Decentralized finance is one of the most popular terms in the blockchain industry recently and it’s considered an alternative to traditional financial services. DeFi, in particular, is made up of smart contracts that power decentralized apps (dApps) and protocols. Many of the first DeFi applications were developed on Ethereum, and it still holds most of the ecosystem’s total value locked (TVL). In April 2021, it reported that total value locked in DeFi surpassed $50 billion, which proves that people in this industry are highly interested in this democratic, decentralized approach to finance.
What is DeFi?
DeFi, stands for Decentralized Finance, is an ecosystem of financial applications built on top of blockchain networks. More precisely, Decentralized Finance aims to establish an open-source, permissionless and transparent financial service ecosystem that enables users to participate in a variety of financial activities without the need for a central authority. These activities are:
- Lending and borrowing
- Spot trading
- Margin trading
- Derivatives trading
With DeFi, users can have full control over their assets and engage with the ecosystem through peer-to-peer (P2P) and decentralized applications (dApps).
The development and execution of smart contracts is essential to most of the existing and potential DeFi applications. A smart contract, unlike a traditional contract, employs computer code to describe the relationship between the parties participating in the contract.
When the preset criteria of a smart contract are met, the code will automatically execute. This means that the contract is settled without the need for human intervention.
Smart contracts are more efficient, easier to use, and lower risk for both parties. Smart contracts, on the other hand, create new sorts of hazards. Because computer code is prone to flaws and weaknesses, smart contracts’ value and sensitive information are at danger.
The code of a smart contract is permanently stored on the public blockchain where it is used. This allows for some of DeFi’s most innovative features, such as:
- Permissionlessness: Without needing prior authorisation, anybody can communicate with DeFi protocols.
- Trust minimization: Because DeFi applications are open-source, there is no need to trust the person who created and distributed them. Users can check the application’s functionality themselves since the code is publicly available.
- Composability: DeFi protocols can communicate with one another, providing functionality that is not feasible in traditional finance.
- Censorship resistance: No one can censor transactions that engage with DeFi applications.
- Immutability: It is economically impossible to change the coding of a DeFi protocol after it has been implemented. Users may rest certain that the same application will function consistently.
- Low cost: For the services, trusted middlemen generally demand a high fee. In DeFi, the protocols do the same job as many of these high-priced intermediaries.
- Transparency: Anyone may be able to see all transactions that interact with DeFi protocols. Traditional finance, on the other hand, is far less open, and it is frequently the site of scandals with central authority betraying the confidence that consumers have placed in them.
The DeFi’s ecosystems
Ethereum has a huge edge in terms of decentralized finance since it was the first blockchain network to provide a programming language capable of constructing smart contracts. Being the pioneer in the field, many developers interested in investigating blockchain technology’s possibilities beyond Bitcoin began experimenting with the network immediately after its introduction.
At the end of 2020, it is recorded that there were approximately 130,000 developers participating in the well-known Ethereum’s development suite, called Infura. It also indicates a growth of 87% compared to last year. Also, in April 2021, there are 251 DeFi projects in total, and 215 of them are built on Ethereum.
Apart from Ethereum, which is the leader in the DeFi sector, there are also other blockchains that are building a decentralized finance ecosystem themselves.
“Ethereum killers” is a term used to describe these smart contract-enabled chains. Such networks, according to their proponents, can be able to fix Ethereum’s shortcomings. They believe it’s just a matter of time until developers abandon the original smart contract platform in favor of developing on a new blockchain.
One of the biggest problems of Ethereum is its high transaction fees. Since the architecture of the network is built to maximize decentralization, it necessitates enticing as many non-trusting and distributed transaction validators as possible.
The amount of transactions that may fit in a single block is restricted in order to keep hardware demands low. However, due to Ethereum’s growing popularity — mostly due to DeFi — blocks are frequently entirely filled. Those who want to transact must thus outbid other users when submitting transactions. The growing transaction fees make it more difficult for retail users looking to interact with Ethereum dApps.
The upgrade to Ethereum 2.0 intends to address this issue. However, it’s still unclear when this rollout will be. Meanwhile, developers are starting to shift to cheaper alternatives.
To assure great performance, these “Ethereum killers” frequently utilize consensus processes that speed up transaction processing, layered designs that reduce competition for block space, alternate data storage techniques, and other improvements. While these modifications can result in networks with considerably higher transaction throughput than Ethereum, they frequently come at the expense of decentralization.
Non-Ethereum blockchains that currently enable DeFi ecosystems include:
Several of the blockchains mentioned above allow Ethereum-native apps to be deployed right away, which allow developers to migrate projects from Ethereum’s overcrowded network to a more economically viable blockchain. SushiSwap, a prominent decentralized exchange, just launched on Avalanche after finding its success on Ethereum.
What is DeFi used for?
Borrowing & Lending
One of the most popular types of applications in the DeFi ecosystem is open lending protocols. The advantages of open, decentralized borrowing and lending over the traditional credit system are numerous, including instant transaction settlement, the capacity to collateralize digital assets, no credit checks, and the possibility of future standardization.
Some of the popular DeFi lending protocols are Aave and Compound. Lenders provide funds to money markets created by protocols in exchange for algorithmically calculated interest payments. Users must submit collateral to a smart contract when borrowing from a platform like Compound.
To safeguard systems against the large price swings associated with digital assets, DeFi protocols typically need over-collateralization — that is, the backing of loaned money with more capital than is borrowed. The collateral minimizes the lender’s risk if the user is unable to repay their obligation for whatever reason.
Currency exchange is one of the major pillars of the traditional financial system that is reflected in DeFi. DEXes allow users to exchange one cryptocurrency for another without requiring cash to be held by a central authority. DEX platforms are divided into two types:
- Automated market makers
- Order books
DEXes with order books connect buyers and sellers to make trading easier. On-chain order book DEXes, such as Bitshares, rely on node networks to maintain a consistent order history. This approach includes a large number of on-chain transactions, which raises the need for block space on the corresponding network substantially.
The automated market maker model, as introduced by Uniswap, changed the notion of decentralized exchanges. Liquidity pools replace traditional order books in AMM protocols. When a trader buys or sells a cryptocurrency on an AMM DEX, they add one of the trading pair’s assets to the pool while taking out the other. Other AMM DEXes include SushiSwap and Bancor.
Stablecoins are an important element of the decentralized financial industry because of the extreme volatility of cryptocurrencies. The rapid price swings of crypto assets have an impact on lending, borrowing, trading, and other financial operations, especially when several assets are involved.
By offering digital assets that are tied to more consistently valued currencies, stablecoins decrease the dangers caused by volatility. Stablecoins, which were originally designed to allow traders to convert their BTC and other crypto assets into something more stable, serve a similar role in DeFi.
There are three main types of stablecoins today, including:
- Fiat-collateralized: Stablecoins issued by a central authority, such as USDT and USDC. Each token is backed by the same amount of fiat money in a bank account.
- Crypto-collateralized: Some decentralized stablecoins, like MakerDAO’s DAI, rely on crypto assets as collateral. Crypto-collateralized stablecoins generally require over-collateralization since the assets underlying them are often volatile.
- Algorithmic: Algorithmic stablecoins, such as ESD and FRAX, aim to keep prices stable by automatically altering supply in response to changing demand. They are more decentralized than fiat-collateralized stablecoins and utilise capital more efficiently than crypto-collateralized stablecoins. Elastic supply token pricing, on the other hand, are generally more volatile than other stablecoin choices since they don’t have any support.
Derivatives are agreements between two or more parties that specify how one party must pay the other. Options, futures, and swaps are examples of derivatives.
Derivatives are frequently employed to hedge risk. A commodities producer, for example, might hedge against price volatility by entering into a futures contract that locks in a sale price at a specific date, regardless of the market price. Similarly, in the cryptocurrency business, firms may use futures contracts to hedge their exposure to extremely volatile crypto assets.
Derivatives are also commonly used for speculation purposes as they allow traders to bet on price movements without having to possess the underlying asset. Contracts are frequently leveraged with borrowed cash as a result. Leveraging a position raises both the risks and the possible profits.
The challenges of DeFi
- Poor performance: Because blockchains are intrinsically slower than their centralized equivalents, the applications developed on top of them suffer as a result. These restrictions must be considered by DeFi application developers, who must then optimize their products accordingly.
- High risk of user error: DeFi apps shift responsibility from intermediaries to the user, increasing the possibility of user mistake. For some people, this is a disadvantage. When products are implemented on top of immutable blockchains, designing solutions that reduce the risk of user mistake is a particularly tough task.
- Poor user experience: Using DeFi apps now necessitates extra effort on the side of the user. DeFi apps must provide a concrete benefit that encourages consumers to migrate from the old system if they are to become a fundamental component of the global financial system.
- Cluttered ecosystem: Finding the ideal application for a given use case can be a difficult process, and users must have the opportunity to locate the best options. Not only is it difficult to develop the apps, but also to consider how they will integrate into the larger DeFi ecosystem.
The future of DeFi
DeFi is one of the most interesting and fastest-growing areas of the cryptocurrency industry. The usage of smart contracts implemented on permissionless networks allows individuals who are normally excluded from financial services to have access to them.
Despite the fact that DeFi is still in its early stages, significant DeFi ecosystems have already absorbed more than $50 billion in funding. This trend is expected to continue, especially as Ethereum transaction prices push developers and consumers to other blockchains like Solana, EOS, Polkadot, and others.
Many of the conventional financial industry’s key pillars are already represented in DeFi. Decentralized lending, borrowing, trading, and insurance solutions have all garnered substantial user bases.
However, DeFi has a long way to go since there are many challenges and errors in the system that need to be fixed.
If DeFi succeeds, it will transfer authority from huge centralized companies to the open-source community and individual users. Once DeFi is ready for widespread use, it will be determined whether this will result in a more efficient financial system.