Decentralized Finance (DeFi) is a revolutionary frontier of the blockchain industry. It represents a sweeping wave of innovation that aims to offer highly liquid and interoperable financial services without any centralized intermediary. The financial products offered by the DeFi ecosystem, such as exchanges, loans and insurance, have existed for thousands of years. Yet for the very first time in human history, users are able to gain permissionless access to on-demand liquidity through DeFi applications while holding custody of their own assets. The decentralized nature of such disruptive technologies brings a number of advantages, including lower barriers to entry to financial markets, better competitive offerings for financial products and greater transparency. All of this is made possible through blockchain technology, the bedrock upon which DeFi is built. In this post, we’ll look at the history of DeFi from its inception up until the present day, and the amazing potential that DeFi applications can offer going forward.
What is DeFi exactly?
In the words of Fabian Schar, DeFi, “generally refers to an open, permissionless, and highly interoperable protocol stack built on public smart contract platforms”. Similar to traditional contracts, smart contracts are agreements written into code which describe the conditions for a successful exchange of value between parties. When transactions meet the requirements of these smart contracts, they self execute in a secure and verifiable manner, with a permanent copy stored on the blockchain.
The term smart contract was originally coined in the late 1990s by Nick Szabo. It was used to describe a contract that is trustless and self-enforcing, removing the ambiguity from contractual relationships. The idea behind smart contracts was that the many types of contractual clauses (such as loans, bonds, property rights etc.) could be embedded into software to make them easy to execute, but that breaching contracts would be expensive for the breacher. A primitive example of a smart contract given by Szabo was a simple vending machine. The vending machine is made up of hardware and software which would return an item chosen by a customer if the money inserted was the right price. The transaction between a person and a vending machine is predictable, safe, requires very little trust and guarantees the contract will execute if the conditions are met.
Today, going beyond simple vending machines, DeFi applications embed various incentive mechanisms in smart contracts to create capital markets, encourage market participation and facilitate transactions, while leveraging the security properties from the settlement layers they operate on. In particular, such generalized usage of smart contracts gives rise to the key innovation of liquidity pools, where crowd sourced funds are deposited into designated contracts to facilitate peer-to-contract trading. As a result, liquidity pools enable a much more efficient financial market as it largely alleviates the problem of double coincidence of wants in an orderbook driven market.
Characteristics of DeFi
There are many hallmarks of DeFi that make it unique compared to traditional finance. In addition to being decentralized, DeFi is also open – anyone can assess this financial infrastructure, compared to traditional finance’s restrictions such as jurisdiction, license, Know-Your-Customer (KYC) etc. DeFi is also transparent. Code exists on an open public ledger, where public addresses and transaction histories can be traced. As these transactions are final and immutable, this massively improves auditability. DeFi is non-custodial, meaning users control their own funds and private key while transactions take place directly between their wallets and the smart contract. Finally, a chief characteristic of DeFi is being composable. This means that smart contracts can interact and build on top of each other. This is important for the user, as one can freely move assets between different DeFi protocols. For instance, one can directly borrow assets from a lending protocol (AAVE), trade these assets on a decentralized exchange (Uniswap), return the asset and keep the rest as profits in one block time.
Smart contracts and blockchain
Smart contracts rely on blockchain technology as their underlying payment rails. Ethereum was the first platform built as a decentralized blockchain-based smart contract network to solve trust issues related to the execution environment. It was designed with a built-in Turing-complete programming language, allowing anyone to write smart contracts and decentralized applications where they can create their own arbitrary rules for ownership, transaction formats and state transition functions. Today, Ethereum is the blockchain which hosts the largest number of DeFi applications, because of its successful smart contract capabilities.
Ethereum can be seen as the base settlement layer (layer 1) for DeFi created on its network. This fits into the overall framework of DeFi, consisting of five key layers. As the base layer, Ethereum hosts the native asset Ether (ETH) and settles all final transactions made by DeFi applications built on the blockchain. These applications often rely on assets issued on the blockchain which sit on the asset layer (layer 2). Fungible tokens (ERC-20 tokens) are popular assets issued on Ethereum’s asset layer, as these can be traded interchangeably with each other. ERC-20 tokens gained popularity during 2017, the ICO period, where these tokens were issued to address different use cases and business needs. Above the asset layer sits the protocol layer (layer 3), which consists of a set of smart contracts that enable various DeFi use cases such as exchanges, lending, derivatives, stablecoins, asset management and many more. It is important to note that these protocols are highly interoperable and thus enabling a near frictionless financial market. The application layer (layer 4) is the bridge between the end users and the protocols, usually through a consumer friendly application. Finally, an aggregation layer (layer 5) connects end users to several applications in an aggregated format, similar to airline booking aggregators may connect a user to multiple airlines for their desired destination.
(Source – Fabian Schär, “Decentralized Finance: On Blockchain- and Smart Contract-Based Financial Markets,” Federal Reserve Bank of St. Louis Review, Early Edition 2021.)
Common Use Cases for DeFi
There are many popular use cases for DeFi currently available on the market. These aim to innovate on traditional financial services. In this section, we’ll explore some of the popular use cases for DeFi applications.
Non-Fungible Tokens (NFTs) (Ethereum’s ERC-721 token standard) represent assets which are unique and are not interchangeable, yet can be bought and sold. Each represents a one-of-a-kind digital item which is often treated as a collectible. NFTs can represent artwork, video game items, video or other forms of creative expression. A popular NFT marketplace is CryptoPunks.
Decentralized Exchanges (DEXes) are on-chain trading platforms with various models such as Automated Market Makers (AMM) and on-chain orderbooks. The most notable one is Automated Market Makers (AMMs), where token prices are determined by mathematical functions with relative token reserves. Liquidity providers deposit their tokens in designated liquidity pools and earn inflation rewards and transaction fees, known as yield farming. Traders can trade against the liquidity pool at every price level, meaning continuous supply of liquidity. Uniswap, Bancor, Kyber, Curve and Sushiswap are popular AMM-based DEXes.
StableCoins are classified into three categories: fiat or asset backed, crypto-collateralized, and algorithmic stablecoins. Fiat or asset back stablecoins are those pegged and backed 1:1 by an asset held in reserve by a private entity. The most common stablecoin in this category is Tether, which reflects the US Dollar. Others include PAXG, which is backed by gold. Crypto-collateralized stablecoins are backed by other cryptocurrencies on the blockchain. Dai is a crypto-collateralized token soft-pegged to the USD, launched by MakerDAO in 2018. Dai has no fiat backing and no central authority with issuing tokens. Finally, algorithmic stablecoins rely on an algorithm to stabilize the price in-line with a real world asset. This algorithm inflates supply to decrease price, and contracts supply to reign in price. An example is Anchor, an algorithmic stablecoin pegged to the performance of the world economy.
While these are some of the examples of DeFi on market, there are other instances of dApps delivering innovative DeFi propositions. These include collateralized lending (e.g. Aave, Compound), derivatives (e.g. Synthetix, Perpetual Protocol, Mirror Protocol), prediction markets (e.g. Augur, Gnosis), insurance (e.g. Nexus Mutual) and asset management (e.g. Yearn). All of these offer unique solutions in a decentralized way.
(Source – The Block)
Challenges and opportunities for DeFi in 2021
While still in its early stages, DeFi has huge opportunities to grow in 2021. Decentralized alternatives to financial services will become more popular as they are more inclusive and cater to a large internet-enabled customer base. The DeFi ecosystem is a highly connected one with a large liquidity base and no barrier for liquidity provision. The barriers to entry are lower, with users free to enter a financial contract and leave to bring liquidity to other protocols. In addition, crowdsourcing liquidation models ensure the protocols and ecosystems remain solvent. Leading by popular protocols such as Uniswap, Synthetix, Compound and many more, any developer can begin to build in the space with very low barriers to entry compared to traditional financial technology. This means that the opportunities for exponential growth due to composability are endless.
However, DeFi is not without its obstacles before reaching mainstream growth and adoption. DeFi Protocols are plagued by high-fees during times of peak interest due to Ethereum network congestion, hamstringing basic trades and transactions. For protocols that need collateral, high token price volatility can trigger unexpected systematic liquidations of collateral. As many DeFi protocols require oracles for real world price feeds to facilitate trades, hackers frequently launch oracle attacks to manipulate prices for self interests. There are also smart contract risks from unaudited code, giving opportunities for exploitation and resulting in loss of funds. The most famous incidence is the fall of YAM protocol.
It is clear that despite the challenges DeFi faces, it is without doubt the next frontier of blockchain applications. While the community is working hard to address some of the challenges mentioned above, we envision a future of DeFi with free liquidity, where cross-chain and cross-layer transactions are largely available. Imagine a future where ERC-20 tokens can be traded and collateralized on Polkadot, transactions settle within seconds on Solana, staked funds are instantly liquid and its derivatives can be traded on other Layer 2 protocols via Acala. With much excitement, dear readers, let’s build towards this inclusive future together!