What is Decentralized Finance – an Introduction to DEFI
Decentralized Finance (also known as DeFi) is a blockchain-based type of finance that does not rely on traditional financial intermediaries like brokerages, exchanges, or banks to provide traditional financial instruments, relying instead on smart contracts on blockchains like Ethereum. People can use DeFi platforms to lend or borrow money from others, trade cryptocurrencies, insure themselves against hazards, and earn income in savings accounts. A layered architecture and highly composable building components are used in DeFi.
Some DeFi applications advertise high-interest rates while posing a high risk. By October 2020, over $11 billion (in cryptocurrency) had been deposited in various decentralized finance protocols, representing a more than tenfold increase over the course of the year. DeFi had received approximately $20.5 billion in investment as of January 2021.
An Overview of History
MakerDAO, a stablecoin-based lending platform, is praised for being the first DeFi application to see widespread adoption. It enables users to borrow Dai, the platform’s native token, which is pegged to the US dollar. MakerDAO aims at maintaining the fixed value of Dai in a distributed and independent manner by utilizing a set of smart contracts on the Ethereum blockchain that control the loan, repayment, and liquidation processes.
Other platforms jumped on board, introducing the “yield farming” or “liquidity mining” concept, in which speculators actively move cryptocurrency assets between different pools within a platform and between different platforms in order to maximize their total yield, which involves not only interest and fees but also the value of extra tokens earned as rewards.
The Washington Post published a primer on decentralized finance in July 2020, detailing yield farming, investment returns, and the hazards involved. Bloomberg reported in September 2020 that DeFi accounted for two-thirds of the cryptocurrency industry in terms of price movements, with DeFi collateral levels reaching $9 billion.
Because of the rising interest in DeFi, Ethereum saw an increase in developers in 2020.
Large cryptocurrency venture capitalists like Andreessen Horowitz, Bain Capital Ventures, and Michael Novogratz have invested in DeFi.
DeFi is based on decentralized applications (DApps) that conduct financial activities on distributed ledgers (blockchains), a technology that was popularized by Bitcoin and has subsequently been used more widely.
Transactions are done directly between participants, mediated by smart contract programs, rather than through a centralized middleman such as a cryptocurrency exchange or a typical securities exchange on Wall Street. These DeFi protocols, or smart contract programs, are often run on open-source software created and maintained by a community of developers.
DApps are usually accessed via a Web3 enabled browser plugin or program, such as MetaMask, which allows users to interact directly with the Ethereum blockchain via a digital wallet.
Many of these DApps can work together to develop more sophisticated financial services. Stablecoin holders, for example, can lend assets such as USD Coin or DAI to a liquidity pool via a borrow/lending protocol like Aave, and then allow others to borrow those digital assets by depositing their own collateral, which is often greater than the loan amount. The protocol modifies interest rates automatically based on the asset’s current demand.
Aave has launched “flash loans,” which are uncollateralized loans of any amount that are taken out and provably repaid in a single blockchain transaction. While there are legitimate uses for flash loans, such as arbitrage, collateral swaps, self-liquidation, and unwinding leveraged positions, flash loans have been utilized to manipulate bitcoin market prices by a number of DeFi platform exploits.
Uniswap, a decentralized exchange (DEX) based on the Ethereum blockchain, is another DeFi technology. Uniswap allows users to trade hundreds of various ERC20 tokens that have been released on the Ethereum blockchain. Uniswap incentivizes users to form liquidity pools in exchange for a percentage of the trading fees made by traders transferring tokens in and out of the liquidity pools, rather than using a centralized exchange to fill orders.
Users can switch from one token to another in a totally decentralized manner while preserving control over their funds via these liquidity pools. Liquidity providers are also urged to deposit tokens in exchange for a share of the fees charged by the exchanges. Liquidity providers can be fully passive after pooling their tokens because the smart contract will automatically update the liquidity-providing logic based on the current market price.
As a result, DEXs are powered by automated market makers that use mathematical algorithms to predict the exchange rate between two assets depending on the liquidity available on the protocol.
There is no entity to check the identities of the people using the platform to comply with KYC/AML rules because Uniswap is controlled by no centralized party (the platform is ultimately regulated by its users) and any development team can use the open-source software. It’s unclear how regulators will approach the legality of a platform like Uniswap.
Because blockchain transactions are irreversible, a faulty DeFi transaction or even the deployment of smart-contract code with faults cannot always be easily reversed. Coding mistakes and hacks are all too common.
Yam Finance, a business that launched in 2020, swiftly raised its deposits to $750 million before crashing due to a technical issue a few days later. Furthermore, the smart contract code that implements DeFi platforms is typically open-source software that can be easily duplicated to set up competing platforms, causing instabilities as funds transfer from platform to platform.
The person or entity behind a DeFi protocol may be unknown, and investors’ funds may be lost. Some DeFi protocols have been labeled as “Ponzi-like” by investor Michael Novogratz.
DeFi has been linked to the 2017 cryptocurrency bubble’s initial coin offering (ICO) excitement. Due to the intelligence necessary to connect with DeFi platforms and the lack of an intermediary with a customer-support department, inexperienced investors are at a higher risk of losing money.
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