Decentralized Finance (DeFi) is a decentralized, open-source, and trustless ecosystem of financial applications/services based on public blockchains, primarily Ethereum.
The DeFi ecosystem encompasses all aspects of financial services and transactions, including lending, lending, and trading within decentralized structures. Any internet user can interact with the ecosystem and manage assets through peer-to-peer (P2P) and decentralized applications (dApps).
Why is the DeFi ecosystem needed?
If Bitcoin is a peer-to-peer electronic money system, then DeFi is a peer-to-peer electronic financial instrument system. The ecosystem of decentralized finance can provide anyone with access to traditional financial services, eliminating the need for intermediaries and lowering barriers to entry.
DeFi applications and services are potentially useful for residents of countries with underdeveloped or unstable economies. DeFi services are also in demand in developed countries, especially in the field of lending, investment, and the development of new models of income generation.
What are the key features and benefits of DeFi?
Decentralization and self-government
DeFi lacks centralized governance structures: the rules for conducting business operations are written in a smart contract. Once the smart contract is up and running, the DeFi app can run on its own with little or no human intervention.
The source code of DeFi applications is open to audit, which allows anyone to understand the functionality of the contract or identify bugs. All transactional activity is public in nature — transactions are pseudo-anonymous by default.
Most DeFi applications are available to any internet user.
The DeFi ecosystem is inclusive — anyone can create and use an app. Unlike the traditional financial sector, there are no controllers and accounts that require complex forms to be filled out. Through wallets, users interact directly with smart contracts.
User experience flexibility
The DeFi ecosystem provides a flexible user experience. If the user does not like the interface of the application, he can use a third-party interface or create his own. Smart contracts are like an open API that anyone can build applications for.
New DeFi applications can be created by combining other DeFi products (stablecoins, decentralized exchanges, prediction markets, etc.). This feature of DeFi resembles a model in which a certain structure can be assembled in various combinations.
Monolithos experts have identified the following benefits of DeFi:
- The main advantage of DeFi services is hidden in the name itself. Decentralization. Thanks to it, control over the ecosystem is evenly distributed among many players. There is no excessive regulation, transactions are transparent, fast execution, there is no long chain of intermediaries. This is convenient, for example, when lending. There is no intermediary bank, which means that the one who gives the loan does not have to share the profits with the bank, which accepts deposits at one interest rate, but issues loans at a much higher rate. There is no such gap in DeFi lending.
- DeFi services are governed by smart contracts and voting. Smart contracts allow you to establish the rule of law in the ecosystem, to create clear rules of the game.
- Open-source. As in the case of the blockchain itself, services using open-source protocols are more trustworthy: they can be verified, they can be modified, and can be used in other services.
How and where is DeFi used?
Stablecoins are cryptocurrencies whose value is tied to an underlying asset (such as the US dollar). Stablecoins are backed by fiat currencies, baskets of currencies, cryptocurrencies (such as ETH), physical assets (such as gold), or a combination of these assets.
USD-backed stablecoins are effectively the right to claim fiat collateral from a centralized vault. The value of USD-pegged stablecoins is provided by the issuer itself, and their use is often associated with AML / KYC procedures. There are already known cases when accounts of stablecoin holders were frozen and closed.
The MakerDAO project, for example, offers a different stablecoin model. It is an Ethereum-based smart contract platform. On its basis, the decentralized stablecoin Dai was created.
Dai’s issuing scheme can be compared to issuing money backed by gold. The difference is that Ether is used instead of gold. The user sends a certain amount of ETH or other ERC-20 tokens (for example, BAT) to the smart contract, which issues the token. This type of smart contract is called Collateralized Debt Position (CDP).
The generated Dai tokens represent a collateralized debt to MakerDAO (Decentralized Issuance System).
MakerDAO uses two tokens — in addition to Dai, it is also the Maker Utility Token (MKR). By analogy with the “gas” in Ethereum, MKR acts as a kind of “fuel” — it is used to pay off fees for using smart contracts. After the commission is paid, MKR tokens are “burned,” thus supporting the demand.
MKR performs the function of governance — the token is used to vote for such a key aspect of the survival and functioning of the project as risk management, as well as the business logic of the platform. Each MKR holder has the right to vote and the ability to create a new proposal, and the proposal with the highest number of votes automatically receive the status of “important,” influencing the further development of the project.
Non-custodial landing protocols
One of the popular use cases for DeFi is to obtain loans without the involvement of a trusted party or intermediary such as a bank or corporation.
Non-custodial landing protocols use smart contracts to mitigate counterparty risks and lower transaction costs.
MakerDAO is one of the first applications of its kind. Following MakerDAO, other protocols appeared — Compound, Fulcrum, Aave. Compound and Fulcrum create capital pools allowing users to lend or borrow crypto assets including Dai, USDC, ETH, and others.
When choosing a protocol, one should take into account not only the size of the interest rate but also other factors, including the risk of certain smart contracts, loan security, and pool liquidity.
Decentralized Exchanges (DEX)
A decentralized exchange (DEX) is a blockchain-based exchange that does not store users’ funds and personal data on its servers and acts solely as a platform for matching orders to buy or sell assets.
Decentralized exchanges offer a new model for trading and exchanging assets, eliminating KYC procedures, dependence on one intermediary, and oligopoly (a market with a limited number of large players).
One of the most successful and actively developing decentralized exchanges is Uniswap, which combines trading and lending options.
dYdX provides users with a summary of the spot prices and liquidity of lending operations on many exchanges.
Other popular DEXs and protocols include IDEX, 0x, AirSwap, Bancor, Kyber, Paradex, Radar Relay, Loopring.
Peer-to-peer prediction markets
Prediction markets are platforms for placing bets on the outcomes of events, games, elections, and more.
Many jurisdictions prohibit gambling and betting on certain events, including elections, sports, court proceedings, and other controversial events.
Forecasting market platforms and applications rely on the wisdom of the crowd to determine the likelihood of a particular outcome. The data of modern scientific research support the notion that a large number of people (“crowd”) always predict the consequences of certain events with greater accuracy than individual experts.
Augur is a platform for creating peer-to-peer prediction markets where anyone can place bets. The Augur protocol allows you to buy and sell shares of a potential profit.
The Numerai platform is a hedge fund that uses AI to find the most efficient ways to trade securities. The fund’s employees — data processing and analysis specialists — create algorithms for predicting transactions and place bets on their predictions using NMR tokens. The amount of remuneration is determined by the accuracy of the forecast and the amount of the bet.
Currently, protocols are being created to issue synthetic assets and derivatives through smart contracts.
UMA (Universal Market Access) develops a derivatives platform to provide financial products with standardized contracts.
The Synthetix team is developing a protocol to create and release synthetic assets.
Platforms for the issue of tokenized securities (Security Token Offering)
Tokenized securities issuance platforms decentralize the process of issuing or creating securities, which in traditional finance requires intermediaries such as investment banks.
The equivalent of the securities market in the DeFi sector is the security token market. STOs imply the issuance of digital assets in full compliance with legal requirements, which provides a higher degree of protection of investor rights and a decrease in regulatory risks for issuers.
If during the ICO participants are usually offered utility tokens, then in the case of STOs, tokens are issued that have properties of securities (security tokens) and meet the requirements of securities legislation.
They are typically backed by assets or a right to a portion of the profits of the issuing company, can be an investment, debt, derivative, or digital portion of an asset, and, as the name suggests, are generally recognized as securities.
The advantage of security tokens is the ability to divide the underlying asset into small units, which makes it more liquid and accessible to investors (“fractional ownership”). For example, instead of investing in the purchase of an apartment for subsequent lease, an investor can buy a token representing a share in such an apartment and giving the right to receive a proportional part of the income from its lease. Moreover, despite the low liquidity of real estate as an underlying asset, the liquidity of tokens can be high.
Today, several platforms provide users with tools for issuing tokenized securities, validating subsequent transactions, an interface, and functionality for interacting with investors and conducting corporate events such as buyouts, dividend payments, voting, etc. (Polymath, Tokeny, Harbor, Securitize).
Although the asset management segment in the DeFi sector is comparatively small compared to that in traditional finance, some projects are offering decentralized solutions, such as Melon. Its users can manage their own and others’ assets in the form of ETH and ERC-20 tokens.
The Melon Protocol is also decentralized — it is administered by the community, not the board of directors.
Another investment solution is Set Protocol, which allows the creation of Sets, ERC20 tokens representing a set of underlying assets. This model is reminiscent of investing in ETFs in traditional finance.
Arwen is an example of a DeFi escrow project. An Arwen user can trade on centralized exchanges without placing funds on them.
Arwen enables traders to securely access the liquidity of centralized exchanges. At the same time, users have no reason to worry about the threats of hacker attacks.
What are the disadvantages and risks of DeFi?
Systemic risks in the DeFi sector are liquidity and credit risks. Another problem with DeFi systems that use cryptocurrencies as collateral is volatility. If the price of underlying assets locked in a CDP falls rapidly, massive asset liquidation takes place and the system may collapse.
To mitigate these risks, DeFi protocols are currently trying to provide loans with excess assets, which has a downward impact on the price of these assets.
The risk of hacking smart contracts
While working with smart contracts in DeFi eliminates the need for human trust, there remains a need to trust the human-written smart contract code.
Centralizing data flow
Blockchain protocols extract data from the outside world using oracles. If the oracle acts maliciously, the correct execution of the smart contract will be in jeopardy. Centralized data oracles are a vulnerability for DeFi as well, although decentralized alternatives have already been developed.
Lack of capital in DeFi loans
Despite its merits (inclusiveness, etc.), DeFi loans are inferior to loans in the traditional finance sector, since the amounts that can be obtained with appropriate collateral are relatively small.
Monolithos experts have identified the following disadvantages of DeFi:
- The boundaries of responsibility are too vague. Decentralized finance is finance where there is no specific authority responsible for what happens in the ecosystem. The main principle of DeFi platforms is decentralized governance, based on the assumption that all players in an ecosystem are interested in its prosperity and therefore will make decisions based on their (and in DeFi ecosystems, this means general) economic benefits. But that might not work. This is not only about openly malicious actions aimed at the collapse of the ecosystem or the seizure of control, but also about the reluctance of the ecosystem players to somehow participate in the development of the service. This is the case when indifference is equivalent to malicious action.
- Control over development is in the hands of one team. This flaw is not common to all DeFi services, because many platforms involve collaborating with users on improvements, but many face it. In particular, problems arise when the responsibility is delegated to the community.
- The hype around the DeFi market. Any hype plays both to help and against the market. An overheated market will burst sooner or later. The situation is very similar to the 2017 ICO bubble. On the other hand, if you follow the well-known Gartner chart, then the bubble will be followed by a fall, followed by a smooth growth and real application of technologies.
Where to track the main indicators of the DeFi sector?
- defipulse.com — the number of funds blocked in DeFi protocols.
- defimarketcap.io is the market cap of DeFi protocol tokens.
- defiprime.com — interest rates in DeFi protocols.
- defiscore.io — risk assessment of DeFi protocols.
- dappradar.com — Data on decentralized applications.
What is DeFi Profitable Farming?
Profitable farming (from English — yield farming) is the process of obtaining native tokens through any form of interaction with DeFi protocols. For example, for providing liquidity to lending protocols or decentralized exchanges (liquidity mining), as well as for obtaining loans and participating in voting.
In theory, such encouragement is intended to stimulate user activity, but in practice, it leads to market manipulations, reminiscent of the ICO bubble in 2017. A good example is the YFI token from the Yearn Finance project, which has grown from $ 35 to $ 4,500 in just a week since launch.
Which DeFi protocols provide the ability to mine liquidity and profitable farming?
- Synthetix distributes SNX tokens for providing collateral to the platform.
- Compound distributes COMP tokens to users who lend/borrow.
- Balancer distributes BAL tokens to whitelisted liquidity pool creators.
Similar programs are offered by the mStable, BZX, Ampleforth, and Curve projects.