An introduction to Decentralized Finances (DeFi)
By: Jasa Srot
Tags: Block42, Tech, Blockchain, Decentralized Finance, Defi

Based on the poll that we did more than 50% of the community have only heard about DeFi or don’t even know what DeFi is. Since DeFi is rapidly growing in the cryptocurrency ecosystem we feel it’s important we expand upon that topic.

Traditional finance system

If we want to take a dive into DeFi it is good to take a look at the traditional finance systems. Trading can only happen when two parties have an excess of goods that the other party needs and originally the trading was made with goods and services, this is called bartering. As the economy grew, so did the need for an intermediary that represents a certain amount of value, hence currency was created. Suddenly you didn’t need to have exactly what the other party wanted, but you could just pay him with the currency and they could use that currency in any way they wanted and get the thing they want if someone else offered it. So a win-win situation, right?

The earliest inscribed coinage

While in ancient Egypt the original money was a form of receipt, representing grain stored in temple granaries and some sort of medium like ox-hide shaped ingots of copper were used and the Chinese used the first alteration of coins somewhere around 770 B.C, but the first official currency that we know of was created by Lydia’s King Alyattes in 620 B.C. This allowed the country increase its internal and external trade, becoming one of the richest empires in Asia Minor.

Earliest paper money

With the need for credit and a lighter medium of exchange in premodern China paper money was introduced, which is basically like an IOU (I owe you) from the issuer of the note. For this to be able to work, people had to put trust in these central authorities like governments or banks, so that more paper money wasn’t created that there was value stored. With this trust and no way to oversee the whole system, central authorities had a lot more power as they could create more banknotes without the need to have it backed up by anything. With the abolishment of the gold standard in 1971, the dollar became backed only by the trust in the government, or in other words, it retains its value through government stability and that of the nation’s economy.

The computer and the internet allowed data to be exchanged at a really fast pace from one part of the globe to the other. This allowed the creation of databases that tell us how much money someone has and payments were transformed simply into transferring this data from one person's banking account to another. Payment cards, debit cards, credit cards, digital money all became available because of this, and while some regulations were set, still everything was controlled by a few central authorities and no way for the public to fully oversee the system.

Starting with Peer-to-peer

The first blockchain Bitcoin is “A Peer-to-peer Electronic Cash System” or in other words, it acts like a currency that is not controlled by a single entity. Since currency is part of the financial system we could say that the first solution on blockchain was a DeFi solution.

It is estimated that only a bit over 8% of the world's money exists as physical cash (banknotes or coins) and around 92% of it is in digital form, so there is a great potential for a digital currency to thrive. More and more banking and financial services are being built on blockchain which can be seen as a natural expansion upon the initial Peer-to-peer currency concept.

A lot of solutions that connect blockchain and the real-world may lag behind as there might be more governmental restrictions and issues (for example the oracle problem). And governments are usually slower to react as it is a long process to establish all regulations, laws and to convince other political parties to agree with certain approaches. While DeFi solutions might find some problems with governmental regulations there is almost no way of stopping someone from releasing a new solution and deploying it on the network. Once it is deployed there is no central authority to take it down.

Onwards to DeFi

With cryptocurrency expanding so are its solutions. Blockchain and decentralization allow anyone to participate, therefore Decentralized finances (DeFi) allows everyone to participate in financial systems. DeFi is bringing centralized solutions and creating Dapps that provide the same function. Currently, one of the most popular DeFi solutions is borrowing and lending with more than 1.2 billion $ locked in this sector on Ethereum alone, compared to the whole DeFi space on Ethereum having 1.5 billion $ locked this represents 78% of the whole space.

Derivatives are second in place with around 194 million $ locked, which represents a bit less than 13% of the Defi space on Ethereum.

A derivative is a financial security with a value that is reliant upon or derived from, an underlying asset or group of assets. The most common underlying assets for derivatives are stocks, bonds, commodities, currencies, interest rates, and market indexes.

Assets with the most famous one of Wrapped Bitcoin or (WBTC) represent 70.7 million $ less than 5%, decentralized exchanges represent 56.9 million $ less than 4%, and payments with Lightning network leading the way have 9.3 million $ locked which is less than 1%.

This data was collected from Defipulse on 23rd of June 2020

While there are also many other DeFi solutions or are currently being built at the moment, Ethereum is currently still the main provider of DeFi solutions and a list of DeFi applications for Ethereum can be easily accessed here or here.

Lego blocks on Ethereum

Start of DeFi on ICON network

Other blockchains are starting to present more DeFi solutions as well, whether they are built on top of a blockchain similar to what Fantom or ICX (with LICX, Balanced, and bridge) is doing or on a completely separate blockchain like Thorchain or Terra. These are only a few examples of how DeFi is being integrated, but the core of it is to decentralize financial services, allow everyone to participate, and lower restrictions and fees by cutting out the middle man. The best way that DeFi operates is by combining all the different solutions and use them almost like Lego blocks, with one protocol being build on top of the others and just adding them together to provide the best possible returns on your investment. With more and more services being developed and the possibilities of combining DeFi on a cross-chain level the whole investing in DeFi can be really confusing for new users. But there are many guides (Defipulse, Defiprime) that you can use to get you up to speed on how to invest in DeFi.

Here are a few of the DeFi solutions and a short description of them:

Compound is a borrowing and lending platform offering rewards for anyone that borrows or supplies assets on compound (Liquidity mining)

Aave is a lending protocol, it allows collateralized loans, “rate switching”, flash loans and unique collateral types.

Balancer is an automated-market maker that allows liquidity pools composed of multiple ERC20 tokens instead of 1:1 pools. It also has liquidity mining.

Uniswap is like a Decentralized exchange where users provide liquidity for swaps and earn fees from swaps

1inch allows finding the best possible ratio on DEX exchanges

dYdX is a decentralized margin trading platform that allows users to borrow, lend and make bets on the future prices of popular cryptocurrencies

Tokensets allows you to follow the trading of other users

Synthetix is a protocol for trading derivatives on Ethereum blockchain such as gold, Bitcoin, Stocks, etc.

RealT allows pooling together to buy real estate properties and earn income from the rent.

Iearn allows users to take advantage of multiple DeFi protocols with one access point

MakerDAO at its core, it is like a credit facility that issues loans with a certain interest rate

REN is a protocol that enables transfer of value between blockchains, which brings interoperability to DeFi

wETH and wBTC are ERC20 representations of ETH and BTC which allows Dapps with ERC20 compatibility to interact with BTC and ETH. This is useful from the development perspective rather than as an investment

And many others

With all of these Dapps interacting with each other, simplification is also needed. Luckily there are services in DeFi that can also help you simplify the process like Idle and platforms which let you interact with the most popular DeFi solutions on the market like Instadapp and Zerion.

How DeFi looks like for someone who is not familiar with it. Image credit: @sassal0x

A the time of writing “Yield farming” is a big upcoming thing for DeFi, which is connecting solutions to maximize your returns and also farm governance tokens of projects like compound, balancer, ren, etc. The reported numbers of Annual percentage yield (APY) were even up to 100%, this is an insane amount but it is probably just the starting push before more people understand it and join, then APY will most likely stabilize at a much lower percentage.

Please note that DeFi is not risk-free, while it can yield great returns on your investment there is also a possibility of smart contract bugs, liquidation risk, liquidity crunch, admin key or governance compromise, stable coin:dollar ratio failing, etc..

While some of this risk can not be removed, you can always ensure your investment from technical fails, like smart contract bugs or stable coin:dollar ratio failing through insurance services Nexus mutual or Etherisc. These services are still centralized at the time of writing.

An important thing to check is if the smart contract has been audited by a reputable auditing company like Trail of bits, Open Zeppelin, Quantstamp to name a few (I can not guarantee the reputation of these companies, my research brought me to believe they are reputable, but always do you own research).

Future of DeFi

The future is always impossible to predict but the way things are resolving now, the future of DeFi seems bright. With the rapid increase of projects being connected to each other, with tokenizing more stuff and consequentially more funds being locked into DeFi, this might just be the next gold rush in crypto space. In the long term, the goal of the space should be that anyone can invest in anything regardless of the amount that they contribute as blockchain allows easy pooling to collect enough funds you could look for example at investing in real estate market with 1$. In traditional markets, this would be impossible as it would not be worth the time for any intermediary. Also, the returns in a decentralized system can be higher because there is no middle man taking their cut of the profits.

At the end of the day, what could be a better sector than finances for cryptocurrencies to dominate, after all, they are currencies and the first use case for a blockchain was a financial one. How will things play out in the blockchain space and the decentralized finance world? I guess we will just have to wait and see.