Understanding DeFi: Decentralized Finance Explained

DeFi or Decentralized Finance, as it is called , is a financial framework that enables common financial services and activities like borrowing, lending, and trading to occur and be managed without the need to rely on any controlling institutions such as banks. DeFi applications find use in banking, insurance, bonds, money markets and more. DeFi is implemented via Decentralized Applications (Dapps), most of which are hosted on the Ethereum platform. Don’t know what Ethereum is? Read this introductory piece here.

The Total Value Locked across DeFi apps can be seen as a growth indicator of the DeFi ecosystem. In 2019 it was around $275 million. But then 2020 clocked a high of $1.2 billion. As of April 2021, it stands at $67 billion in Ethereum alone.

Types of DeFi Applications

1. Centralized 

Custodial, uses centralized price feeds, centrally-determined interest rates, centrally-provided liquidity for margin calls. For example, Salt, BlockFi, Nexo and Celsius

2. Semi-Decentralized

Non-custodial, decentralized price feeds, permissionless initiation of margin calls, permissionless margin liquidity, decentralized interest rate determination, decentralized platform development/updates. For Example, Compound, MakerDAO, dYdX, and bZx

3. Fully Decentralized

Every component is decentralized. Note: No DeFi protocol is completely decentralized yet.

Popular DeFi Crypto Implementations

1. Popular DeFi Crypto Implementations

Cryptocurrencies are notoriously volatile, exhibiting intraday swings of over 10%. Stablecoins pegged to other stable assets (e.g. the USD) attempt to address this volatility. Tether (USDT) was the earliest stablecoins but it is centralized and backed by $1 in the issuer’s bank account. This requires that users must believe that the USD reserves are fully collateralized and actually exist.

Decentralized stablecoins, created via an over-collateralization method, working on decentralized ledgers provide a reliable solution. They are governed by decentralized autonomous organizations. Anyone can publicly audit their reserves.

Noted Decentralized Stablecoin Defi Project – MakerDAO

Maker is a smart-contract platform that runs on the Ethereum blockchain and its governance token is known as Maker (MKR). MKR holders have voting rights proportional to the amount of MKR tokens they own. This makes Maker a Decentralized Autonomous Organization (DAO). Their vote on parameters governing the Maker Protocol is vital in keeping the ecosystem healthy, as well as ensuring that its Stablecoin Token remains pegged to $1.

2. Decentralized Lending and Borrowing

Borrowing from banks requires having a good credit score and having sufficient collateral to assure that one is credit-worthy and able to repay a loan.

Decentralized lending and borrowing remove this barrier, allowing anyone to collateralize their digital assets to obtain loans. Infact, it’s also possible to earn a yield by contributing to lending pools and earning interest on these assets.

Noted Decentralized Lending and Borrowing Defi Project – Aave

Aave is another decentralized lending and borrowing DeFi Application similar to compound, albeit offering more assets (24) and more features plus flexibility to its users. It operates however similarly to compound wherein lenders can provide liquidity by depositing cryptocurrencies into the available lending pools and earn interest. Borrowers can take loans by tapping into these liquidity pools and pay interest. In addition , it offers:

• Stable and variable interest rates on loan
•  Collateral Swap
•  Repayment with collateral
• Flash loans and Liquidations
• Credit Delegation to other users

3.Decentralized Exchanges

Exchanges like Binance and Coinbase are essentially centralized exchanges, acting both as the intermediaries and custodians of the traded assets. Users of these exchanges are at risk if the exchanges get hacked and are unable to repay their obligations.

Decentralized exchanges aim to solve this issue by allowing users to exchange cryptocurrencies without giving up custody of their coins. By not storing any funds on centralized exchanges, users need not trust the exchanges to stay solvent.

Noted Decentralized Exchange Defi Project – Binance SmartChain

Work in progress innovation project of the centralized Binance Chain, aiming to introduce smart contracts. Expected benefits include short block time, lower fees, security, stability, and chain finality. 

Noted Decentralized Exchange Aggregator Defi Project – 1inch

1inch is a DeFi Application that helps users discover the best trade prices for tokens. It features over 40 sources of liquidity. Instead of swapping tokens from a single DEX’s liquidity pool, 1inch aggregates across various liquidity pools and suggests the most efficient token trade route. The fees charged to use 1inch depends on the fees charged by the underlying DEX. Users holding the 1INCH governance token can vote on the swap fee charged on 1inch’s liquidity pool, governance reward, referral reward, and more.

Noted Decentralized Exchange Defi Project – dydx

dydx is an Order book-based Decentralized Exchange (DEX) operating quite similarly to Centralized Exchanges (CEXs) where users can set buy and sell orders at either their chosen limit prices or at market prices. Asset Custody is where it differentiates from CEXs. In CEXs, assets for the trade are held on the exchanges’ wallets, whereas in dydx, assets for the trade are held on users’ wallets.

dYdX token is its governance token allowing token holders to govern the dYdX Layer 2 protocol built with Starkware to align incentives between traders, liquidity providers, and partners.

4. Decentralized Derivatives

A derivative is a contract whose value is derived from another underlying asset such as stocks, commodities, currencies, indexes, bonds, or interest rates. Traders can use derivatives to hedge their positions and decrease their risk in any particular trade. Derivatives contracts are mainly traded on centralized platforms. DeFi platforms are starting to build decentralized derivatives markets.

5. Decentralized Fund Management

Fund management involves overseeing assets and managing cash flow to generate a return on investments (ROI). In DeFi, some projects are exploring decentralized fund management to allow for transparency in tracking how funds are being managed and the underlying costs involved.

Noted Decentralized Fund Management Defi Project – DefiPulse

DeFiPulse Index (DPI), an index that tracks DeFi tokens’ performance based on a market capitalization-weighted index. This allows exposure to more assets and reduced gas fees by purchase of a single token instead of buying multiple assets individually. There are over 120 DeFi assets available under DeFiPulse Index (DPI).

6. Decentralized Lottery

A concept work in progress involves putting a DeFi Application spin onto lotteries by the elimination of custodianship of the pooled capital into a smart contract on the Ethereum Blockchain. Another variation of it involves linking a simple lottery Dapp to another DeFi Dapp to pool their capital together. The pooled money is then invested into a DeFi lending Dapp and the interest earned is given to a random winner at a set interval. Once the winner is selected, the lottery purchasers get their lottery tickets refunded, ensuring no-loss to all participants.

7. Decentralized Payments

A key role of cryptocurrency is to allow decentralized and trustless value transfer between two parties. With the growth of DeFi, more creative payment methods are being innovated and experimented upon.

8. Decentralized Governance

Governance is central to crypto, however not centralized or concentrated in a few hands but across the entire user base. All DeFi projects issue governance tokens to give users voting power and have a say in the protocol’s roadmap

Summary

DeFi allows users to access financial services anywhere and anytime, as long as one is connected to the Internet. Let’s have a quick recap on some of the things DeFi offers:

• Transparency: A transparent, auditable financial ecosystem.
•  Accessibility: Free access to DeFi applications without fear of
  discrimination on race, gender, beliefs, nationality, or geographical status.
• Efficiency: Programmable money makes it possible to remove the centralized middlemen to create a more affordable and efficient financial market.
• Convenience: Money can now be sent anywhere, anytime, and to anyone with a cryptocurrency wallet. All this for a small fee and with little waiting time.

All of the above have made it possible for users to provide liquidity to earn yields on unproductive assets with no maturation/lock-in period, take loans (with collateral) without paperwork and repay them anytime, and execute automated trading strategies easily. As DeFi continues to grow, there’s already massive interest and entry of institutional and retail investors and it's only just getting started!