The term DeFi, or Decentralized Finance, refers to an ecosystem of financial applications built upon blockchain networks. The DeFi movement aims to create permissionless, open-source payment protocols not unlike the already existing fiat payment networks, except that the DeFi systems follow the core concept of cryptocurrencies – truly decentralized, distributed finance where no centralized authority figure/institution holds any semblance of control over your money.
Bitcoin, the very first cryptocurrency launched back in 2009, may have been considered an example of DeFi back then, but would certainly not pass for it now. The concept of DeFi has evolved within the crypto community since then.
DeFi and Ethereum
At present, most applications of DeFi have accumulated on the Ethereum blockchain. Ethereum, the second-largest cryptocurrency platform in the world, has gradually become more compatible with DeFi than the Bitcoin platform. This is primarily because Ethereum makes it easier to build different types of decentralized applications beyond Bitcoin’s basic transactions. As Ethereum creator Vitalik Buterin pointed out in the original Ethereum whitepaper back in 2013, Ethereum supports a lot more complex financial use cases. From implementing increased financial security and transparency to offering more flexibility to providing more liquidity opportunities, the Ethereum smart contracts gave DeFi some of its more advantageous features.
The DeFi movement has been giving the centralized monetary system a run for its money across the fintech space for a while now, with DeFi’s applications in areas ranging from trading to asset management to insurance to lending and borrowing protocols. Before we take a detailed look at DeFi’s varied use cases, however, let’s first see why exactly DeFi has become a preferable alternative to the traditional banking system for many, many users all over the world, shall we?
What are the Primary Features of DeFi?
- Permissionless: A DeFi system’s foundation blockchains are permissionless ones – which allows anyone to access the applications on a DeFi protocol and trade over the network without requiring anybody to sanction it.
- Open Source and Transparent: The coding is open-source on a DeFi system. So the code is visible to every user, allowing everyone on the network to audit it and verify its security and functions. This transparency of the network doesn’t tamper with the users’ privacy either, since all users are identified by their digital signatures (like a social media username). Additionally, open-source coding ensures DeFi’s credibility.
- Interoperability: DeFi is very easily compatible with the integration of other applications, so DeFi always has the scope to expand further, offer new financial services, and even develop new financial marketplaces.
- Accessibility: Anyone with a computer/smartphone and a decent internet connection from any corner of the world can join a DeFi network. This feature in particular definitely gives decentralized financial systems the upper hand over traditional banking systems, considering the sizable portion of the global population who can not avail of essential banking services due to geological issues.
Use Cases of DeFi:
The DeFi movement has always been about developing a substitute financial system that’d rival, and eventually surpass, centralized monetary services in the global financial markets. While it’s true that DeFi is still in its development stage and has a long way to go still before achieving its objective, there have already been several prominent use cases of DeFi so far – sectors where DeFi has proven to be a massive success. Below we have rounded up some of the best practical examples of decentralized finance seen till date.
Providing a new and secure way of trading was one of the primary aims behind a decentralized financial system’s initiation, and of course remains one of its basic functions. Across decentralized exchange platforms, liquidity pools and decentralized marketplaces, a range of trades happen within the DeFi space, from derivatives trading to token exchanges to margin trading to token swaps.
2. DEXes/ Decentralized Exchanges
The most broadly known application of DeFi so far has been the DEX. Decentralized exchanges are, of course, cryptocurrency exchange platforms that allow all users to perform P2P (peer-to-peer) transactions between themselves and control their own funds without a central administrative figure watching over; the trading fees are much lower too. DEXes provide increased liquidity, safeguard all personal data of the users and their funds against threats of hacking and lower the risks of market manipulation by a considerable margin. Another key feature of DEXes is that they allow physical assets to be tokenized; so the exchanges are swifter and safer compared to traditional trading methods.
3. DeFi derivatives
A derivative, as you’re probably aware, is a coded financial agreement that procures its value based on the performance of an underlying entity. This entity can be a crypto asset (forming crypto derivatives), fiat currency, a valuable commodity such as gold, or stocks, bonds etc. DeFi derivatives, similarly, can represent both real world and virtual assets.
For a DeFi derivative, smart contracts embody contracts which auto-execute in a permissionless manner. There are two basic benefits to trading a DeFi derivative –
- Avoiding the risks associated with any upcoming price fluctuations of a particular asset by agreeing to trade at a fixed price in the future.
- Potentially earning profits by speculating on a certain asset’s future performance.
Here are some of the prominent types of derivatives contracts:
- Futures: A crypto futures contract contains an agreement to buy/sell the underlying crypto asset at a specific point in time in the future.
- Options: Options allow the holders the right to buy or sell the underlying assets at a certain price, but they are not obligated to perform the trade.
- Swaps: Swaps are derivatives contracts through which counterparties exchange the cash flows or liabilities associated with one financial instrument for another. Swaps are customized based on the requirements of both sides involved.
- Perpetual Swaps: Perpetual swaps are very similar to regular futures contracts, except that they don’t have expiry dates.
A token, in DeFi’s case, is a virtual asset minted, issued and managed on a blockchain. Digital tokens are securely coded so they can be transferred instantaneously and are programmed to carry a bunch of functionalities. Tokenization is a native feature of the Ethereum blockchain, meaning it can provide DeFi platforms on the same blockchain with a range of economic benefits. Digital tokens have come out as a secure way for users on DeFi platforms to store their asset values, and trade without ever risking the actual assets.
DeFi platforms usually offer tokens to provide users with an attractive deal to invest in a particular platform: some protocols give away platform specific tokens that give the tokenholders governance powers, or these tokens can incentivize users to try out a certain application. For instance, the Yearn.Finance platform offers the $YFI token, and Compound gives out the $COMP token.
Stablecoins are essentially cryptocurrencies, the only difference is that the value of a stablecoin can be tethered to the value of another cryptocurrency, a physical currency like the US dollar, or even the price of a valuable physical asset, like gold. The primary goal of stablecoins is to reduce the risks associated with the price fluctuations of a regular cryptocurrency, and to offer price stability.
Currently, most stablecoins exist as tokens on the Ethereum blockchain across the DeFi space, and are used for payments on DEXes, or for lending and borrowing purposes. Some popular stablecoins are USDT, USDC, and DAI.
6. Synthetic Assets
Synthetic assets are virtual assets that provide exposure to other real world assets such as fiat currencies or precious metals like gold, or cryptocurrencies- basically anything with a dependable price feed can be translated into a synthetic asset. These assets can be staked as collateral on DeFi platforms and have synthetic assets (which are basically crypto tokens, much like stablecoins) minted against them. For example, Synthetix is a synthetic asset protocol. A user can store Synthetix’s token SNX or ETH as collateral on Synthetix, and have synthetic assets minted against it.
7. Lending and Borrowing:
P2P (peer-to-peer) lending and borrowing platforms are one of the most extensively used applications of the decentralized finance system. DeFi lending platforms give out loans to individual borrowers or organizations in a trustless way- so there’s no third party interference required, and allow lenders to earn interest in the form of crypto coins on the funds they deposit.
Here’s some of the advantages DeFi lending platforms offer over the traditional lending/borrowing procedure –
- More easily accessible to both lenders and borrowers
- Instant fund settlements through smart contracts
- Total transparency in the fund flow
- Reduced risks
- Flexibility in lending and borrowing
The DEX platform Compound is a good example of a DeFi lending/borrowing protocol.
Compound is an algorithmic, autonomous interest rate protocol that, by providing interest rate markets on Ethereum, allows lenders to earn interest on the assets they have deposited in the Compound lending pool. The Compound smart contract is coded to match borrowers and lenders and calculate the interest rate for every specific situation. We’ve discussed the strategies in Yield Farming here.
8. Asset Management
Finding beneficial exchange platforms, strategizing and distributing assets for portfolio diversification, and keeping track of all investments and trades across multiple platforms can be fairly complicated. This is where DeFi asset management tools come in, which include virtual apps and wallets for securing and managing financial assets on behalf of the users.
Crypto wallets let you interact with DeFi platforms and handle all transfers of funds- like buying, selling, moving cryptocurrency from one system to another, and earning interest on deposited assets.
As mentioned before, decentralized finance is still in its development phase. Even though it was designed to be fully secure and risk-free, users have previously faced all sorts of vulnerabilities that come with open-source coding: including smart contract breaches due to bugs, theft of personal information/funds, and compromised private keys. The decentralized nature of the system makes it really difficult to reverse any losses suffered; this is why DeFi insurance – one of the more recent innovations within the DeFi space – plays a key part in giving the users the maximum possible security, and serves to attract more investors and traders to DeFi.
Through DeFi insurance protocols, users can take out insurance policies on cryptocurrencies, smart contracts, or their funds to cover any claims in the future.
10. DAOs/ Decentralized Autonomous Organizations
A decentralized autonomous organization is an institution that operates as per encoded rules that are transparent, and is controlled by the members of the organization instead of a centralized authority. Some well-known platforms within the DeFi world have launched DAOs to provide their user-bases with decentralized governance powers, run financial operations and fundraise among other things; Compound Finance and MakerDAO being two of the foremost examples.
The peer-to-peer payment system is one of the basic features of decentralized finance, since it also happens to be a key quality of the blockchain tech. DeFi payment networks allow all users to trade directly with each other, with no intermediary intervention required. DeFi payment solutions can create a convenient financial system for the large part of the global population that’s still unbanked or underbanked; plus, they can convert the current market structures to benefit all parties involved in the trades.
12. Decentralized Marketplaces
DeFi protocols have already been used to back online marketplaces so they can serve consumers worldwide and all functions become a lot easier – from payments to the exchange of products. The open source structure allows rules governing the marketplace to be transparent and visible to everyone operating on the network, and the combination of DeFi’s transparency and immutability make sure that features such as customer ratings and reviews are completely honest and indubitable.
The DeFi space, at its current stage, faces some issues, foremost of them being the fact that the system structure isn’t yet ready for mundane use – which is why it hasn’t been capable of replacing the traditional financial systems in the mainstream markets yet. However, as decentralized finance continues to grow and keeps widening its horizons incessantly to introduce financial uses and opportunities never imagined before, it’s undeniable DeFi already holds the potential to revolutionize financial sectors on a global scale.