Decentralized Finance (DeFi) is the fastest growing trend in crypto. Considered a revolutionary movement rather than a single service, DeFi is beginning to establish itself as a legitimate global financial tool.
The term Decentralized Finance refers to financial applications that exist on the blockchain. Traditional financial services, such as banking and commerce, all rely on a centralized body acting as an intermediary for all operations. DeFi aims to become a completely decentralized alternative to these services.
Just a few years ago, blockchain technology was used only for asset transfers and exchanges. It had no significant impact on the greater financial world. Now, thanks to DeFi, blockchain technology is beginning to transform almost all aspects of finance. Lending, trading, asset management, and more is now possible on the blockchain and the popularity of DeFi applications is on the rise.
Between mid-2019 and the end of 2020 the total value locked in DeFi applications rose by 3,000 percent from USD 500 mln to USD 15 bln! It is possible to see real-time valuations and track the growth of all DeFi applications through sites such as Defipulse.
Decentralized Finance (DeFi) – how it started
The journey began in 2014 with the advent of Ethereum. Its proposition was to create a smart contract platform allowing people to build any type of application on the blockchain. This gave rise to a multitude of new possibilities and DeFi was one of them.
As soon as the Ethereum blockchain went live in 2015, people began building applications on top of it, known as Decentralized Apps (DApps). The advantage of creating a DApp is that once it is implemented onto the blockchain, it inherits all its features – for example, being open source, difficult to manipulate and having no central control.
DApps can be implemented for everyday use in the same way as any digital app. Initially, popular use-cases for DApps were games, art, music and voting platforms. But after some time, people began looking at other financial applications and started creating DApps for lending, trading, brokerage, insurance and asset management. These applications were dawn of what we now call DeFi.
Ethereum remains the blockchain of choice for most DeFi apps. Competing chains, like EOS and Solana, have also developed DeFi projects within their ecosystems and may provide viable alternatives in the future. Some of the most popular use-cases for DeFi applications currently operating within the Ethereum ecosystem are decentralized exchanges, money markets, yield farming and price oracles. Let’s go over them in more detail.
Commonly known as a DEX, a decentralized exchange facilitates the decentralized swapping or trading of one cryptocurrency to another. Traditional crypto exchanges rely on a centralized model, which requires buyers and sellers to provisionally give up control of their digital assets in order to make a trade. This is to guarantee liquidity. DEXes faced the same need of liquidity, but platforms like Uniswap and Curve managed to resolve this issue through the use of liquidity pools.
Liquidity pools are just large volumes of assets stored in a smart contract. These assets are provided by users and anyone can contribute to the pool.
Why would users want to do that? DEXes charge a small fee for each trade. Fees get distributed to the users who have funds within the liquidity pool, meaning they earn interest on their assets. This concept has given birth to another major application within DeFi – yield farming.
So, crypto assets sit in a liquidity pool and earn a nice little bit of interest. But maybe another liquidity pool will earn more interest? This “grass is always greener” mentality led to the emergence of what is now called yield farming.
Yield farming is about moving assets around from one DeFi platform to another in an attempt to get the best yield. Yield optimization platforms, such as Yearn Finance and Idle, streamline this process so that assets deposited by users are automatically allocated to the DeFi protocol with the highest returns.
In DeFi, money markets are decentralized lending platforms that allow users to earn interest on their cryptocurrency. Lenders simply need to deposit assets into their desired money market to begin earning.
The assets deposited by the lender are sent to a smart contract and can be borrowed by other users. In return, the smart contract issues tokens to the lender which represent their deposited assets plus interest. These tokens can be traded and used like any other crypto token.
Users who wish to become borrowers must first put forth collateral in the form of the asset they plan to borrow. Since it is impossible to carry out a credit check on a decentralized lending platform, the collateral required usually exceeds the amount that can be borrowed.
Overall, it seems like a complex process, but so do all financial lending operations. Companies such as Aave and Compound are helping to simplifying it through their user-friendly platforms. Now, almost anyone who is capable of using the internet, can lend and borrow using DeFi.
Oracles connect smart contracts to the outside world. Blockchains are unable to retrieve information from sources outside their own network. Without oracles communicating this information to the blockchain, DeFi would not be possible.
The majority of oracles operating in the DeFi space are price oracles, like Chainlink. They retrieve the current price of assets from multiple trusted sources, such as major exchanges, and feed that information to the smart contracts central to the operations of DeFi platforms.
Oracles don’t only function as price validators. They can retrieve almost any information required by a smart contract, like sports results, weather forecasts or flight delays.
Concerns associated with DeFi
Many of the concerns with DeFi stem from some of the core features of blockchain and Distributed Ledger Technology. Blockchain transactions are irreversible, meaning that any faulty transaction associated with a DApp cannot easily be changed.
This even applies to coding errors in smart contracts, giving hackers a way to find and exploit any loopholes in the code. Such a loophole was exploited in a DApp during the 2016 DAO attack, where hackers managed to move over 3.6 million ETH into their personal account.
Further concerns arise from the fact that the smart contract codes are open source. Anyone can copy the code and create a new competing platform. While this is generally considered beneficial, it also led to many scams and unregulated websites popping up, raising concerns for the safety of customers.
As there are no custodians or central entities managing the users’ funds, there is no need to provide any personal information while using DeFi applications. Therefore, implementing any KYC (Know your Client) or AML (Anti-money Laundering) measures is currently not possible. A major issue from the perspective of regulatory authorities.
DeFi still has a few hurdles to overcome, but big steps are being taken. Auditing platforms have been developed to check, verify and double-check smart contract codes and release their findings to the public. Platforms like DeFiAudits and DeFiSafety are currently leading the way in the DeFi auditing space.
Why use DeFi?
DeFi lending allows users to make money/crypto just like banks, but in a completely decentralized environment. When a user deposits crypto into a DeFi lending platform, the interest earned on that deposit goes directly to them, with no central entity in place that can change that.
Borrowing funds through a DeFi lending platform also has its benefits. For example, it can be very useful for those who need money urgently, but don’t want to sell their assets.
DEXes give users the opportunity to trade crypto peer-to-peer, without the need for a centralized middleman. When using a DEX to trade, there is no need to provide any personal details, and there is no central point of failure that could be exploited by hackers – users remain in control of their assets during the entire process.
The DeFi movement has recently seen significant growth in the Ethereum ecosystem. By the end of 2020, there were around 130 million ETH addresses registered in the network, with a daily average increase of 100,000 new addresses only in the last quarter of the year!
The number of unique Ethereum addresses linked with DeFi applications has followed the same trend throughout 2020. According to a Consensys report, over 1,195,000 unique Ethereum addresses have interacted with decentralized finance platforms, with over 607,000 new addresses added in Q4 2020 alone. This indicates a significant increase in the number of new participants while confirming the popularity gained by DeFi and its greater adoption in the crypto space.
At the beginning of January, the total value locked in DeFi applications exceeded the USD 20 bn mark. It continues to grow, recently reaching a new all-time high and breaking the level of USD 40 bn in assets locked in the DeFi ecosystem.
These statistics underline the power and significance of the current DeFi movement and its increasing potential use cases.
As time goes by, DeFi will only continue to thrive and expand further into the mainstream. With multiple use-cases and major DeFi platforms already established, we are beginning to see a new revolution in the world of finance.