DeFi is one of the hottest topics in the crypto space. In this guide, let’s take a closer look at what DeFi is and how it works. This will also be the first in a series of guides on the DeFi landscape.
A Pretext to DeFi: Current Economic Landscape
The traditional finance market is centralized. Central authorities issue the regular currency that drives our economy and used for every trade like the government and banks. Therefore, the power to manage and regulate the flow and supply of such currencies in the market resides to them. We also pass the control of our assets to various financial organizations like banks in expectations of getting higher returns. The problem with this is since all the control and fund is centralized, the risk is also at the center.
This raises a couple of questions.
What if central bodies decide to print more such currencies to tackle a financial crisis and it backfires? Central bodies consist of humans and errors can happen in their judgment. Take the case of the Venezuelan government – their poor monetary policies, including printing huge amounts of money amid oil price drop – resulted in inflation exceeding 1,000,000% as per the IMF data. This has destroyed its economic balance.
You stack your money in banks and other financial institutions for savings and often put in fixed and recurring deposits to earn profits. These organizations invest that money in share markets as well as give loans at high-interest rates earning huge profit. But only a small fraction of that is returned to the depositors, i.e. us. With the global inflation rate vacillating around 3.64% (2% in the US), the actual value of this return becomes even less. So some of us choose to invest.
Now when it comes to investing, you put your trust in financial advisors to advise you on schemes, mutual funds, and share market in exchange for a cut in your return. The return here is more but it’s risky as the advisors can also make mistakes or fail to see market risk. So you receive just a fraction of the money from the investment.
In the case of the share market, how many of us directly hold shares of companies?
Though compared to 2017, now middle-class people own much more stock but it’s still widely disparate to what the rich hold. NYU economist Edward Wolff’s research showcases that the top 1% of households by wealth owned nearly 38% of all stocks shares. While the top 10% of Americans have investments in stocks over $1,000,000, the next 40% have an average of $100,000, with most of the rest having none. There are people in countries where they don’t even have access to the stock market.
Also, point to note here is we have very little to no say in where our money gets invested and how it is handled by these corporations – meaning there’s a lack of transparency present.
All the issues arise because of the centralization of the finance that underpins the global economy, but it is definitely not an open system.
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The solution is to decentralize.
Aren’t Cryptocurrencies Supposed To Tackle Decentralization?
Bitcoin and other early crypto coins have offered a way of secure peer-to-peer trading without the need for intermediaries like a bank for trade settlement. This gives users complete control over their assets.
However, keep in mind that these cryptocurrencies have not really decentralized the financial system. They have just decentralized the issuing of money and its storage. There are a couple of problems exist which are hindering blockchain from making the financial system genuinely decentralized.
- While the cryptocurrencies are decentralized, they can mostly be accessed via centralized access points such as exchanges.
- Most of these crypto projects are managed through centralized companies that lack accountability or transparency.
What is DeFi?
DeFi is short for Decentralized Finance. Decentralized Finance includes digital assets, protocols, smart contracts, and dApps built on a blockchain.
Given the flexibility and amount of development, the Ethereum platform is the primary choice for the DeFi application, but that doesn’t mean it’s the only blockchain platform.
Think of DeFi as an open financial ecosystem where you can build various small financial tools and services in a decentralized manner. Since these are applications built on a particular blockchain, they can be combined, modified, and integrated according to your needs. Just like a lego!
What is DeFi Offering?
DeFi is offering you control of your own assets.
Though many new-age banks and fintech firms promise to provide more control to the users, in reality, you are still trusting in them to manage your funds. The objective of DeFi is to give you full control of your assets, and it can because of decentralization and blockchain technology. Also, many developers of financial apps are adopting open-source protocols for trading through decentralized exchanges.
The fact that all protocols are open-source allows anyone to build new financial products on top of them. Developers across the globe can collaborate with each other to create new products leading to faster innovation and a secure network.
Anyone can store, trade, and invest their assets in blockchain securely and earn a much higher return than from the traditional financial system. Since there no intermediaries handling your asset, you have complete control over your investments.
The DeFi Ecosystem and Its Products
The various products involved in DeFi are also collectively referred to as open finance since it’s an ecosystem where blockchains, digital assets, open protocols are integrated with conventional financial structures.
Let’s go through some of these products.
Open Lending Protocols
As the name suggests, this is a digital money lending platform built on a blockchain. Open Lending Protocols have probably become the most popular among other open finance sectors in recent years, thanks to the recent extensive use of Dai, other peer-to-peer protocols such as Dharma, and liquidity pool designs such as Compound Finance.
Just like a bank, users deposit their money and when someone else borrows the digital assets they earn interests. However, instead of intermediaries, here the smart contracts dictate the loan terms, connect lenders and borrowers, and are in charge of distributing the interest. Due to the inherent transparency of the blockchain and no middleman, the lender earns higher returns and more clearly understands the risks.
The Open Lending Protocol is strictly based on a public blockchain like Ethereum and thanks to the importance of its capability to lend digital assets can be widely adopted globally. It offers several advantages over the traditional lending/crediting services –
- Integration with digital asset lending or borrowing
- Collateralization of digital assets in case of defaulting on the loan
- Instantaneous settlement of transactions and new secured lending methods
- Standardization and interoperability which can also reduce costs with automation
- No credit checks, meaning broader access to people that cannot tap into traditional services
MakerDAO has become the most prevalent decentralized lending protocol this year. This can be observed as the firm has proposed multiple stability fee raises in order to maintain parity with its Dai-USD price peg, caused by scaling problems.
Other such protocols are Dharma and BlockFi. The later allows users to borrow and lend digital assets but employs familiar credit models like credit checks and a company processing loan requests on the backend.
Unlike other crypto coins which have a volatile value, stablecoins are blockchain-issued tokens designed to hold on to a specific value. This is usually done by pegging it with fiat currencies like the US dollar, but oftentimes with other assets like gold. Stablecoin incorporates collateral to accommodate for the price variation.
Stablecoins can be primarily categorized into 3 types:
#1 Fiat-collateralized –
These types of stablecoins are the most popular. These coins store their value in fiat currencies like the US dollar or Euro and are usually supposed to be redeemable at a 1:1 ratio with the pegged currency.
These regulatory-compliant and audited coins have great opportunities for mass adoption since active measures are taken to maintain the peg. A fiat currency reserve is kept in a bank to back the current circulating supply of the token. Tether, Gemini Dollars, and USDC are other such stablecoins.
However, this makes it centralized, thus posing the counterparty risk. These stablecoins need trust in a centralized entity and are therefore vulnerable to loss of peg and destabilization from external geopolitical factors. It also becomes risky when there is a lack of trust in the central party’s ability to cover the issued IOUs. This issue is solved by making these stablecoins auditable.
Note that firms behind these stablecoins get their revenue from the interest earned on the deposited funds (in fiat) from users that they store in a bank account. Research suggests that eventually, this rate margin would come down and benefit the customer more.
#2 Crypto-collateralized –
These decentralized stablecoins are backed by crypto assets as collateral. They rely on trustless issuance and maintain their 1:1 peg against assets through various methods including over-collateralization and incentives.
The trustless issuance makes this type of coin wholly transparent and the reserve auditable. Maker’s Dai is such a stablecoin. ETH, The underlying asset here is over-collateralized against the loaned Dai based on the current collateralization ratio. For example, the DAI stablecoin is pegged to USD and backed by Ether. For every DAI, there are $1.50 worth of Ether (ETH) coins locked into the MakerDAO smart contract as collateral.
The collateral is held in a smart contract which is accessible only when stablecoin debt is cleared. If excess collateral falls below a certain predetermined level, the stablecoin system can close the smart contract and sold the collateral.
The volatility of the underlying collateral is the biggest threat to this model. If the collateral loses too much value, the system becomes under-collateralized and fallback procedures like stablecoin liquidation could be enabled.
Among these stablecoins, Maker’s Dai is an interesting stablecoin as it is only composed of borrowers, while the protocol itself is the lender. Thus it mints/burns the Dai based on the governance and CDP parameters. This stablecoin offers decentralized leverage and is censorship-resistant.
#3 Non-collateralized –
These types of stablecoins are neither centralized nor over-collateralized with crypto assets. Based on an algorithm, the system supplies more tokens with increased demand while the price of each token is lowered and vice versa in order to maintain a stable peg.
“Basis” is such a stablecoin example but got shut down following regulatory concerns with its model late in 2018.
The risk here is that it is difficult to maintain stability while constantly contracting the money supply. Also, it requires that participants believe that the demand will increase in the future. In case demand stops growing, the stablecoin will not be able to maintain its peg.
Exchanges and Open Marketplaces
Unlike centralized exchanges like Coinbase, decentralized exchanges have peer-to-peer transactions of digital assets between two parties on the blockchain with no third-parties involved. The advantage of this approach is that there are no sign-ups, no identity verification, or any withdrawal fees.
In recent years, a couple of decentralized exchanges (DEXs) and P2P marketplaces have been created. These exchanges are in the early stage of adoption and thus don’t observe a substantial volume due to their small number and non-friendly User Interfaces.
Like Centralized exchanges, DEXs also employ some highly innovative methods like atomic swap for swapping crypto tokens or other non-custodial methods for exchanging one asset for another with minimal settlement time or risk. Though many DEXs claim to be decentralized and non-custodial, that may not be the case. So it’s always better to do your own research before using them.
Eg. IDEX is the most popular DEX – a dapp on Ethereum blockchain. Other DEXs include Binance DEX, Radar Relay, and EtherDelta. Kyber Network and 0x are two other decentralized exchange examples.
Other types of open marketplaces focus on non-fungible tokens (NFTs) exchange. These tokens are often referred to as crypto-collectibles. OpenSea and Rarebits are two such platforms that help the exploration, discovery and buying or selling of such crypto-assets. There are also some marketplaces like District0X which even let you create your own marketplaces and vote on governance procedures.
Ethereum-based P2P marketplaces have outstanding long-term potential. They may cover markets for native digital assets and tokenized real-world assets in the near future.
Issuance and Invest Management Platforms
This sector covers a broad range of platforms. A significant portion of issuance platforms is honing in on the security token market. This platform also includes exchanges like tZERO from Overstock which also acts as issuance mediums.
Polymath and Harbor are two such security token issuance platforms that provide the necessary framework, tools, and resources for any issuers to launch tokenized securities on a blockchain. They have their own standardized token contracts for securities such as the ST-20 and R-Token. It enables them to automate compliance and customize trade parameters to meet the regulatory requirements. Additionally, they are also integrated with various service providers such as custodians, broker-dealers, legal entities to assist issuers.
There are various smart contract-based asset management platforms like Melonport that integrates price feeds, exchanges, compliance, risk management, etc. These platforms offer a front-end digital asset management interface built on IPFS.
As more players especially institutions enter open financial markets, these issuance platforms and investment management frameworks are likely to gain momentum rapidly.
How Decentralized Is DeFi Really?
In crypto space, it is said –
“A system is decentralized only as its most central component.”
This is part truth since decentralization exists in sequence and on multiple levels. The degree of decentralization in DeFi services varies since neither every component can be decentralized nor it should be
For example, let’s talk about categorizing decentralized Lending Protocols which can be done based on common components all DeFi lending protocols, such as custody, price feeds, provision of margin call liquidity, initiation of margin calls, protocol development, and interest rate determination.
Degree 0 Defi aka CeFi: Centralized Finance (CeFi) products are custodial in nature, use centralized price feeds, and initiate margin calls, provide liquidity for their margin calls, and centrally determine interest rates all centrally.
Examples – BlockFi, SALT, Celsius, Nexo.
Degree 1 DeFi: These categories of DeFi products are non-custodial but use centralized price feeds, initiate margin calls centrally, provide liquidity centrally, centrally determine interest rates, as well as centrally administer updates and platform developments.
Examples – Dharma.
Degree 2 DeFi: These level 2 DeFi products are non-custodial but have one additional decentralized component from the list while rest are centrally operated.
Examples – Expo, Nuo, ETHLend.
Degree 3 DeFi: Degree 3 DeFi products are also non-custodial and have permissionless initiation of margin calls and provision of margin call liquidity, while the rest are centrally administered.
Examples – MakerDAO, Compound.
Degree 4 DeFi: What’s different in these types of DeFi products are in addition to being non-custodial, having permissionless margin calls and provision of margin call liquidity, its price feeds are decentralized, while the rest two are centralized.
Examples – dYdX, Fulcrum.
Degree 5 DeFi: Here, the interest rate determination is decentralized along with the first three components in Degree 4 DeFi, but the control for the platform developments and updates is centralized.
Examples – bZx.
Degree 6 DeFi: In the last category every component of DeFi should be decentralized. But as of now no DeFi protocol is completely decentralized.
Similarly, for Stablecoins also, except for a few like DAI, not all stablecoins are decentralized. They are simply tokens that represent fiat currency deposits held in a bank somewhere. That’s why you can tokenize your asset and move around the blockchain, but the need to redeem and manage the money physically exists.
Until the law completely adapts to DeFi services, there will always be some form of centralization. For example, take the case of buying a property on the blockchain. Though you can tokenize the deed, the law and the court of that country should recognize that.
Is There Any Risk Involved With DeFi?
With any high return product, there is always some risk involved and DeFi has its fair share too.
Securely handling cryptocurrencies and finance tools require specialized knowledge, so of course, there’s a risk factor involved. It’s the user’s responsibility to keep their key and holdings secret, use a hardware wallet and multi-factor authentication.
The infamous DAO hack happened in June 2016. During the incident, the hacker managed to transfer one-third of DAO funds to another account by exploiting a vulnerability in its coding. This forced the Ethereum community to hard-fork the blockchain to restore the funds. DApp and Smart contract security has since become much tougher, but it would be irresponsible to take it for granted. Some DeFi tools have gone through security audits – for example, Dai has received four security audits so far. Further, there are firms like the Nexus Mutual that have taken the initiative to develop insurance to cover issues like smart contract failure.
As a DeFi user, you must keep yourself updated with the changing terms of services between various DeFi products, wallets, exchanges, and crypto projects. Some DeFi products can add new dimensions that are paired with DAOs that govern the protocol or platform. For example, MarkDAO token holders can vote on the stability fee of Dai, which has experienced its value varying between less than 1% to 20% so far.
As with the traditional currency, investors usually use historical data and benchmarks such as the annual inflation of a currency and the risk-free rate of return to evaluate investment opportunities. But in the case of DeFi, the lack of extensive historical data and benchmarks makes it hard to assess the risk of investments in DeFi.
To mitigate these risks, tokens like cDai (Compound Dai) have been proposed. cDai automatically gains variable interest using the compound lending protocol. This will allow users to invest in DeFi products relatively risk-free.
The DeFi market is tiny compared to traditional finance, but it has picked up its pace rapidly since last year. With more projects and financial dApps we can expect to reach a genuinely decentralized financial reality where the traditional finance market is interoperating with digital assets and blockchain in perfect sync.
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