and exploit the locked funds or that there are unintended bugs in the code from the developer team which result in errors.
Secondly the user interface design of many DeFi applications is still very basic and technical, which can discourage new users to start interacting with DeFi. The third issue is not directly related to the DeFi applications but to Ethereum which currently has scalability limitations.
DeFi is one of the most promising use cases in the digital assets space as it showcases the benefits of decentralised protocols. It can be expected that the sector will further grow and attract many new users due to its low entry barriers, transparent nature and high yields compared to traditional financial applications.
The current limitations of DeFi are due to the novelty of the technology. As the space matures, more standards and best practices will establish, applications will have a more user-friendly interface and the scalability on Ethereum will improve after the Ethereum 2.0 update.
In our next post we will explore some of the most popular DeFi use cases.
This document was prepared by Sygnum Bank AG. This document may contain forward looking statements and may be subject to change. The opinions expressed herein are those of Sygnum Bank AG, its affiliates, and partners at the time of writing. The document is for informational purposes only and contains general material. It is for use by the recipient only. It does not constitute any advice or recommendation, an offer or invitation by or on behalf of Sygnum Bank AG to purchase or sell assets or securities. It is not intended to be used as a general guide to investing, and should be used for informational purposes only. When making an investment decision, you should either conduct your own research and analysis or seek advice from an expert to make a calculated decision. The information and analyses contained in this document have been compiled from sources believed to be reliable. However, Sygnum Bank AG makes no representation as to its reliability or completeness and disclaims all liability for losses arising from the use of this information.