Decentralized finance, abbreviated as DeFi, is an umbrella term for diverse financial applications in the blockchain and cryptocurrency space. It is primarily geared towards the disruption of financial intermediaries by creating an open alternative to traditional banking services.
The use of smart contracts on blockchain networks like Ethereum makes DeFi possible. While some concepts might seem futuristic, automated transfer of funds to settle trades between strangers, without any banking intermediation is already live today, through the use of blockchain platforms like Ethereum.
The majority of the world's crypto trading has been executed through the traditional centralized medium using digital platforms like Binance, Coinbase, Bittrex, etc. However, a surge in DeFi has given rise to DEX, which facilitates cryptocurrency trades on a distributed ledger.
Decentralized Exchanges (DEX) eliminate single point of failures and transfer the control of trading and funds to the users and applications. This prevents any possibility of government intervention on taxation or confiscation of funds.
In today’s post, let’s examine DeFi and DEXs in further detail.
Decentralized Finance refers to the banking and financial services that are offered through smart contracts. Smart contracts create a system to enforce agreements without the need for a lawyer or bank to transfer money or perform other currency transactions using blockchain technology and a wallet. In the past 1 year, the total value locked up in DeFi contracts has surged from US$500 million to US$12 billion.
Let’s review a few key differences between DeFi and Traditional Finance:
Decentralized finance uses public blockchain platforms like Ethereum as a source of trust to allow users to lend and borrow money. This eliminates “know your customer” system and paperwork followed by traditional banks. Thus, participation in DeFi is permissionless as the same rules apply to all users without the need for a custodial oversight which entails laws and licensed financial institutions.
Staking of DeFi protocols can provide varying interest rates. Market prediction suggests that some of these rates could reach double-digit figures. Traditional banks, on the other hand, offer less than 1%.
Traditional financial networks allow various collateralization options like staking your home to raise capital. Though DeFi doesn’t support this at present, tokenization could change this, with houses and other assets being represented in the form of tokens.
Decentralized finance is more transparent and open than traditional finance. It eliminates barriers to entry like credit scores, KYC and more. Thus, anyone can build financial services and tools by using blockchain technology. In contrast, traditional finance presents cumbersome barriers to entry as one must procure appropriate authorization and licenses from regulators before dealing in banking applications or crypto trades for assets like Bitcoin, Ethereum, etc.
The majority of DeFi applications are running on the Ethereum blockchain because Ethereum makes it easier to develop DApps.
Below are some of the practical uses of decentralized finance:
1. Trading, Decentralized Exchanges, and Marketplaces
Markets have been lacking a secure way of trading since its inception. Across liquidity pools, decentralized exchanges, and marketplaces, several trades are executed within the DeFi space. Thus, DEX is one of the most widely known applications of DeFi. DeFi protocols are also used to back online marketplaces to facilitate payments and exchange of products to serve consumers globally. The transparent and open structure allows the rules governing exchanges and marketplaces to be visible to everyone ensuring complete auditability and accountability.
2. DeFi derivatives
DeFi has seen a surge in crypto derivatives as they can be used to represent both virtual and real-world assets. DeFi is used to create smart contracts that can issue tokenized derivative contracts executed on permissionless blockchain platforms automatically. There are two key advantages to trading a DeFi derivative –
Eliminating the risk associated with price volatility for an asset by agreeing to execute the trade at a fixed cost in the future.
Speculating on certain asset's performance in the future, to potentially earn profits.
3. Stablecoins and P2P Platforms
Stablecoins are cryptocurrencies whose value is tethered to that of another currency like the US dollar, or a physical asset, like silver or gold. They are used to reduce the volatility risk associated with cryptocurrencies. A number of these stablecoins are offered on Ethereum Blockchain across the DeFi space. They are used for making payments on DEX platforms, or for lending and borrowing.
The peer-to-peer lending and borrowing platform is an extensively used application of the DeFi system. Decentralized finance lending platforms give out loans in a trustless way without the need for a third-party. Moreover, lenders can earn interest on the funds that they deposit, in the form of crypto.
DeFi projects are created to make assets easily accessible to ensure adequate liquidity. The end-goal is to make cryptocurrency and blockchain technology easier to use, thus promoting financial inclusion. Thus, the key fields of DeFi include lending, Decentralized Exchanges, Derivatives, Payments, and Assets. Another use of DeFi in Prediction Markets. Augur is a decentralized prediction market protocol used to vote on the outcome of events by attaching a value to your vote.
Decentralized exchange, like Binance, is a crypto exchange platform that allows P2P transactions between users. The funds are controlled without any intervention from central administrative authorities. Thus, they have low trading fees, increased liquidity, and can safeguard user data against threats of hacking.
The key functions of an exchange include deposit of money, order books, order matching, and asset exchange. In DEX, most of these processes are decentralized. DEX can either use a traditional order book model or an automatic market maker (AMM) system. The order book matches buyers’ bids with sellers’ offers. AMM compares each transaction with a pool of assets in a smart contract, such that the transaction price is determined by the ratio of assets in the pool. The latter does not need a particular counterparty for every transaction as the smart contract executes the orders. Thus, AMM is ideal for tokens that lack liquidity. DEX crypto trading can take place either on-chain (usually Ethereum) or on side-chains, to increase the throughput. Eventually, all trades are verified on the main blockchain.
DEX also use a staking process. Staking places focus on maintaining control of asset ownership and private keys. With staking on DEX, users are no longer required to trust third-party to secure and control assets. Thus, user have complete control. This provide a trust layer ensuring less susceptibility of private funds when it comes to being compromised, as key management is crucial for security. Increase in validators means more keys that need management. Thus, Staking offers greater support.
Though Decentralized exchanges differ when it comes to trust protocols, technology, systems, legality, security, and more, all of them share the common goal of resolving the shortcomings of traditional exchange platforms.
Custody: Since Decentralized exchanges eliminate middlemen from cryptocurrency trading by presenting a peer-to-peer system, traders do not need to relinquish control of their private keys to conduct transactions.
Security: Most decentralized exchanges use distributed hosting to minimize the risk of attacks and infiltration. Moreover, all transactions are tracked in a ledger without the participants’ identity being divulged, as DEX platforms do not collect user data. Thus, if a leak takes place, a user's data won't be compromised.
Liquidity Issues: Decentralized Exchanges usually have low liquidity due to the lack of traders on the platform. Traditionally, people have been using central authorities like a bank, so they feel comfortable when a service is rendered by such an authority. Moreover, DEXs use several protocols that are not easy to understand for the mainstream audience, deterring them from using DEX platforms. Low liquidity worsens itself as exchanges with low trade volumes attract fewer traders causing the liquidity to get worse.
Limited Functionality: Large centralized exchanges offer advanced trading functions like stop-limit orders, crypto-bots, graphs, fiat transactions, and more. However, DEX platforms typically lack these functions due to limited history, lack of government support, and unclear regulations.
A decentralized financial world is poised to provide democracy and proxy for user value and create a stable cryptocurrency market. Given the security risks and high-profile breaches that centralization has witnessed over the years, DEX and DeFi seem like a real use case to positively impact the world. Though DEXs are in their infancy, they form the backbone to a DeFi ecosystem and are expected to enter mainstream adoption in the coming years.
The 0x protocol is one of the most popular frameworks for creating a decentralized exchange. You will need to download Yarn, node.js, Docker, and npx, to use it.
Though Coindesk’s Blockchain Bites suggests that Bitcoin has become more decentralized, a currency’s extent of decentralization is defined by properties like trustlessness, permissionless, and scalability. Keeping that in mind, Zilliqa, Tezos, and Elastos are some of the leading decentralized cryptocurrencies.
Anyone with an internet connection and a smartphone can access financial services in decentralized finance. A smart contract represents the core logic behind the applications. The front-end of these applications can be built on a desktop or mobile, and serves as the user-interface, while the back-end contains the business logic that leverages one or more smart contracts to interact with the blockchain network. Users can also host the front-end on decentralized storage networks like Swarm or IPFS.
The front-end will be a wallet that will help communicate with a blockchain. This wallet can manage your cryptographic keys and blockchain address. MetaMask is a great example of a decentralized finance app example.
This is done to prevent users from having to transfer their assets to the exchange, thus reducing the risk of theft from the exchange being hacked.