The DeFi Ecosystem : Where Rubber Meets the Road

Friction, inaccessibility, and regulatory uncertainties are some of the major issues plaguing the current banking system. Unfortunately, not everyone is privileged to be banked in the current financial system, nor can they compete financially on a level playing field. The decentralized finance (DeFi) movement is about bridging these gaps and making finance accessible to everyone without any form of censorship. In short, DeFi opens up huge windows of opportunities and allows users to access various financial instruments without any restrictions.

DeFi allows users to utilize financial services such as borrowing, lending, and trading without the need to rely on centralized entities. These financial services are provided via Decentralized Applications (Dapps), the majority of which are deployed on the Ethereum platform.

While it is helpful to understand how Ethereum works to visualize the ecosystem better, you do not need to be an Ethereum expert to utilize the tools offered by DeFi.

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. DeFi Dapps enable users to combine these services to achieve desired financial goals. It is often called money LEGOs due to its composability.

For DeFi Dapps to work, collateral locked into smart contracts is usually required. The cumulative collateral locked in DeFi Dapps is often referred to as the Total Value Locked, which serves as a growth indicator of the DeFi ecosystem.

The DeFi Ecosystem

DeFi Dapps stand to revolutionize traditional financial services by removing the need for any middlemen. DeFi in its current state is still highly nascent and experimental, with many projects rapidly improving each day. As time goes on, DeFi may develop further and look entirely unrecognizable from what it is today. Nevertheless, it is helpful to understand the early beginnings of DeFi, and one can still take advantage of the features offered by DeFi Dapps today with the right know-how.

How Decentralized is DeFi?

It is not easy to answer the question. For simplicity, separate the degrees of decentralization into three categories: centralized, semi-decentralized and completely decentralized.

1. Centralized

○ Characteristics: Custodial, uses centralized price feeds, centrally-determined interest rates, centrally-provided liquidity for margin calls

○ Examples: Salt, BlockFi, Nexo

2. Semi-Decentralized (has one or more of these characteristics but not all)

○ Characteristics: Non-custodial, decentralized price feeds, permissionless initiation of margin calls, permissionless margin liquidity, decentralized interest rate determination, decentralized platform development/updates

○ Examples: Compound, MakerDAO, dYdX, and bZx

3. Completely Decentralized

○ Characteristics: Every component is decentralized

○ Examples: No DeFi protocol is completely decentralized yet.

Currently, most DeFi dapps are sitting in the semi-decentralized category.

DeFi Key Categories

Although Governance is not strictly a DeFi category, it is also important to discuss how protocols govern themselves.

1. Stablecoins

The prices of cryptocurrencies are known to be highly volatile. It is common for cryptocurrencies to have intraday swings of over 10%. To mitigate this volatility, stablecoins that are pegged to other stableassets such as the USD were created.

Tether (USDT) was one of the first centralized stablecoins to be introduced. Every USDT is supposedly backed by $1 in the issuer’s bank account. However, one major downside to USDT is that users need to trust that the USD reserves are fully collateralized and actually exist. Decentralized stablecoins aim to solve this trust issue. They are created via an over-collateralization method, operate fully on decentralized ledgers, and are governed by decentralized autonomous organizations (DAO). Anyone can publicly audit their reserves. While stablecoins are not financial applications themselves, they are essential in making DeFi applications more accessible to everyone by having a stable store of value.

2. Lending and Borrowing

Traditional financial systems require users to have bank accounts to utilize their services, a luxury that 1.7 billion people currently do not have. Borrowing from banks comes with other restrictions, such as having a good credit score and having sufficient collateral to convince the banks that one is credit-worthy and able to repay a loan.

Decentralized lending and borrowing removes this barrier, allowing 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. With decentralized lending and borrowing, there is no need for a bank account nor checking for credit-worthiness.

3. Exchanges

To exchange one cryptocurrency for another, one can use exchanges such as Coinbase or Binance. Exchanges like these are centralized exchanges, meaning they are both the intermediaries and custodians of the traded assets. Users of these exchanges do not have complete control of their assets, putting their assets 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 do not need to trust the exchanges to stay solvent.

4. 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. For example, imagine you are a glove manufacturer and want to hedge yourself from an unexpected increase in rubber price. You can buy a futures contract from your supplier to deliver a specific amount of rubber at a specific future delivery date at an agreed price today.

Derivatives contracts are mainly traded on centralized platforms. DeFi platforms are starting to build decentralized derivatives markets.

5. Fund Management

Fund management is the process of overseeing your assets and managing its cash flow to generate a return on your investments. There are two main types of fund management - active and passive fund management. Active fund management has a management team making investment decisions to beat a particular benchmark, such as the S&P 500. Passive fund management does not have a management team but is designed in such a way to mimic the performance of a particular benchmark as closely as possible.

In DeFi, some projects have started to allow passive fund management to occur in a decentralized manner. The transparency of DeFi makes it easy for users to track how their funds are being managed and understand the cost they will be paying.

6. Lottery

As DeFi continues to evolve, creative and disruptive financial applications will emerge, democratizing accessibility and removing intermediaries. Putting a DeFi spin onto lotteries allows for the removal of custodianship of the pooled capital into a smart contract on the Ethereum Blockchain.

With the modularity of DeFi, it is possible to link a simple lottery Dapp to another DeFi Dapp and create more value. One DeFi Dapp in particular allows participants 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. 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. Insurance

Insurance is a risk management strategy in which an individual receives financial protection or reimbursement against losses from an insurance company in the event of an unfortunate incident. It is common for individuals to purchase insurance on cars, home, health, and life. But is there decentralized insurance for DeFi?

All of the tokens locked within smart contracts are potentially vulnerable to smart contract exploits due to the large potential payout possible. While most projects have gotten their codebases audited, we never know if the smart contracts are truly safe, and there is always a possibility of a hack that may result in a loss. The risks highlight the need for purchasing insurance, especially if one deals with large amounts of funds on DeFi.

9. Governance

Governance is essentially crypto’s idea of business management. In order for DeFi protocols to manage a project, governance tokens are often introduced to give users voting power and have a say in the protocol’s roadmap. Naturally, multiple toolkits and Dapps have also been developed to facilitate effective governance and complement existing systems.

Reference

Darren Lau, Daryl Lau, Teh Sze Jin, Kristian Kho, Erina Azmi, Benjamin Hor, Lucius Fang, Khor Win Win, "How to DeFi: Beginner" , May 2021

Recommended Reading

1. Decentralized Finance Explained (Yos Riady) https://yos.io/2019/12/08/decentralized-finance-explained/

2. A beginner’s guide to DeFi (Linda J. Xie) https://nakamoto.com/beginners-guide-to-defi/

3. A Beginner’s Guide to Decentralized Finance (DeFi) (Coinbase) https://blog.coinbase.com/a-beginners-guide-to-decentralized-finance-defi-574c68ff43c4

4. The Complete Beginner’s Guide to Decentralized Finance (DeFi) (Binance) https://www.binance.vision/blockchain/the-complete-beginners-guide-to-decentralized-finance-defi

5. 2019 Was The Year of DeFi (and Why 2020 Will be Too) (Mason Nystrom) https://consensys.net/blog/news/2019-was-the-year-of-defi-and-why-2020-will-be-too/

6. DeFi: What It Is and Isn’t (Part 1) (Justine Humenansky) https://medium.com/coinmonks/defi-what-it-is-and-isnt-part-1-f7d7e7afee16

7. How Decentralized is DeFi? A Framework for Classifying Lending Protocols (Kyle Kistner) https://hackernoon.com/how-decentralized-is-defi-a-framework-for-classifying-lending-protocols-90981f2c007f

8. How Decentralized is “Decentralized Finance”? (Aaron Hay) https://medium.com/coinmonks/how-decentralized-is-decentralized-finance-89aea3070e8f

9. Mapping Decentralized Finance https://outlierventures.io/wp-content/uploads/2019/06/Mapping-Decentralised-Finance-DeFi-report.pdf