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What Is DeFi?
- Decentralized finance (DeFi) is an umbrella term for applications built on blockchains that mimic traditional financial services.
- While DeFi is a relatively new term, Bitcoin, the first widely used form of digital money, was introduced back in 2009.
- However, more complex financial transactions only became possible after Ethereum introduced smart contracts.
- In this blog, we explain the most common DeFi applications and evaluate the opportunities and risks of this emerging technology.
Decentralized finance (DeFi) promises to create a global, fully automated, and economically inclusive financial system from the bottom up. It is an umbrella term for applications built on blockchains that mimic traditional financial services.
DeFi has come a long way since its breakthrough in 2020. Today, anyone, regardless of origin or status, with an internet connection has 24/7 access to financial services such as peer-to-peer trading on decentralized exchanges (DEXs), payments, lending and borrowing.
DeFi assets consist of cryptocurrencies, stablecoins that are linked to the value of a fiat currency like the US dollar, synthetics, derivative tokens that can reflect the value of other traditional assets like stocks or gold, and, as a crucial part of the democratization of finance, governance tokens.
DeFi gives its users access to a permissionless financial system without intermediaries like banks, as services are automated and governed by smart contracts. This is promising not only for the 1.4 billion people who remain unbanked, but also for those looking for alternatives to low interest rates on traditional bank accounts.
In this article, we take a look at the major use cases of DeFi, its promises, as well as the potentials and risks that users and investors should be aware of.
While DeFi is a relatively new term, Bitcoin, the first widely used form of digital money, was introduced back in 2009.
Bitcoin was conceived as a "peer-to-peer electronic cash system". Over the years, the narrative around the largest cryptocurrency by market capitalization changed. Today, Bitcoin is mainly considered a store of value due to its high security and scarcity, with a maximum supply of 21 million Bitcoin.
In the DeFi ecosystem, assets on the blockchain can be stored in a Web3 wallet, which is accessible and secured by a private key (similar to a password). Using these wallets, users can conduct permissionless transactions with other people or wallets.
The development of these crypto wallets was a huge breakthrough, considering that even today, 1.4 billion people do not have access to traditional financial services.
More complex financial transactions, however, only became possible after Ethereum introduced smart contracts.
What is a smart contract?
The code written in smart contracts determines exactly how decentralized finance protocols work. Smart contracts enable the automated and autonomous execution of decentralized applications which made DeFi possible to begin with.
For example, DEXs are built using smart contracts. These exchanges allow anyone to trade crypto assets and are an essential building block of the DeFi ecosystem.
Before smart contracts, cryptocurrencies like Bitcoin already enabled peer-to-peer payments. However, the inherent volatility of these assets mean that Bitcoin may not be a viable form of payment for goods and services.
Stablecoins utilize smart contracts to overcome this problem of crypto volatility. Stablecoins are tokens that leverage smart contract functionality to create a peg to a “fiat” currency. Examples include USD Coin (USDC) and USD Tether (USDT), which are theoretically pegged to the US dollar.
Stablecoins offer a variety of use cases. They allow traders and investors to exit risky and volatile cryptocurrency assets into dollar-pegged assets without leaving the DeFi system. This dramatically increases flexibility within the ecosystem and allows for the execution of diverse trading strategies.
Another obvious use case is financial transactions.
Traditional financial institutions often use outdated technologies such as the 45-year-old Swift system, which relies on manual input for money transfers. Meanwhile, international transfers rely on good banking relationships between the sender's bank, the recipient's bank and the intermediary facilitating the transaction. This results in delayed transfers and sometimes unpredictable fees.
With stablecoins, on the other hand, payments (including cross-border) are typically processed within minutes and at a much lower cost.
These applications explain why stablecoins have become increasingly popular in both bear and bull markets.
Centralized vs decentralized stablecoins
There are many different stablecoins available, each of which has its own characteristics. Broadly speaking, the key choice is between centralized and decentralized stablecoins.
Centralized stablecoins, like USDC and USDT, are backed by assets held in custody with a bank or another custodian, such as commodities, fiat currencies, treasuries or other equivalent, liquid high credit grade assets. Decentralized stablecoins, such as DAI, are backed by other cryptocurrencies.
When DAI, the first decentralized stablecoin pegged to the US dollar, was launched in 2017, its creator - the Maker protocol - allowed anyone to mint (create) DAI against collateral such as ETH or BTC. Since these are volatile assets that are susceptible to large price swings, DAI takes an over-collateralized approach.
To date, DAI is a popular alternative to centralized stablecoins such as USDT and USDC, which are exposed to greater regulatory risks due to their link to centralized institutions. You can find in-depth information about Stablecoins in our Stablecoin 101 blog.
DEXs form another cornerstone of decentralized finance. For the first time, these exchanges allowed users to trade with an unknown counterparty without the need for centralized financial institutions, as their architecture eliminates the need to trust one another. As a result, anyone with an Internet connection can now trade their digital assets 24/7 with near-instant settlement on a peer-to-peer basis in a permissionless manner.
To facilitate these functions, DEXs typically use automated market makers (AMMs), a two-sided 50/50 market in which some users (often referred to as liquidity providers) provide capital so others can trade against that capital.
Providing liquidity to DEXs such as Uniswap and Curve in exchange for rewards is one of the most popular strategies to generate income with digital assets, as it has typically outperformed interest rates offered on a bank deposit account in most developed countries. The price of the two assets in a liquidity pool is determined by a curve as a function of the ratio between the two assets.
With DEXs, users retain control over their digital assets. As they can hold them in self-custody at any time, they avoid some of the traditional risks associated with a centralized exchange, reducing counterparty risk.
Lending and borrowing
While DEXs allow users to trade assets without an intermediary, decentralized lending platforms bring the same benefits to their users.
Decentralized lending platforms, such as Aave and Compound, allow users to turn their cryptocurrencies, such as stablecoins, Bitcoin or Ethereum into productive assets by depositing them in a pool of capital and allowing borrowers to access these assets without the need for identity checks and means testing.
To borrow these assets, users must put up a certain amount of collateral, another digital asset. Should the borrower default and fail to repay the loan, the collateral can be liquidated. To avoid this, positions are typically over-collateralized, meaning the collateral makes up more than 100% of the borrowed amount.
This is necessary due to the high volatility of most crypto assets. Since the loan-to-collateral ratio can change quickly and lead to liquidations, over-collateralization protects against potential losses.
Simply put, these DeFi lending protocols allow users to generate revenue from otherwise non-productive assets and borrowers to access liquidity quickly, without bureaucracy and in a decentralized manner. But the decentralization of DeFi goes beyond financial products like payments, exchanges and lending.
A key component of DeFi is decentralized governance. In an attempt to create more equitable financial organizations, many DeFi projects delegate responsibility and control over the project to their stakeholders, reinforcing the community's collective interest in maintaining the integrity and security of the system.
DeFi protocols empower their communities to manage and improve the project by distributing governance tokens. They are incentivized by the potential profit from these governance tokens should the project be successful.
Technically, on-chain governance is executed on the blockchain itself. Proposals for protocol changes, collaborations, new financial products or new hires are encoded into smart contracts; holders (or stakers) of governance tokens can then exercise their voting rights. If the proposal reaches the required number of votes, it is executed.
While governance tokens were originally intended for the above purpose, they quickly became popular as a means to attract liquidity and new users to protocols. Since these tokens can be traded on the open market, users have an incentive to invest their capital in protocols that reward them with their governance token.
For example, Compound, which was the first project to issue a governance token (COMP) to its users, has benefited from tremendous growth. It also inadvertently created the yield farming phenomenon.
What is yield farming?
Yield farming (also called liquidity mining) is a trading strategy that utilizes DeFi incentive structures to maximize returns. This involves yield farmers providing liquidity to DeFi platforms in exchange for governance tokens or other cryptocurrencies.
To optimize returns, yield farmers quickly shift liquidity to the platform that offers the highest returns at the time. In the meantime, governance tokens can either be traded on the open market or redeployed to other decentralized finance protocols to earn respective rewards.
After Compound launched its governance token in June 2020, other protocols quickly followed suit, marking the beginning of the so-called DeFi Summer. While the COMP token is still used for governance today, in practice, it is more commonly bought and sold to speculate on Compound's future value and for yield farming.
The example of yield farming shows how DeFi is developing and innovating at a rapid pace. Unfortunately, the lucrative opportunities of DeFi do not come without risks.
The risks in DeFi
DeFi applications are a nascent technology. As such, the industry remains unregulated and does not provide consumer protections common to most financial services in the centralized finance world. Below is an overview of the common risks of DeFi for users and investors.
Market risk, or systematic risk, is not limited to DeFi, as it simultaneously affects the performance of the entire market, leaving investors without the ability to protect themselves through diversification.
A prime example of this is the tightening of global monetary conditions in the face of rising inflation that we have experienced since early 2022. These events tend to have a major impact on both the equity and crypto markets.
A risk unique to digital assets is self-custody risk – the risk of managing your own digital assets.
Self-custody means that you hold your digital assets yourself, as only you have access to the private key of your Web3 wallet. This is similar to the password to your bank account in traditional finance, but you are in the role of the account holder and the bank, and therefore the sole responsible party.
This is attractive to many investors. However, should the private key be compromised, you can lose access to all your assets forever.
An example of a DeFi-specific fraud is a rug pull. This is a type of scam where the developers of a crypto project create a worthless token, collect substantial funds, and then quickly withdraw all assets from the liquidity pool to irretrievably take possession of investors' money.
Smart contract risk
The most dangerous DeFi-specific risk is smart contract risk. While the DeFi ecosystem has proven resilient even in the face of significant market declines and liquidation cascades, the technology is still in its infancy.
In essence, the question is: are smart contracts designed flawlessly? For end users, this question is difficult to answer because it would require them to undertake complex due diligence processes.
Smart contracts are very complex and have only undergone a few years of testing. As a result, malicious actors are constantly trying to exploit potential vulnerabilities and gain access to the funds stored behind these smart contracts.
How to mitigate DeFi risks?
As a rule of thumb, when choosing a DeFi protocol to interact with, it is, therefore, best to choose ones that have been around the longest and seen a lot of use.
Should a user choose a proven DeFi application such as Uniswap, Compound or MakerDAO, the smart contract risk is significantly lower than with newer DeFi applications (dApps). The longer these protocols have been in place, the lower the probability that hackers will find a vulnerability in the contract,, a residual risk always remains.
Ultimately, each individual investor is well advised to perform due diligence before making any investment decision. This typically involves making sure that the smart contract or project has undergone a security audit that examines potential vulnerabilities in its design. The auditors then present their findings to the project so it can make changes based on the findings.
However, this does not exempt potential investors from market, self-custody, and fraud risks. Those looking to avoid these risks might consider a digital asset platform such as Yield App, as we strive to unlock the potential of digital assets in the most user-friendly way possible while maintaining the highest security standards for our users.
Most individual investors do not have the time or resources to conduct rigorous due diligence on their own. Our portfolio team conducts thorough risk assessments on the customers' behalf, ensuring that the assets on our platform remain as safe as possible.
What is DeFi? – Key takeaways
Decentralized finance has undergone tremendous development since its inception and continues to evolve at a rapid pace. DeFi's fully automated design and permissionless nature provide financial services to both underprivileged communities locked out of the traditional financial system and sophisticated investors.
In the coming years, new innovative DeFi applications such as synthetic assets and derivatives are expected to thrive. In the meantime, global regulators, with the support of the industry, are working towards putting in place a regulatory framework that supports the innovative growth of the industry while protecting its users.
Until this regulatory framework develops, however, those looking to participate in the ecosystem would be well advised to conduct their own due diligence before making financial decisions. Individuals looking to take advantage of emerging opportunities without exposing themselves to DeFi-specific risks could turn to a digital asset platform like Yield App to benefit from industry-leading due diligence processes and security standards.