Decentralized Finance is a term that’s been thrown around the ever-shifting financial services sector the last couple of years, but why has it suddenly become a hot topic in the crypto space? We explain what ‘DeFi’ is by presenting a brief overview to get you started with the “game-changing” movement.
What is DeFi?
DeFi is the creation of basic financial primitives that are implemented on top of permissionless blockchains. Its common goal is to re-create financial services used in the traditional financial system and operate these in a decentralised way, without intermediaries, on top of a transparent and trustless blockchain network.
Imagine taking out a mortgage without needing a bank.
Why combine traditional financial services with blockchain?
When Bitcoin was introduced in 2008, it was to offer a completely new alternative to the financial world. Ten years later, Bitcoin has a place as a major alternative asset and continues to be the leading digital currency in a thriving crypto space. However, a mass-market adoption beyond a thriving alternative investment market is yet to be seen.
Many concepts that have been successfully applied in banking for centuries have powered the move through industrialization to today's digital age. For example, the possibility of taking out loans to invest or to bridge short-term credit requirements or payment difficulties is a legitimate financial product.
Similarly, exchanging assets on an exchange or broker is one of the most fundamental primitives of the past and today. This is exactly where Decentralized Finance comes in. Many traditional financial services are gradually being mirrored on top of blockchains. In this way, users benefit from the best of both worlds.
For example, collateralizing your digital assets and taking out loans against them. Or swapping digital assets and cryptocurrencies on top of a fully decentralized, permissionless infrastructure.
Most popular DeFi use cases
DeFi lending protocols such as Compound Finance already offer significantly higher interest than traditional bank account savings. While these services do have a fundamentally different risk profile (more on that later), they work with a very similar economic model to traditional banks - you the lender, supply a cryptocurrency into a lending pool (smart contract), which collects interest from the borrowers, who take out the loans against the deposit of collateral.
De-Fi Interest Rates (Source: Debank.com)
The interest rates paid out are based on the supply and demand of the particular currency pool, where most or all of the interest payments are passed to the lender - which means much higher interest rates than traditional banks - often up to 20x higher.
Another significant improvement over fixed-term interest rates is the variable interest rate in DeFi. Interest rates themselves are ‘floating’ based on the supply/demand curve of the specific lending protocol and asset type. Your money, therefore, compounds interest in real-time and you have the choice to withdraw or add more funds at any time.
The most popular applications and use-cases of DeFi include
The complete list of important DeFi protocols can be found on DeFi Pulse.
Liquidity Mining & Yield Farming
Another emerging trend in the DeFi space has been ‘Yield Farming’. Broadly, yield farming is the effort to put crypto assets to work and generate the most returns possible on those assets. For example, when users exchange tokens for each other on a decentralized exchange, this is only possible if other users have provided this liquidity.
For this service (and the associated risk), they are rewarded with a portion of the transaction fees and depending on the underlying protocol with native governance tokens. This type of process, called "Liquidity Mining", is available in various DeFi applications. ‘Yield farming’ is the crypto community name given to maximizing this return.
So, what’s the catch?
There is no such thing as a ‘free meal ticket’, and everyone knows that reward comes with risk.
Broadly speaking, there are two types of risks in Decentralized Finance: technical risk and financial risk.
Technical risk: This risk primarily relates to smart contract risk, for example, errors, bugs and unexpected outcomes in smart contracts.
Financial risk: Most of today's DeFi platforms rely on collateralization of assets. Lending protocols such as Compound or Aave use over-collateralization to address liquidity and credit risk ie. the risks that a lender will not be able to exit a position or be paid back in full.
Just a hype or a long lasting financial innovation?
The hype around Decentralized Finance is not only noticeable in the sharp appreciation in value of the DeFi related cryptocurrencies - many of which being the biggest winners in 2020. Today, over 6 billion Euros are locked up in DeFi protocols where many of these are generating millions of euros in annual revenues for their treasuries or token holders. Looking at actual DeFi users, this number is still relatively small at approximately 400k users, but growing exponentially.
Many believe that DeFi finally meets the potential of programmable money and proves to be one of the most important new potentials of blockchain technology. DeFi could well be the technology digitising banking, an industry that hasn’t changed its infrastructure for decades.
Interested to learn more? Dive deeper into the technical side of DeFi by checking out this great resource from Cryptotesters.
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