Everything you need to understand about DeFi (Decentralized Finance), and how it is changing the conventional financial systems.
Overview
A new movement is pumping adrenaline into the cryptocurrency industry. Decentralized finance (DeFi) has been making a splash over the last few months with the surge in DeFi platforms and products. It’s a belief that blockchain startups can recreate the traditional financial system in a decentralized architecture, where companies’ and governments’ control is eliminated.
The remarkable shift in Ethereum’s application narrative has coincided with the sheer popularity of open financial tools on the products. The Ethereum’s DeFi framework with the creations of lending protocols, security tokens, derivatives, exchanges, and more - is playing out as one of its greatest application environments so far.
So what is DeFi?
In its most basic form, DeFi is an ecosystem comprised of financial applications built on a blockchain, specifically Ethereum.
DeFi can be defined as the movement that promotes the use of decentralized networks and open-source software to create multiple types of financial services and products. The idea is to develop and operate financial DApps on top of a transparent and trustless framework, such as permissionless blockchains and other peer-to-peer (P2P) protocols.
Today, all these protocols are based on Ethereum smart contracts. Some of the most promising and advanced ones are:
Decentralized exchanges like 0x or KyberNetwork
Non-asset-backed stablecoins like Dai, with a reliable value for hedging and transferring
TokenSets - decentralized financial trading instrument equivalent to ETFs, through Setprotocol
Smart contract-based asset management funds like MelonPort
Why do we need DeFI?
While many fintech companies and new-age banks promise to give more control to their consumers, the fact is they still manage the asset, and consumers have to rely on them to take good care of it. Even though they are faster and more convenient, nothing is fundamentally different from traditional finance.
Many entrepreneurs for innovative financial products are moving towards open-source protocols for exchanging assets through decentralized platforms. Through the properties of smart contracts and distributed systems, deploying a financial application or product becomes much less complex and secure. For example, many dApps are being developed on top of the Ethereum blockchain, which provides reduced operational costs and lower entry barriers.
Decentralized finance brings many benefits when compared to traditional financial services. The new ecosystem provides a series of common financial instruments and marketplaces that ensure every individual is the sole custodian of their own assets, at all times.
To put these ideas into perspective, let's breakdown some of the primary open financial sectors of DeFi on Ethereum: open lending protocols, decentralized exchanges and markets, and stablecoins.
Open Lending Protocols
Recently, open lending protocols have probably achieved more attention than any other form of decentralized finance on Ethereum. The reason is mainly due to the striking adoption of Dai, P2P protocols like MakerDao, and liquidity pool designs like Compound Finance.
Decentralized lending platforms offer numerous advantages over traditional credit structures, including:
Integration with digital asset lending/borrowing
Collateralization of digital assets
Instant transaction settlement and novel secured lending methods
No credit checks, meaning broader access to people that cannot tap into traditional services
Standardization and interoperability — can also reduce costs with automation
Secured lending using open protocols like MakerDAO is designed to rely on the trust minimization that Ethereum affords to reduce counterparty risks regardless of intermediaries.
Open protocol lending is entirely restricted to public blockchains like Ethereum and has fascinating long-term implications for the expanse of financial inclusion worldwide. Speaking of which, MakerDAO is the most prominent decentralized lending protocol, soaring in popularity in 2019 so much that multiple stability fee raises have been proposed to maintain parity with its Dai: a USD-pegged stablecoin.
Here is the top 6 prominent decentralized lending platforms based on their crypto collateral market shares.
Decentralized exchanges and P2P markets
Exchanges in open finance are primarily in the form of decentralized exchange (DEX) protocols and P2P marketplaces. DEXs are peer-to-peer (P2P) exchanges of assets on Ethereum between two parties, in which no third-party acts as the middleman in a transaction like Coinbase or Binance.
DEXs are also constructed with highly innovative methods for swapping tokens and other non-custodial means for exchanging assets with minimal settlement time or risk.
HB DEX, a 100% decentralized exchange, which operates entirely on HB Wallet Desktop Application, covers most comprehensive functionalities that centralized models lack, offering users a seamless trading experience. HB Wallet is also recognized as the best Ethereum Wallet in Japan in 2019.
Instead of depending on third parties to approve your transaction, all transactions on HB DEX are executed directly on Ethereum, secured by Smart Contracts.
The trading process is faster, less expensive, and more secure than any web-based exchanges and wallets. HB DEX supports real-time trading with ETH for any cryptocurrencies under the form of ERC-20 tokens and vice versa.
HB Wallet has partnered with Simplex, allowing users to buy cryptocurrency via Credit or Debit Cards provided by Visa, Master Card, JCB, or American Express.
HB DEX is also in association with HB Wallet mobile app on both iOS and Android, allowing users to sync their wallets into HB Wallet and monitor their assets from mobile devices. Most importantly, HB DEX is free to use.
Another form of open marketplaces emphasizes the exchange of non-fungible tokens (NFTs) as virtual collectibles. Platforms like Nagemon facilitate the exploration, discovery, and buying/selling of crypto assets from any Ethereum-based games like Cryptokitties, Etheremon to the Nagemon Machine.
Ethereum-based P2P marketplaces have substantial long-term potential, and could eventually encompass markets for digital asset ownership and tokenized real-world assets.
Stablecoins
Stablecoins have flooded the cryptocurrency markets for the last few months with new models for issuing tokens, auditing their reserves, and managing their price pegs.
Stablecoins can be categorized into 3 types:
Crypto-collateralized
Fiat-Collateralized
Non-Collateralized
Maker’s Dai is a crypto-collateralized stablecoin, in which the underlying asset ETH is collateral against the loaned asset (Dai) based on the collateral ratio. Interestingly, Maker only is composed of borrowers, since the protocol is the lender and mints/burns the Dai token based on the CDP and governance parameters. Dai is abnormal thanks to its censorship-resistance and decentralized leverage offering.
Apart from the potential for noble use cases of Dai, like helping residents of troubled countries, people are primarily using it to make bigger, leveraged bets on Ethereum. The successful adoption of a decentralized stablecoin like DAI shows the potential for DeFi to recreate money without central control, and why it is better that way.
Find out more about Dai and its amazing stabilization mechanism.
Tether, USDC, and Gemini Dollars are fiat-collateralized stablecoins. The models for these stablecoins do not differ very much at all, and they rely on their users trusting them by providing transparent audits to maintain the price peg.
However, Tether - the issuer of USDT, has admitted that the coins are not 100% backed by actual dollars. There have also been a few controversies causing the peg to be no longer credible.
Tether may consider one USDT as the same as one U.S. dollar, but without either the reserves or the central bank backing to guarantee this, those are just words.
In fact, fiat-collateralized stablecoins remove the advantages of a public blockchain-based cryptocurrency and are more likely adding a layer of risk. Operators behind these stablecoins earn revenue from the interest earned on the deposited funds (in USD) from users that they store in a bank account.
Non-collateralized stablecoins entirely rely on contractions and expansions of the supply based on an algorithm to maintain a stable peg. Basis was the flagship example of such a stablecoin but stumbled and shut down following regulatory concerns with its model late last year.
Conclusion
Aside from the aforementioned, there are many more types of participants, services, and products in the DeFi and open finance ecosystem — including custodians, infrastructure platforms, insurance, and payment avenues.
DeFi presents a compelling glimpse into the future of digital assets, blockchains, and conventional financial systems interoperating with each other in an open and accessible environment.