With the recent crypto bull run that reached new record highs (and crashed), many are still wondering about the fundamental value of cryptocurrency and blockchain. In this article, you will get an overview of one of the most exciting pillars of the crypto scene – DeFi.
DeFi might still be considered to be in an infant stage of growth, but it has promising potential to become a real powerhouse. According to DeFi Pulse, as of June 2021, the total value locked in DeFicontracts currently exceeds US$60 billion.
(Total value locked = Number of tokens in each protocol *Token value in USD.)
The main objective of DeFi is to take legacy and centralized financial tools and services and replace them with transparent and efficient decentralized applications that allow equal access to everyone.
What is DeFi?
DeFi is blockchain-based applications focused on disrupting traditional financial systems. One of their key objective is to cut out intermediaries such as banks & brokerages and allow market participants to transact peer to peer.
Source: DeFi is a one-way road to transparency and fairness by Blockcast
Some key benefits of DeFi include:
- Anonymity and Pseudonymity– No government ID or personal information needed for access
- Decreased fees and charges
- 24/7 availability
- Ability to handle sophisticated use cases
- Increase control over your financial assets
These DeFi applications are mostly built on the Ethereum platform due to its reliance on smart contacts which are contacts that automatically executes the agreement terms when certain pre-decided conditions are met.
A simple example is – Transfer $100 from James to Alan (agreed terms) only when Alan turns 21 years old (condition)
The DeFi ecosystem in a snapshot
Source: An overview of the DeFi ecosystem by The Block Research
4 Highlights of the DeFi ecosystem
Here are some of the highlights in the DeFi ecosystem:
1 – Decentralized exchanges (DEXs)
The New York Stock Exchange (NYSE) or even Coinbase, are centralized exchanges where orders are routed to and matched by the exchanges.
A decentralized exchange on the other hand is an autonomous peer to peer exchange that connects buyer and sellers of cryptocurrencies, without the need for any authority to oversee and administer transactions.
The advantages of a decentralized exchange include low transaction fees and minimal hacking risk as individuals hold their own tokens instead of relying on one central custody that incentivises hackers to attack.
One of the key disadvantages of a decentralized exchange is the lack of liquidity – having enough buyers and sellers to transact. To attract liquidity, users earn rewards and interest through yield farming and liquidity mining, which we’ll get to in the next section.
2 – Stable coins
Stable coins are cryptocurrencies that can be a digital representation of, or backed by
- fiat currency such as the US dollar,
- commodity such as gold,
- other cryptocurrencies or,
- algorithms
As the name “stable” suggests, it is an attempt to create cryptocurrencies with lower volatility.
An example of a stable coin is Tether, which is pegged 1-to-1 to the US dollar.
Stable coins are widely used for:
- Reducing exposure to volatile crypto assets without fully cashing out into fiat.
- Compared to low bank rates, lending stable coins on decentralised exchanges can potentially earn double-digit returns in Annual Percentage Yield (APY).
- Cross-border remittance; as compared to traditional methods, using stable coins offers lower fees and faster transactions.
If you’re wondering how it works, here’s a beginner’s guide on stable coins.
And if you want to pocket greater yields in crypto, join Chris Ng at this live webinar.
3 – Lending and borrowing platforms
DeFi lending works by having a smart contact serve as an automated digital intermediary. A borrower can directly take a loan and the lender can earn interest through a decentralized platform known as Peer-to-peer (P2P) lending. Due to the volatility of cryptocurrencies, loans are typically over collateralized.
P2P lending is not new. Many marketplaces have sprung up to facilitate these microloans denominated in fiat currencies.
The difference of lending and borrowing in the DeFi space is the decentralized concept – there’s no middleman to facilitate the matching (and even screening) of the lenders. The algorithm does the job.
Source: How DeFi loans work
4 – Prediction markets
Prediction markets are where people speculate on the outcome of a future event.
The speculated events are widespread and diverse from prices to sports championships. Prediction markets work on the principle that the wisdom of the crowds is more accurate than a few experts. These markets crowdsource information from a diverse community with different levels of understanding, to get the most accurate prediction of future outcomes.
DeFi prediction markets such as Polka Markets have benefits such as having little to no censorship and low fees due to the removal of middlemen.
3 interesting DeFi concepts
1 – Yield farming & Liquidity mining
Yield farming is done to generate interest or dividends by investing cryptocurrency in DeFi applications.
Liquidity mining provide liquidity to Decentralised Exchanges (DEXs) that uses the Automated Market Maker (AMM) model for interest and further incentives in the form of tokens.
Liquidity pools consist of many users pooling similar cryptocurrencies. In this shared pot, the price of the tokens is determined by a mathematical formula. One of the most popular AMM is Uniswap which uses the formula:
X * Y = K
X being token A balance, Y being token B balance and K is a constant
This formula at its core works by the principle of supply and demand, where if there is more demand for token A and its supply is reduced, the price of token A relative to token B increases.
Interests and rewards earned through these 2 methods are usually very attractive, however they do carry a high level of risk.
An example of a yield farming platform is Compound.
2 – Oracles
Oracles are key components of the decentralized finance ecosystem because they are inherently closed off from external sources.
Oracles act as bridges for these systems to access external real-world data. Their role is to relay a variety of data from off-chain sources to a smart contract so that smart contacts are only triggered based on accurate information. An example of an Oracle is Chainlink.
Oracles are like Bloomberg terminals, which aggregate data and are often seen as a reliable source of truth for market participants to act, based on the information provided.
3 – Composability
A composable system is defined as a set of components that can be assembled to meet specific user requirements.
It allows different DeFi protocols to communicate, work with each other and create new financial services. This is attractive as it allows unlimited possibilities and combinations of new services that also allow assets and features to be brought over from multiple platforms over a shared network.
Like Legos, each piece has a unique feature. Developers can pick, choose and combine parts that they like to create a desired application or outcome
In summary
DeFi is the fastest-growing segment of the cryptocurrency industry. Its decentralized networks extend the reach of financial services to those who were previously excluded.
Despite the industry’s young age, DeFi still presents significant risks. These include the existence of various security vulnerabilities that can affect the operation of smart contracts.
However, it is only a matter of time before these kinks get ironed out and decentralized finance becomes mainstream. Once it becomes mainstream the different aspects of DeFi will impact the everyday finance of people and businesses alike.
That is it for a brief overview of DeFi! As each topic is another rabbit hole, let me know which DeFi topic or project would you like to be covered in detail next? Comment and vote below!
Disclaimer:
This is not financial advice. Any action you take is solely your own responsibility. Cryptocurrencies are extremely volatile, only invest with what you can afford to lose.
I would like to know how to use Uniswap v3, provide liquidity and basically earn money from staking into the top pools which you recommend
Hi Alexander,
Thanks for a most interesting piece on DeFi. I was wondering if you are planning to cover how one can invest in the DeFi ecosystem in a next article. Thanks.