What is decentralized finance (DeFi)?
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Decentralized Finance (DeFi) is a decentralized, public and trust-free ecosystem of financial applications/services based on public blockchains, primarily Ethereum.
The DeFi ecosystem covers all aspects of financial services and transactions, including lending, borrowing and trading within decentralized structures. Any Internet user can interact with the ecosystem and manage assets through peer-to-peer (P2P) and decentralized applications (dApps).
Why the DeFi ecosystem?
If bitcoin is a peer-to-peer e-money system, then DeFi is a peer-to-peer system of electronic financial instruments. A decentralized financial ecosystem can provide anyone with access to traditional financial services, freeing them from the need for intermediaries and lowering entry barriers.
DeFi-applications and services are potentially useful for residents of countries with underdeveloped or unstable economies. DeFi services are also in high demand in developed economies, particularly for credit, investment and new revenue models.
What are the key features and benefits of DeFi?
Decentralization and self-governance
There are no centralized management structures in DeFi: the rules for business operations are written in a smart contract. Once the smart contract is up and running, the DeFi application can operate independently with little or no human intervention.
The source code of DeFi-applications is open for auditing, allowing any user to understand the functionality of the contract or identify bugs. All transaction activity is public – transactions are pseudo-anonymous by default.
Most DeFi-applications are available to any Internet user.
The DeFi ecosystem is inclusive – anyone can create an app and use it. Unlike the traditional financial sector, there are no controllers or accounts that require complex forms to operate. Through wallets, users interact directly with smart contracts.
Flexible user experience
The DeFi ecosystem provides a flexible user experience. If the user doesn’t like the application interface, they can apply a third-party interface or create their own. Smart contracts are like an open API for which anyone can create applications.
New DeFi applications can be created by combining other DeFi products (stabelcoins, decentralized exchanges, prediction markets, etc.). This feature of DeFi resembles a model in which a certain structure can be assembled in various combinations.
Monolithos experts have identified the following advantages of DeFi:
- The main advantage of DeFi services is hidden in the name itself. Decentralization. It ensures that control over the ecosystem is evenly distributed among multiple players. There is no excessive regulation, transactions are transparent, fast, and there is no long chain of intermediaries. This is convenient, for example, in lending. There is no intermediary bank, so the one who gives a loan does not have to share the profitability with the bank, which takes deposits at one interest rate and gives loans at a much higher rate. There is no such gap in DeFi lending.
- DeFi services are driven by smart contracts and voting. Smart contracts allow the rule of law to be established in the ecosystem, to create clear rules of the game.
- Open Source. As with blockchain itself, services that use opensource protocols are more trustworthy: they can be tested, they can be refined, they can be used in other services.
How and where is DeFi used?
Stablecoins are cryptocurrencies whose value is tied to an underlying asset (e.g., the US dollar). Stablecoins are backed by fiat currencies, baskets of currencies, cryptocurrencies (such as ETH), physical assets (such as gold), or a combination of these.
Stablecoins backed by the U.S. dollar are effectively the right to claim fiat collateral from a centralized repository. The value of dollar-linked stackablecoins is secured by the issuer itself, and their use often involves AML/KYC procedures. There have already been cases where the accounts of stablcoin holders have been frozen and closed.
Project MakerDAO, for example, offers a different model of stabelcoin. It is a smart contract platform based on Ethereum. It is the basis for the decentralized stablcoin Dai.
The Dai issuance scheme can be compared to the issuance of money backed by gold. 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 Collaterized Debt Position (CDP).
The Dai tokens created are collateralized debt to MakerDAO (a decentralized issuing system).
MakerDAO uses two tokens – in addition to Dai, it is also a Maker utility token (MKR). Similar to “gas” in Ethereum, MKR acts as a kind of “fuel” – it is used to pay commissions for the use of smart contracts. After the commission is paid, MKR tokens are “burned,” thereby supporting demand.
MKR serves a governance function – the token is used to vote on a key aspect of the project’s survival and operation, such as risk management, as well as the platform’s business logic. Every MKR holder has the right to vote and create a new proposal, and the proposal with the highest number of votes automatically gets “important” status, affecting the further development of the project.
Non-castodial lending protocols
One of the popular scenarios for using 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 its kind. MakerDAO was followed by other protocols – Compound, Fulcrum, Aave. Compound and Fulcrum create pools of capital, allowing users to lend or borrow cryptoassets, including Dai, USDC, ETH and others.
When choosing a protocol, you should consider not only the interest rate, but also other factors, including the risk of certain smart contracts, the security of the loan, and the liquidity of the pool.
A Decentralized Exchange (DEX) is a blockchain-based exchange that does not store user funds or personal data on its servers and acts solely as a matching platform for matching orders to buy or sell assets.
Decentralized exchanges offer a new model for trading and exchanging assets, eliminating KYC procedures, dependence on one intermediary and oligopoly (a market with a limited number of major players).
One of the most successful and actively developing decentralized exchanges is Uniswap, which combines trading and lending/borrowing options.
dYdX provides users with summary data on spot prices and liquidity of loan transactions on many exchanges.
Other popular DEX and protocols include IDEX, 0x, AirSwap, Bancor, Kyber, Paradex, Radar Relay, Loopring.
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, sports, court outcomes, and other controversial events.
Prediction market platforms and applications rely on the “wisdom of the crowd” to determine the likelihood of certain outcomes. Current scientific research evidence supports the notion that large numbers of people (“the crowd”) always predict the consequences of certain events more accurately than 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 – data scientists and analysts – create algorithms to predict trades and bet on their predictions using NMR tokens. Remuneration is determined by the accuracy of the prediction and the amount of the bet.
Protocols are being created to issue 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.
Platforms for issuing tokenized securities (Security Token Offering)
Tokenized securities platforms decentralize the process of issuing or creating securities, which, in the traditional financial sector, requires the participation of intermediaries, such as investment banks.
The equivalent of the securities market in the DeFi sector is the market for tokenized securities (security tokens). STOs involve the issuance of digital assets in full compliance with legal requirements, which provides a higher degree of investor protection and reduces regulatory risks for issuers.
Whereas ICOs usually offer utility tokens to participants, STOs issue tokens that have the characteristics of securities (security tokens) and are compliant with securities laws.
They are typically backed by assets or the right to receive a portion of the profits of the issuing company, can be an investment, a debt instrument, a derivative or a digital asset share and, as the name implies, are generally recognized as securities.
The advantage of security tokens is the ability to divide the underlying asset into smaller units, making it more liquid and accessible to investors (“fractional ownership”). 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 proportional 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.
Today, there are a number of platforms that provide users with tools to issue tokenized securities, validate subsequent transactions, interface and functionality to interact with investors and conduct corporate events such as buybacks, dividend payments, voting and more(Polymath, Tokeny, Harbor, Securitize).
Although the asset management segment of the DeFi sector is relatively small compared to this area in traditional finance, there are a number of projects offering decentralized solutions, such as Melon. Its users can manage their own and others’ assets in the form of ETH and ERC-20 tokens.
Melon Protocol’s governance is also decentralized – it is run by the community, not the board of directors.
Another investment solution is Set Protocol, which allows the creation of Sets, ERC20 tokens that represent a set of underlying assets. This model resembles ETF investments in traditional finance.
An example of a DeFi-esque project that provides an escrow service is Arwen. An Arwen user can trade on centralized exchanges without depositing funds.
Arwen enables traders to gain secure access to the liquidity of centralized exchanges. At the same time, users have no reason to worry about the threat of hacker attacks.
What are the drawbacks and risks of DeFi?
The systemic risks in the DeFi sector are liquidity and credit risks. Another problem with DeFi systems that use cryptocurrencies as collateral is volatility. If the price of underlying assets blocked in CDP drops rapidly, there is a massive liquidation of assets and the system can collapse.
Currently, to mitigate these risks, DeFi-protocols are basically trying to provide credits with excess assets, which has a downward impact on the price of these assets.
The risk of smart contracts being hacked
While dealing with smart contracts in DeFi eliminates the need to trust a human, there remains a need to trust the smart contract code, which is written by a human.
Centralizing the flow of data
The lack of capital in DeFi loans
- Overly blurred lines of responsibility. Decentralized finances are finances where there is no specific body responsible for what happens in the ecosystem. The basic principle of DeFi platforms is decentralized governance, based on the assumption that all players in the ecosystem have a stake in its prosperity and will therefore make decisions based on their (and in DeFi ecosystems, that means shared) economic benefit. But that sort of thing may not work. It’s not just about blatantly malicious actions aimed at destroying the ecosystem or taking control, but also about the unwillingness of ecosystem players to participate in the development of the service in any way. This is a case where indifference is equivalent to malicious action.
- Control of development in the hands of one team. This flaw is not inherent in all DeFi-services, because many platforms involve collaborative work with users on improvements, but many face it. In particular, problems arise at the point of delegating responsibility to the community.
- The hype around the DeFi market. Any hype plays both to help and against the market. An overheated market will sooner or later burst. The situation is very similar to the ICO bubble of 2017. On the other hand, if we follow Gartner’s famous chart, the bubble will be followed by a fall, followed by a smooth growth and real application of technology.
Where do you track the DeFi sector’s key metrics?
What is revenue farming in DeFi?
Revenue farming is the process of obtaining native tokens through any form of interaction with DeFi protocols. For example, for providing liquidity to lending protocols or decentralized exchanges (liquidity mining), as well as for taking loans and participating in votes. Read more at the link.
In theory, such rewards are designed to encourage user activity, but in practice lead to market manipulation reminiscent of the ICO bubble in 2017. A good example is the YFI token from the Yearn Finance project, which has grown from $35 to $4500 in just one week since launch.
What 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/borrow.
- Balancer distributes BAL tokens to whitelist liquidity pool creators.
What else should I read about DeFi?
Every three weeks, Our website publishes a digest with the main news from the DeFi sector. Read all of them at the link.
Analytical resource CoinGecko has published a book on DeFi in Russian. You can download it by following this link. It is free to download.