Defi Ecosystem Explained

Rahul Ravindran

DeFi is short for Decentralized Finance. DeFi is the ecosystem of fintech apps built on top of blockchain protocols and therefore decentralized in nature. Most DeFi apps are built on top of the Ethereum blockchain, but as new blockchain protocols gain popularity, the DeFi ecosystem is likely to expand.

For a quick summary of DeFi checkout this Video:

Traditional finance operates in a centralized manner with complex procedures, intermediaries, and checks and balances in place. Traditional finance has high fees associated with it due to procedural complexity and the number of parties involved, even for reasonably simple transactions. Traditional finance also leaves out a good portion of the world’s population, referred to as the “unbanked.” These users aren’t served by conventional finance because the cost of serving these users is higher than what could potentially be earned from them in the form of transaction fees.

In this way, the DeFi movement addresses an important core criterion of cryptocurrencies, and that is the promise of making money and its transaction universally accessible. And that is for every person, no matter where he or she lives in the world.

Essentially, DeFi is a movement built on top of blockchain technology. DeFi aims to create an inclusive, decentralized, permissionless, censor-proof, transparent and open-source financial system available to anyone with a cryptocurrency wallet, smart device and internet connection. In DeFi systems, users interact with the network using DApps and peer-to-peer networks. Unlike traditional finance in DeFi systems, users maintain complete control over their assets. Once users deposit their money on the platform, they decide how to manage their investments using smart contracts rather than trusting human intermediaries to do the job.

Smart Contracts

DeFi applications turn financial rules and procedures into smart contracts and code. This helps to automate the processes and make them accessible to everyone on the platform. By turning the rules into code embedded within smart contracts, users can automatically execute a wide range of processes with the click of a button, which would be expensive to do and require manual supervision in traditional finance.

Smart contracts make the transactions faster, cheaper, easier, and more secure for all parties involved. Most of the DeFi industry is on Ethereum, with 100B of total value locked, and 100’s of DeFi protocols. There are also DeFi apps on other Blockchain like Binance Smart Chain, Polygon or Solana, but it’s still much smaller than on Ethereum. The idea of DeFi started in 2017, when the MakerDAO protocol was released.

Advantages of DeFi

Democratized Finance

DeFi democratizes access to financial services. Users can access DeFi systems across the world regardless of their jurisdiction and financial status. All they need to participate is a smart device, a cryptocurrency wallet, and an internet connection.

Permissionless

DeFi networks are inherently permission-less and censor-proof, meaning there is no central authority that has the power to allow or stop a user from participating. There are no gatekeepers in these networks that can prevent users from accessing their solutions; everyone is free to join and transact with one another.

Decentralized & Interoperable

DeFi applications are built on decentralized blockchain networks which don’t have a single point of failure. Most blockchains are interoperable; this means a user can transact across platforms and asset classes.

Accessible Globally

DeFi networks are available everywhere; all users need to access them is an internet connection, a cryptocurrency wallet, and a smart device. No government, credit authority, or geographic constraint can stop a user from participating. DApps are designed to be available globally.

Peer to Peer

DeFi applications do not require the presence of arbitrators or intermediaries. The logic of each transaction type is embedded in code and agreed upon by users digitally. This reduces any associated arbitration costs and enables the applications to offer their services at highly competitive price points.

Transparent

The code and terms of transactions in DeFi are transparent. Users can review and audit them in real-time.

DeFi Use Cases

pen credit protocols have probably attracted more attention recently than any other category in the field of DeFi on Ethereum. Largely due to the meteoric rise in Dai’s use and other P2P protocols like Dharma and the creation of liquidity pools like Compound Finance, decentralized lending is garnering powerful attention, and rightfully so. Open, decentralized lending offers numerous advantages over traditional lending structures. It enables:

  • The integration of lending/borrowing of digital assets,
  • the insurance of digital assets,
  • instant transaction processing and new methods of secured lending,
  • broader access to people who are unable to access traditional services
  • standardization and interoperability, which can reduce costs through automation.

Lending

Lending platforms allow borrowers and lenders to transact with one another using smart contracts instead of intermediaries. Lenders can earn interest on their crypto by offering them on loan to a borrower. In comparison, borrowers can access additional liquidity without having to sell their assets.

StableCoins

Stablecoins, as their names suggest, aren’t as volatile as other cryptocurrencies because they are backed by real-world assets or pegged to a real-world fiat currency. Stablecoins make it easy to tokenize real-world assets and then enable trading these assets on blockchain-based platforms.

Stablecoins now come in a wide variety of models. They differ in part in how they issue coins, how their reserves are checked, and the mechanism for fixing their price. Stablecoins are tokens issued by a blockchain that are intended to maintain a stable value. There usually is a peg to an external asset such as USD, gold, or others to achieve this. Roughly, the following 3 categories can be distinguished in stablecoins:

  1. Crypto collateralized
  2. Fiat collateralized
  3. Non-collateralized

Crypto collateralized stable coins include Maker’s Dai. Fiat-backed stablecoins, however, are by far the most popular stablecoins on the market. First and foremost is Tether, although there are now numerous alternatives. The models for these stablecoins do not differ much from each other. With all of them, users have to trust the providers. Some offer regular and voluntary audits to create the necessary trust through transparency.

Unsecured stablecoins are neither centralized nor backed by crypto assets. They are built on an algorithm to maintain a stable value. To put it simply, the algorithm considers supply and demand as parameters and adjusts them accordingly, always to keep them in a balanced ratio. The basis was the pioneer in this category but failed due to regulatory concerns. As a result, the project was scrapped.

Decentralized Exchanges (DEXes)

Decentralized Exchanges offer services that are similar to regular crypto and digital asset exchanges, except that they remove the need for storing the digital assets on the exchange. These exchanges enable instant peer-to-peer transactions and operate without an intermediary. Once an exchange of assets or trade has been initialized, a series of smart contracts ensure the proper execution of the trade and the secure transfer of funds.

Prediction Markets / Betting Platfrorms

Betting platforms, or prediction markets, have long been popular financial tools for hedging risk and speculating worldwide events. Decentralized prediction markets enable the same thing, but with cryptocurrencies and without the ability to censor the markets. Everything from political and weather forecasts to hedging all kinds of risks on financial or adverse events in the real world is already offered in Augur.

Users make bets about the outcome of future events on prediction markets. Prediction markets on DeFi platforms operate without intermediaries.

DeFi Philosophy

Composability

DeFi apps are usually open-source, meaning anyone can view and use the code that underlies these apps. New larger apps and solutions can be built or “composed” using this open-source code as building blocks.

Money Legos

Building on the concept of composability, you can think of DeFi apps as lego blocks which are joined together to build more comprehensive solutions. People in the DeFi community often refer to these building blocks as “money legos” which can be used to create new financial products

Liquidity Mining

Liquidity mining is the act of providing “liquidity” to Decentralized Exchanges by lending crypto holdings to them for a fee. DEXes provide liquidity to their clients and reward users willing to deposit their crypto on their platform because it increases liquidity.

Yield Farming

Yield farming is a way users can generate rewards with their crypto holdings by lending them to a protocol. Traders who are willing to take higher risks engage in complex strategies and move their crypto through different lending platforms to maximize their return. Yield farming is a form of liquidity mining, except it employs more complex techniques to maximize returns.

Impermanent Loss

Liquidity providers deposit trading pairs with DEXes in exchange for fees. The temporary loss experienced by volatility in a trading pair is called impermanent loss. Only if the liquidity provider decides to withdraw their liquidity for good does impermanent loss become permanent.

Challenges & Risks

While DeFi has a promising future there are a few challenges that users should be aware of.

Enter Barrier

The adoption rate remains a challenge in the DeFi space. A fraction of overall crypto users are active in DeFi. In theory, once a user has an internet connection, a crypto wallet, and a smart device, they can use DeFi apps. Still, the adoption rate remains low in part due to the perceived difficulty in starting and operating a crypto wallet. While seasoned crypto enthusiasts may find it easy to use Metamask, Shapeshift and other crypto wallets, the average non-crypto users shy away from the space, citing the difficulty of using wallets as their primary difficulty.

Scalability

While credit card processors can support thousands of transactions per second, public blockchain networks can only support a handful of transactions at a time. There are several projects underway to make public blockchain networks more scalable, such as the lightning network. The latest blockchain protocols being developed are also able to support a higher number of transactions per second.

** Volatility**

The volatility of cryptocurrency prices is another challenge for DeFi. Wild price swings in BTC and other major cryptocurrencies threaten to undermine the stability of DeFi apps and invalidate user strategies. Stablecoins provide a sense of security, but they cannot be used for every transaction on DeFi platforms.

Smart Contracts Failures

Smart contracts are the backbone of every DeFi protocol; they govern and quantify the transactions between users. Smart contracts in the DeFi space are open-source so that users can review them before investing. Security firms and other users often audit these open-source smart contracts, but flaws in the code sometimes remain undetected. Once users engage with these problematic smart contracts, it becomes incredibly tedious and time-consuming for DeFi platforms to undo these transactions.

Theft and Fraud Are Rampant

Imagine the piracy that flourished in the Caribbean when Spain stole everything from Incas and Aztecs that wasn’t bolted down. Their galleons, in turn, were plundered by rapscallions from every corner of the Earth.

Well, in this latest gold rush, the DeFi space is pillaging the highly profitable rent-seeking empires of middlemen. There is still no shortage today of lawless degenerates hoisting the Jolly Roger and taking what they can along the way.

There have been many high profile attacks, including a recent theft of $600 million. However, in a strange twist that underscores the difficulty of getting away with crimes using blockchains, the perpetrator has returned most of the funds.

Popular DeFi Protocols

Uniswap

Uniswap consistently ranks as the highest among DeFi exchanges in terms of volume and market share, both of which are at least twice as big as any other DeFi exchange. One of the earliest DeFi exchanges, it was also one of the first to provide liquidity pools and automated market makers. Its most recent version, V3, allows users to choose the price range they expect the highest return from when seeking to invest their coins.

AAVE

Borrowing is one of the most important infrastructure in the DeFi sector. Lending protocols have served as banks in the DeFi space, with revenue mainly from interest spreads. Therefore and TVL from savings and lending is the most important metric for lending protocols. AAVE has solidify itself as the top lending protocol in the world. Its platform token price has appreciated 1,000 times, driven by its dominance in the DeFi lending space, with more than $12 billion TVL, more than $8 billion in total borrowing, and the most tokens staked.

Synthetix & dYdX

Derivatives courses are also a highly anticipated sector in DeFi. With no major outbreak in term of popularity yet, let’s look at some data on the leading plaforms Synthetix and dYdX. Synthetix defines itself as a “derivative liquidity protocol” and its main business is on synthetic assets and derivatives trading. According to Debank’s ranking, Synthetix is the only derivative protocol in the top 10 with $2 billion in TVL.

Conclusion

With decentralised applications still in their infancy, the future of DeFi could be determined by the uptake of cryptocurrency tokens for financial transactions from borrowing and lending to saving and investing. Large-scale financial institutions, like JP Morgan and Visa, have entered the DeFi space, and some financial services companies are using blockchains to facilitate international payments.

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