A Brief Introduction to DeFi
By: Ondrej Sarnecký
Tags: Finance, Defi, Smart Contracts, Ethereum, Blockchain

In this article, I would like to explain what DeFi stands for. In the end, you will have a better understanding of what DeFi means — not only for you as an individual, but also for the world and your financial freedom.

Ethereum: The Digital Finance Stack

Ethereum is a platform that doesn’t need to be presented to the reader. With smart contracts, we can imagine the Ethereum platform literally as a free world of unlimited possibilities for all kind of decentralized applications. Just as the Internet creates tools for content creators, Ethereum does the same by enabling the creation of new financial services. Why Ethereum? Compared to the DeFi on Ethereum, the Lightning Network makes Bitcoin available for micro-payments, but at the moment, it is unusable for functionality like the smart contractors on which the entire DeFi ecosystem stands. Other networks such as EOS, Cardano, Dfinity and many others with smart contracts can potentially be useful for DeFi, but so far the Ethereum network is the market leader.

To begin with, I would like to note the difference between “open-finance” and “decentralized finance”. These terms often come together, even though they are two different terms with different meanings. Open-finances point to the banking services industry in traditional (centralized or fiat) finance, where startups provide specialized services in a limited geographic region. A good example is the Revolut application, which many people consider to be a bank, but in fact, it is a fintech application that has a banking license but is not involved in the deposit guarantee fund, which is not a reliable signal. Decentralized finances, on the other hand, often act as pseudo-anonymous, potentially censor-resistant, globally available and much more transparent due to operations run on publicly accessible blockchains.

In a relatively short period of time, a package of decentralized financial services appeared on the Ethereum network. Anyone with an Internet connection and crypto wallet has now access to a full spectrum of financial services. I will gradually explain the different categories that logically follow one another.

DEX — Decentralized exchanges

Decentralized exchanges have one big advantage over traditional, centralized exchanges. They get rid of the risk of misappropriation of user data, and/or popularly said “hacking”, and hence the leakage of private keys to user wallets. A decentralized exchange will allow the user to trade with funds without the need to register or verify an account and especially without an intermediary, only with the user’s own wallet (most often Metamask). The user deals directly with the smart contract, which in this case acts as a safe and transparent administrator. Like any solution, DEX has its advantages and disadvantages. Security can be an unquestionable advantage, and although it may not seem so at first glance, from a security perspective, the processing time of the transaction and the gas charges the user has to pay for each transaction. This mechanism makes manipulation of the market a bit more difficult. Unfortunately, the downside may be a much smaller user base and thus a narrower orderbook (fewer open deals) and especially poor liquidity.

For these disadvantages, the Uniswap project, which is one of the best known within the DeFi ecosystem, may be the solution. Uniswap not only delivers decentralization but also solves the orderbook problem by implementing the smart contract with which the user interacts with the store, keeping the tokens in reserve and thus not having to associate the user with a particular open position or wait for a new order. These smart contract pooling token reserves are referred to as “reserve pool”.

Home page of Uniswap.exchange

Uniswap, presents itself as a protocol for automated exchange of ERC-20 tokens on the Ethereum network. Unlike traditional DEX, Uniswap does not use an order book but instead uses an algorithmic pricing mechanism that guarantees liquidity and provides low spreads. This mechanism is very simple which allows relatively simple operations directly with Ethereum smart contracts. This provides additional security benefits and, thanks to simplicity, low gas fees.

Each ERC-20 token traded on Uniswap has its own pool and also an ETH pool. The price of the token is determined by the ratio of the ETH pool (fund) size to the traded token pool size. Whenever someone sells a token for ETH, the amount of token in the pool increases and vice versa. This gradually reduces the price of the token. Whenever someone buys an ETH, the amount of Uniswap token will decrease and the amount of ETH will increase, increasing its cost. This pricing mechanism is automatic, so there is no need to create orderbooks. Instead, the price is adjusted through arbitration. Each time the price of the Uniswap token is lower than the market, it is preferable to trade the Uniswap token and thereby gradually adjust the price to the market.

Reserve funds or liquidity pools only partially solve the liquidity problem. They certainly have tremendous potential for growth, as adding an additional liquidity pool to the network is relatively easy, but they still do not create a fully liquid market. Each operation on a smart contract is limited by the time it takes to process a transaction on the Ethereum network, which can be a significant limitation.

DEX is a separate chapter on which much could be written, but it is important for this article as a gateway to the DeFi ecosystem and the financial freedom it represents, even though centralized exchanges that continue to run “trustless” variants of their own services. For example, Binance and Bitfinex already offer their own decentralized exchanges.

Stablecoins

Several attempts have been made tokenize physical assets over the past few years, but the trend and demand has consistently indicated an interest in tradable tokens. Thanks to the Ethereum platform and the flexibility of smart contracts, different token variations have arisen over time with different functions and uses. The Cryptokitties phenomenon in 2017 was the arrival of increased interest in issuing new virtual assets, the so-called NFT (non-fungible tokens — ERC-721), which is based on the demand for “virtual assets” in the market.

Stablecoin is a kind of asset that is “backed” — covered by another asset, commodity or anything that represents the value. For example, in the case of stablecoin Tether, its price is covered by the dollar value, ie 1 Tether is US $ 1. Thus, this cryptocurrency is not subject to market volatility such as Bitcoin.

The most popular are currently Tether (USDT) and DAI. Although they come from one family, there are substantial differences between them. The biggest differences are in the question of centralization and decentralization.

Tether is a centralized stablecoin that requires a “trusted manager”. This may be a bank or fund that holds value as collateral, which in the case of USDT is a dollar. At the same time, it carries out audits and verifies that each issued USDT is covered by the same amount in dollars. However, this creates opportunities for abuse and Tether admitted that USDT has been underpriced several times.

DAI, on the other hand, is a decentralized stablecoin that utilizes market mechanisms implemented in Ethereum smart contractors to maintain its USD-bound value. Its collateral does not represent the amount of dollars locked in a bank account like USDT, but its users who manage Dai using the Maker platform where they actually store assets as collateral to Dai. Thus, Dai is a truly decentralized stablecoin and the cornerstone on which most of the DeFi ecosystem has been built.

Makerdao & Dai

Dai is a freely tradable ERC-20 token on the Ethereum network. Anyone who has a wallet on the Ethereum network can own, receive, transfer or exchange DAIs on decentralized exchanges. No authority controls it and therefore no one can restrict or stop it from being published. Its stable price is ensured by the “stabilization mechanism”, which we will explain later.

DAI works on the principle of secured loans, where the user puts security in the form of ETH into smart contracts and gets the loan in the form of DAI stablecoin. In the context of a smart contract, this means that the ETH sent by the user in exchange for the DAI to the smart contract is exchanged for the WETH, which is subsequently stored, pooled as PETH in CDP, otherwise known as “Collateralized Debt Position”. The wallet holder does not have access to ETH in the CDP until the user repays the DAI loan.

Source: DeFi.Pulse January 2020

With the acquired DAI, user can continue to trade or use DAI in DeFI dapplications, but this means that there is the same market mechanism of supply and demand as another cryptocurrency, so a stabilization mechanism is needed. This mechanism can be better explained by the diagram below.

In case of coordinated network attack, MakerDAO has the ability to manage DAI stablecoin, and the platform users can vote together to revert the changes. Maker’s has a capability to act in a means of intervention if necessary, but in no way can affect the cost of DAI.

The good thing about DAI is that its stabilization mechanism is not just a theory like in many other platforms, but has been successfully implemented from its start. To date of releasing this article, the stabilization mechanism has not failed in any way, while the daily trading volume is still in millions of USD and the market capitalization is nearly 90 million USD.

DAI is a great example and a successful implementation of the cornerstone of decentralized finance — stablecoin, as well as a great example of how it can work in such an environment without intermediaries or any authority.

Decentralized financial markets

Many fintech companies and modern banks now promise consumers greater control over their resources. These are misleading promises because in most cases banks still manage assets and the client must trust the bank, that the bank will take good care of his funds. They may be faster and more convenient, but they are not fundamentally different from old banking.

True innovation only comes with full control in the user’s hands and immediate access to assets. This innovation is conditional on freedom and free access to user assets and financial products. The second condition is the openness of the code and transparency. All protocols are open-source, so anyone can develop new financial products and people from all over the world can collaborate and come up with new forms of value creation. This can lead to even faster innovation and a strong “network effect”.

DeFi already provides a variety of common financial tools and products as open-source protocols that ensure that the user is always the only administrator of his assets. The DeFi ecosystem is growing every day and a global financial market is slowly emerging with programmable assets and services that not only serve the user but are completely in his hands. Here is a growing list of projects that extend the DeFi ecosystem.

The infographics below presents protocols and projects within DeFi. Many of these services are free and decentralized versions of traditional financial products.

Infographics of DeFi Ecosystem for the year 2019

Today, however, most of these protocols make no money. Many of them are successful, according to some sources, but only time and market inscrutability will show whether they bring real value to the protocol.

Some of the DeFi projects focus purely on the development of smart contracts, for various financial products, unlike many projects from previous years, do not implement their own token or token economy, they provide purely smart contract services. A good example is projects such as Compound and Synthetix.

The diagram below shows how much ETH is currently in DeFi. The screenshot is taken from Defi.Pulse, which monitors key metrics for DeFi projects and follows the latest trends in this field.

Source: DeFi.Pulse January 2020

Today a lot of development is happening in the DeFi ecosystem and even startups are beginning to understand that to create new decentralized products or applications, it’s not necessary to build their own network, but everything can be a one-man-show with a smart contract on Ethereum.