What is decentralised finance (DeFi)?
In the past decade we have seen how digital innovation was transformative of business models, but failed to play a disruptive role. The ecosystem merely copied and pasted the outlines of a traditional financial system designed for the analogue world, overlaying digital interfaces to make it more accessible to a public with its centre of gravity in mobile and PC. This is nothing like what is happening and will happen in the digital world, especially in view of decentralised finance. What do we mean by the concept of decentralised finance or DeFi?
Short for decentralised finance, DeFi is an umbrella term for a variety of applications and projects in the public space of the blockchain oriented blockchain that are going to break very strongly into the world of traditional finance. DeFi consists of peer-to-peer applications and protocols developed on decentralised blockchain networks that do not require access rights to facilitate lending, insurance, oracles, cryptocurrencies, swaps, derivatives, asset management or trading of financial tools. Most DeFi applications today are built using the Ethereum network, but many alternative public networks are emerging that provide speed, scalability, security and lower costs.
How did DeFi start?
Humans initially exchanged goods and services. But as we have evolved, so have economies: we invented currency to facilitate the exchange of goods and services. Subsequently, currencies helped introduce innovations and created better levels of economies. However, progress comes at a cost. Historically, central authorities have issued currencies that underpin our economies, which eventually gave them more power as more people began to trust them. However, trust has broken down from time to time, causing people to question the ability of centralised authorities to manage such money, as well as their remit and function of being. DeFi was developed based on the idea of creating a financial system that is open to all equally and that minimises the need to trust and rely on a central authority for governance.
DeFi provided a plethora of opportunities to achieve a transparent and robust financial system that no single entity controls. But the tipping point for financial applications began in 2017, with projects that facilitated more functionality beyond simply transferring money.
Financial markets can generate big ideas and drive societal prosperity. Yet power in these markets is centralised. When people invest in today’s financial system, they give their assets to intermediaries, such as banks and financial institutions; this keeps risk and control at the centre of these systems.
Historically, we have seen bankers and institutions failing to see the risks in the market, as seen in the 2008 financial crisis. Certainly, when central authorities control the money, risk accumulates at the centre and endangers the system as a whole.
Bitcoin and early cryptocurrencies, which were initially developed to give individuals complete control over their assets, were only decentralised in terms of issuance and storage. Providing access to a broader set of financial instruments remained a challenge, until the emergence of smart contracts and that enabled DeFi.
DeFi protocols and how they work
DeFi has become a complete ecosystem of working applications and protocols that deliver value to millions of users. Assets worth more than $30 billion are currently locked in DeFi ecosystems, making it one of the fastest growing segments within the public blockchain space.
The most popular DeFi use cases and protocols available in the market today are:
- DeFi Lending and Borrowing
DeFi conferred finance a new direction by enabling decentralised lending and borrowing, considered as ‘Open Finance’, offering cryptocurrency holders borrowing opportunities for annual returns. Decentralised lending allows individuals to borrow money at a specific interest rate, meeting the needs of the cryptocurrency holding community.
- DeFi’s best lending and borrowing platform: Composite Finance
Launched in 2018, Compound Finance is the brainchild of Rober Leshner. The project is a lending protocol developed on the Ethereum blockchain that allows users to earn interest by lending assets or borrowing against collateral. The Compound protocol makes this possible by creating liquidity for cryptocurrencies through interest rates set by computer algorithms. Compound users earn interest by depositing cryptocurrencies. Once cryptocurrencies are provided on the Compound platform, users can use them as collateral for loans.
Decentralised exchanges (DEx) are one of DeFi’s core functions, with the maximum amount of capital locked up compared to other DeFi protocols. DEx allow users to exchange tokens with other assets, without a centralised intermediary or custodian. Traditional exchanges (centralised exchanges) offer similar options, but the investments offered are subject to the willingness and costs of that exchange. The additional cost on each transaction is another negative aspect of CEx, which DEx address.
Top decentralised exchange: Uniswap
Founded in 2018 by Hayden Adams, UniSwap is the largest automated token exchange by transaction volume implemented on the Ethereum blockchain. The project was launched after receiving grants from multiple equity firms, including the Ethereum Foundation. UniSwap automated transactions between cryptocurrencies through smart contracts. UniSwap today offers three functionalities: exchanging tokens, adding liquidity and removing liquidity.
- Token exchange:
Users must create a Metamask account to use this service. Once a Metamask account is created, users can select the tokens they own to exchange for another type of cryptocurrency.
- Adding liquidity:
To provide liquidity, users deposit an equivalent value of tokens into the exchange contract associated with the token. Once you have liquidity tokens, you can add them to a “pool” in the UniSwap interface. Users who provide liquidity on UniSwap earn exchange fees, calculated by the value of the tokens offered for liquidity.
- Removing liquidity:
You can remove liquidity in UniSwap by simply choosing the ‘Remove liquidity’ option from a drop-down menu.
Stablecoins are a viable solution to the volatility issues surrounding cryptocurrencies and are helping DeFi gain prominence. The name says it all: the value of stablecoins is tied to a relatively stable asset that seeks to keep its price constant, such as gold or the US dollar. Stable currencies became useful during risky times in the crypto space, providing a safe haven for investors and traders. Stability makes them a reliable collateral asset. Stablecoins also play an important role in liquidity pools, an integral part of the DeFi and DExs ecosystem.
Founded in 2015 by Rune Christensen, MakerDao is an organisation-building technology for savings, loans, borrowing and a stable cryptocurrency on the Ethereum blockchain. The project was one of the first DeFi protocols. Instead of conducting an ICO, the project privately sold MKR $ tokens to fund development over time.
The protocol works so that a user can send or deposit $ ETH to a smart contract on the Maker protocol and create a Collateralised Debt Position (CDP). This will allow the possibility of taking $ ETH at a specific collateral rate. Suppose the price of $ ETH falls in the future.
In that case, a user’s CDP will be automatically closed to ensure that the network has enough capital locked up against borrowed tokens. This can be prevented by putting in more $ ETH or taking out less IAD in the first place.
ETH $ can be reclaimed by returning the principal amount, with the addition of a small fee.
Prediction markets are platforms where people can make predictions about the occurrence of future events, ranging from sports or political betting to stock price predictions and more. DeFi opens up these markets for participation. The concept of decentralised prediction markets has long been promoted as a possibility through smart contracts.
Top prediction marketplace: Augur
Augur is a decentralised prediction market platform that uses the collective prediction of the masses. August, the DeFi platform, uses Ethereum to harness the “wisdom of the crowd” to create real-time predictive data. The first version of Augur was launched in 2015 and its mainnet was launched in 2018.
Augur offers you two main actions:
- Market making:
Users can create an Augur marketplace by spending a certain amount of Ethereum. When creating a market, users must set buyer fees and maker fees, which should be low enough to encourage people to bid and high enough to cover the cost of Ethereum.
- Trading event shares:
Users can buy or trade shares that represent the probabilities of a market event occurring. Traders can make money by buying positions at low cost and selling them when the price rises. People who predict an event correctly will also receive rewards when the market closes.
Another kind of service offered by DeFi is asset management. It is intended to make investing faster, less expensive and more democratised. Aspects of the DeFi ecosystem play very favourably for asset management, which include: transparency, composability and trustlessness.
Decentralised transparency will mean that information is accessible and secure, composable to enjoy hyper-personalisation of portfolios and make it possible to access historically illiquid assets and manage your investment regardless of location.
Launched in 2020 by Evan Kuo, Ampleforth aims to provide an unsecured digital asset that helps traders and investors diversify their crypto portfolios. Ampleforth is a DeFi asset management protocol designed to be synthetic and smart base money. “Synthetic” because they are created by humans, but are not commodities like gold.
Ampleforth adjusted the supply of its tokens daily to match market demand using a smart contract. These smart contracts use Ampleforth’s price oracle and Chainlink to pull real-time data from Bitfinex Exchange and KuCoin Exchange. These decentralised price feeds help determine whether the price of the token is within the equilibrium range (0.96-1.06 USD range). Suppose the price of an AMPL $ token is less than $0.96, the supply decreases. If it is greater than $1.06, Ampleforth increases the bid.
AMPL is an ERC-20 token that seeks the target price of $1. However, rather than linking it to a fiat currency, Ampleforth allows tokens to fluctuate in addition to the price, as it seeks to achieve an equilibrium range. The price is automatically adjusted in Ampleforth wallets. Since the supply of AMPL $ tokens is not affected during inflation or deflation, Ample is an ideal asset that can maintain its purchasing power against other assets.
The future of DeFi
We are seeing a quantum leap in new possibilities for the functionalities of money through the innovation of distributed ledger technologies. For the first time in history, that same population is shaping a global financial system for a global population. Everyone can participate in the governance of the DeFi protocols and get a seat at the table where the world of decentralised finance is actively being created.
The DeFi space is gradually moving closer to the traditional financial system and, despite some of the obstacles that are certain to be encountered while operating at the forefront of innovation, the world of decentralised finance is on the road to prosperity. Over time, it is difficult to predict how this space will shape up when the power to build financial services is democratised. However, at the point where DeFI and fintech map and merge, we will have a tipping point where nascent financial technology is just part of a new financial system. One that realises the dream of being fast, secure, available and equal.
DeFi will be a success if the protocols are technologically sound, if they ensure the correct functioning through performance and transparency of the algorithm/protocol and facilitate its auditing, and if they have a record of all operating nodes at all times. At AddVANTE we work actively to mitigate vulnerabilities and introduce new risk mitigation mechanisms in an efficient and challenging manner.