DeFi at its simplest is Decentralized Finance, i.e., Decentralized Finance or DeFi is the movement that allows users to utilize financial services such as borrowing, lending, and trading without relying on centralized entities.

DeFi is not a single product or company but a range of financial services which emulates traditional financial industries, including banking, insurance, bonds, money markets and more.


Problems with Traditional Finance

  1. Payment and Clearance System: If you have tried to send money to someone or a business in another country, you know this pain all too well—remittances involving banks worldwide typically take a few working days to complete and apply all sorts of fees. To make matters worse, there may also be issues with documentation, compliance with anti-money laundering laws, privacy concerns, and more.
  2. Accessibility Chances: If you are reading this, you are banked and have access to financial services offered by banks—to open a savings account, take a loan, make investments, and more. However, many others are less fortunate and do not have access to even the most basic savings account. The World Bank estimates that as of 2017, there are 1.7 billion people who do not own an account at a financial institution, and more than half of them are from developing nations.
  3. Centralisation & Transparency: There is no denying that traditional, regulated financial institutions that comply with government laws and regulations are some of the most secure places to park funds. But they are not without flaws—even large banks can fail. Washington Mutual, with over $188 billion in deposits, and Lehman Brothers, with $639 billion in assets, died in 2008. In the U.S. alone, over 500 bank failures have been recorded.

Defy-ing Traditional Norms

A good wordplay with DeFi would be that it’s trying to defy the rules with which age-old institutions have made a chokehold on the access to capital and the overall financial infrastructure.

  1. Cryptocurrencies that power the DeFi movement bypass intermediaries who take the lion’s share of these transfers’ profits. It is likely to be quicker, as transfers will be processed with no questions asked with relatively lower fees than banks.
  2. The centralisation of power and funds, when tied with little to no transparency, has historically been the prime cause of financial havoc. The 2008 financial crisis was a prime example of this. The distribution of governance and community-led voting substantially reduces the power vested in bad actors, bringing flaws to public scrutiny.
  3. DeFi represents a movement that seeks to push borderless, censorship-free, and accessible financial products for all. DeFi protocols do not discriminate and level the playing field for everyone.

Composability or Money Legos

Composability is the most critical aspect of building decentralised finance on a smart contract platform like Ethereum. This is why this movement is also called ‘Money Legos’ - because just like the pieces of lego - these instruments, through code, can be embedded into one another and create financial products that were not possible before.

An example could be prediction markets with insurance to cover volatility or black swan events or NFT based gaming done through borrowing NFTs from a platform where the lender is earning interest on his investment. There can be more nuanced products that we’ll see once the market starts maturing.

A few terms and instruments that enable these legos are:

Stablecoins:

Cryptocurrencies tend to fluctuate, making them hard for everyday use. Values of currencies like the dollar or commodities like gold do change gradually over time. Tough, they are often more drastic for cryptocurrencies.

A stablecoin is a digital currency pegged to a “stable” reserve asset like the U.S. dollar or gold. Stablecoins are designed to reduce volatility relative to unpegged cryptocurrencies like Bitcoin.

Stability is achieved through two commitments. First, the issuer agrees to mint and buy back coins at par. Second, the issuer holds assets to back its obligation to redeem the outstanding stablecoins. This “reserve” provides comfort that the issuer can buy back all outstanding coins on-demand. Reserve assets should be denominated in the currency of the reference asset, remain highly liquid during a crisis, and incur minimal losses in a run or stressed market conditions.

Also, there are variations in Stablecoins in terms of the asset they’re backed with. Primarily there are four types of stablecoins based on the reserve assets:

a. stablecoins backed by Fiat Currency.

Examples:

USDT - Issued and backed by Tether

USDC - Offered by Coinbase and backed by Circle

b. Stablecoins backed by Commodities.

Example:

Digix Gold - Offered by Digix, which has gold reserves equalling the amount of DGX Tokens issued

c. Stablecoins backed by Crypto Assets

Examples:

Terra USD - Issued by South Korea based Terraform Labs and is backed by the supply of Terra’s native token, Luna

DAI - Issued by MakerDAO and is backed by MakerDAO’s natove token MKR

d. Non-Collateralized or Seigniorage-styled Stablecoins - Seigniorage is generally governed by an algorithm or process compared to a currency or asset. In this case, smart contracts on decentralised platforms can serve as independent supporters for the Seigniorage-backed stablecoins

Examples:

Empty Set Dollar - ESD

Basis Cash

Liquidity Pools:

A liquidity pool is a collection of funds locked in a smart contract. Liquidity pools facilitate decentralized trading, lending, and many more functions. To create a market, users called liquidity providers (LP) add an equal value of two tokens in a pool.

Liquidity Pools are the backbone of Decentralized Exchanges, also known as DEXs. For the sake of this article, all you need to know is DEXs like Uniswap, Sushiswap, 0x Protocol run via Liquidity Pools and CEXs or Centralized Exchanges like Coinbase, Binance, Huobi run through ‘Order Books’.

In brief, Order books record all of the ongoing trading activity on the exchange and are a collection of the currently open orders for a given market. They display the different sections for buyers and sellers — the sellers’ section consists of asks, while the buyers’ section has bids.

Yield Farming:

Yield farming is any effort to put crypto-assets to work and generate the most returns possible on those assets.

Liquidity Mining:

Liquidity mining is when a yield farmer gets a new token and records all the expected returns in exchange for the liquidity provided by the farmer.

The reward can be in the form of the native token provided by the farmer or a governance token of the DApp or DAO where they’ve provided tokens.

Smart Contracts:

A smart contract is an automatic and self-executing agreement existing on the blockchain that operates without the need of a central authority or rent-seeking third party. Smart contracts remove unnecessary paperwork and expensive intermediaries required to facilitate traditional contracts, transactions and exchanges while upholding transparency and visibility on the blockchain.

TVL:

Total value locked (TVL) is the overall value of crypto assets deposited in a decentralised finance (DeFi) protocol – or in DeFi protocols generally. It has emerged as a critical metric for gauging interest in that particular sector of the crypto industry.

DApps:

DApps are computer applications maintained by a distributed network of computer nodes instead of a single server.

Use Cases

1. DeFi Lending & Borrowing: Decentralized lending and borrowing remove the barrier of a. Having a suitable credit score & b. having enough collateral to convince the creditworthiness allows anyone to collateralize their digital assets and use this to obtain loans. One can also earn a yield on their assets and participate in the lending market by contributing to lending pools and earning interest on these assets. There is no need for a bank account or checking for creditworthiness with decentralized lending and borrowing.

One might say that lending institutions introduced credit scores to have some certainty on the capital they’re lending out. The party borrowing the funds has a history of repaying loans and is reliable enough. But, the problem is that calculation of these credit scores has been questioned time and again. On some days, it’s difficult for even people with good financial history to get a credit score suitable enough to get a loan or a credit card. Thus, to think about someone who’s newly injected into the banking system to get themselves a loan based on such a score will, on most days, only lead to either disappointment or brobdingnagian interest rates.

2. Prediction Markets: Prediction markets are collections of people speculating on an event’s outcome. At its core, a prediction market is a marketplace where you can buy and sell predictions. Or, to put it more accurately, shares in the outcome of an event.

The issue with centralised prediction markets is that the strength of a prediction market is directly proportional to its size. The more operators and regulators you have, the more they limit access to the markets, reducing effectiveness. Centralisation also means a low betting cap, preventing the participation for high risk/high reward investments - due to regulatory risks.

These institutions also act as an intermediary, charging trading fees and cuts from profits. DeFi prediction markets fundamentally change the outlook as the lack of a central overseer opens up the markets for free and open participation, increasing the potency of such markets. People can also bet on any outcome, anytime they want.

Also, some people’s formerly closed assets are accessible via DeFi prediction markets. For example, certain countries can’t usually access American stocks. However, defi applications can be allowed to do so. DeFi prediction markets The lack of intermediaries eliminates counterparty risk, and the fees collected are noticeably lesser.

3. Payments: Peer-to-peer payments DApps like Flexa and Tornado Cash have made a mark in enabling payments. Jack Dorsey’s Square, renamed Block, is also working on crypto payments. P2P payments are the foundation not just of DeFi, but of blockchain itself.

4. Digital Identity: Blockchain-based digital identity systems paired with DeFi protocols could help access the global economic system. The traditional approach prizes one’s income or accumulated assets as the nominators for creditworthiness. With DeFi-paired digital identity, it’s possible to consider the other practical attributes, such as — financial activities or professional prowess.

Apart from these use cases, DeFi also massively enables functions like Derivatives and Margin Trading, Insurance and even tokenisation of real-world assets to work on the blockchain.

The Bitcoin Dilemma

A lot of people think that DeFi is based on Bitcoin. But, this is a partial truth. While Bitcoin led this whole movement of having an open financial structure, it is somewhat lagging in this race instead of what BTC Maximalists might think.

The problem is that one can’t build projects on top of Bitcoin’s blockchain, making it difficult to deploy new mechanisms and frameworks that’ll entice people to come on the platform. It is incredibly difficult and expensive to mint new bitcoins, thus leaving very little room for open governance for newer projects.

Ethereum is solving this problem. Most DeFi projects are based on Ethereum, giving them the flexibility to launch their tokens for governance and rewarding, make new financial products and platforms like DEXs, lending protocols and much more.

The plot twist here is that Ethereum has slowly started facing competition while being widely popular. This is primarily due to the issues of its reduced capacity to process transactions - making them highly expensive (since gas fees are added to them). This has led to projects shifting allegiance to new and emerging protocols like Polygon, a Layer 2 Ethereum scaling solution that came out of India.

Terra is a new age protocol - developed by Do Kwon and Daniel Shin - based out of South Korea is a finance specific protocol that not only has its own crypto asset-backed stablecoins - Terra-USD(UST), which is pegged to the US Dollar, Terra JPY - pegged to the Japanese Yen, TerraKWD - pegged to the Korean Won and even TerraSDR - which is pegged to international Monetary Funds’ SDR (Special Drawing Rights). Terra has caught attention due to its focus and partnership on enabling ease of payments through products like Chai - a crypto-enabled eCommerce payment system partnered with the most prominent players in the country - which lets people pay in crypto and turns it to fiat for the vendors.

Another protocol that is seeing significant traction is - Fantom. It is a decentralized, open-source, permissionless blockchain that offers high throughput. It was built to better facilitate the use of smart contracts for dapps. The USP of this protocol is that it has an EVM - (Ethereum Virtual Machine) embedded in the system, which not only lets developers that have built DApps on Ethereum to port them to Fantom but also has its ERC20 equivalent token which through the same route can be used on the Ethereum network.

Projects

While several projects are experimenting with DeFi, each trying to solve a significant problem in different sectors, here are a few projects that have gained enormous traction in terms of eyeballs and asset volumes:

  1. Aave - Aave (AAVE), initiated in 2017 under the name ETHLend, is one of the original DeFi platforms on the market. Aave is a decentralised liquidity platform that allows for borrowing assets and earning rewards on deposits. It brings together lenders and borrowers in a decentralised space to allow for an equal opportunity lending system. You can also earn rewards and discounts by staking the AAVE coin on the Aave DeFi platform.
  2. Compound - Compound is a DeFi borrowing and lending protocol built on Ethereum that functions as a money market blockchain version. One can diversify their investment portfolio by putting their savings into Compound. In return, the protocol will keep paying interest to the LP(Liquidity Provider) for the entire period the money is kept. However, suppose one wishes to make some investments elsewhere. In that case, they can also take loans from the protocol and will pay interest to Compound for borrowing money from the protocol’s liquidity pool.
  3. Synthetix - Yet another Ethereum-based protocol, Synthetix is specifically geared toward issuing synthetic assets or “synths,” financial instruments in the form of ERC-20 smart contracts that track and provide returns on an asset without demanding you to hold a said asset. Synths can be traded in a number of realms – cryptocurrencies, fiat currencies, indices, inverses, real-world assets – on Kwenta, Synthetix’s DEX. The Synthetix Network Token (SNX) can provide collateral against issued Synths.

Synths operate via decentralised oracles or smart contract-based price discovery protocols. These are used to track asset prices, allowing traders to hold and exchange Synths as if they owned the underlying assets.

The Caveat

The Web3 space is trying hard to make a case for itself, and to be honest; the promises are very appealing. But these developments should be taken with a pinch of salt. While there are some significant developments and these early iterations of products are gaining confidence, there is still a lot of ground left to be covered.

Today, the fundamental promise of banking the underbanked, i.e., 1.7 billion unbanked population as per the World Bank, has little to no access to these products. While it is true that we are very early and still working on trial and error methods to find suitable, legal and most importantly, equitable solutions, it’ll take a few years before we see this dream turning into reality.

Also, the second biggest arbitrage that web3 world promises is that lines of code will determine the nature of all transactions and since it’s code, leaving no room for errors and emotions like greed and mortality. But, this also means that on a technical level, most of these structures can only be understood and accessed by people understanding these languages on a technical level. They determine the functionality of such products. Ideally, in a high trust society - this would work perfectly well. Still, just like there is no existence of an ideally rational being as explained by Adam Smith beyond theory books, the same applies here.

Finally, several problems need to be solved at scale, and regulatory approvals stand at the top of this queue. Most nations and their central banks are closely monitoring these developments and are yet to recognize them under law. Mind you, this does not make these practices illegal unless specifically mentioned but also make them fall under the grey area of uncertainty.

By a huge margin, the benefits of DeFi outweigh the setbacks. If successfully implemented, DeFi will disrupt the unchallenged dominance held by large centralized organizations by providing the value benefits of transparency, composability, decentralization, and the elimination of intermediaries. And, with the growing interest in DeFi, there is potential for a plethora of opportunities in the sector, particularly once DeFi becomes mainstream and gets accepted by the general public.

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