DeFi – Decentralized Finance Explained

Last updated on 10th January 2021

The Revolution of the Financial System

Those who closely follow the main cryptocurrencies can’t have missed the entry of several tokens into the top positions of CoinMarketCap last year, with names as exotic as yearn.finance, SushiSwap or Polkadot. These also present huge increases in the annual cumulative, in some cases above 500%, in a very short period of time.

Is a new era in cryptocurrency before us? Will Bitcoin finally be dethroned as the main cryptocurrency in the coming months? Or are we simply facing a new boom similar to that of the 2017 ICOs?

In this article, besides trying to answer these questions, we will also analyze the new trends in the world of cryptoactives such as DeFi, yield farming, interoperability between blockchains, and the use of oracles to incorporate data from external sources.

DeFi: The Decentralized Finance Revolution

The term DeFi (Decentralized Finance) refers to a whole new ecosystem of tokens and protocols that aims to reinvent the traditional financial system by removing intermediaries (read here, banks and financial institutions) from the equation.

Thus, many conventional financial products and services such as loans, structured products, and stock trading have become available through a decentralized open source network running on Ethereum.

As you can imagine, it could be a real headache for conventional financial institutions if this trend begins to take hold. They would see a very real financial world begin to develop in parallel and beyond their control and in which they’d have a very difficult time competing.

Without a doubt, this is Satoshi Nakamoto’s dream come true. Things look serious: at the time of writing, the total value of the blocked cryptocurrencies in the DeFi ecosystem exceeded $10 billion, practically equaling the total capitalization of the third crypto-currency, Ripple.

This value has increased fivefold since last July, surpassing the entire Ripple capitalization. Within these projects, Uniswap stands out with more than 2,000 million dollars, Maker with 1,800 million and Aave with 1,400 million.

Source: Defipulse.com

If we were to situate the start of the DeFi revolution in time, we wouldn’t have to go too far back in time: in June of this year, Compound began to distribute its COMP token. It turned out to be a spectacular success, going from a price of $80 to a maximum of $427 a few days later. In good part, this was achieved with the support of the Binance exchange, which gave the green light to release this token.

Although it is true that Compound had not been listed until 3 months ago, this project actually originated back in 2017. Developed by economist Robert Leshner, it received funding from Coinbase through Coinbase Ventures.

Compound – Decentralized Lending System

Within the ecosystem of this project, we can differentiate two kinds of tokens: on the one hand there is the original project token (COMP), which is a government token. That is, the holders of the COMP obtain voting rights that allow them to decide in a decentralized manner on matters such as protocol updates or the inclusion of new assets for loans on the platform.

On the other hand, we should not forget that Compound is, in practice, a decentralized lending application developed on the Ethereum blockchain. And this is where the magic of DeFi begins: with the so-called cTokens.

In essence, these tokens work as follows:

Anyone whose cryptocurrency is accepted by this protocol can deposit it in a smart Compound contract where it joins a liquidity fund and starts generating interest. The interest comes from other users who borrow funds and pay interest on the loans.

At the time the lender deposits the funds to offer them to other users, the protocol issues the so-called cTokens, which represent the right to a portion of the reserve of an asset in Compound. If, for example, we deposit Ethereum in Compound, we will receive its equivalent value in cETH.

Assets supported in Compound

Currently the assets supported in Compound are Wrapped BTC (WBTC), Ether (ETH), Tether (USDT), USD Coin (USDC), DAI (DAI), Uniswap (UNI), 0x (ZRX), Augur (REP), Basic Attention Token (BAT) and SAI – Legay DAI (SAI).

Each of the loans denominated in these assets generates the corresponding cTokens (cWBTC, cETH, cUSDT, cUSDC, cDAI, cUNI, cZRX, cREP, cBAT, cSAI), each with its own interest rates, which are updated in an algorithmic way according to supply and demand.

Interest Rates

This unique interest rate for each asset is called the Average Percentage Yield (APY), which considers the effect of reinvestment of profits (other protocols use the Average Percentage Rate (APR), which does not consider this effect). In any case, it should not be forgotten that these yields are future projections and can fluctuate quite a bit as such.

If you are curious, you can check what interest rates you can obtain as a lender on the Compound website. You can  also see what you would pay if you were a borrower. The values traded at the time of writing ranged from near zero in Uniswap cTokens, Basic Attention Token, and Augur to almost 3% in the case of Dai.

In any case, by borrowing from our tokens we can easily achieve higher returns than many current bank deposits.

Values range from near-zero in Uniswap, Basic Attention Token, and Augur cTokens to nearly 3% in Dai. Some of these loans allow us to achieve higher returns than many current bank deposits.

Main DeFi Solutions

Like almost everything else in the world of cryptos, Compound is only the tip of the iceberg of the DeFi. The revolution comes with many other projects.  Let’s see some of the most relevant projects within this wide ecosystem to follow below, classified according to their practical use:

Loans

These are, as we have just seen, decentralized loan applications executed on the Ethereum blockchain. Within this segment, the main projects to be considered are Aave (LEND), Maker (MKR), and yearn.finance (YFI) apart from Compound (COMP).

Learn more about cryptocurrency loans.

Exchanges

We now enter the field of protocols that enable setting up of decentralized markets or Decentralized Exchanges (DEXs). These are intelligent contracts that act as automatic market makers (the so-called Automated Market Makers or AMMs) with which we can remove the owner of the trading platform from the equation while acting as custodians of the funds and digital assets deposited.

In return, participants who provide liquidity by purchasing tokens on the exchange receive commissions for this. In this regard, I recommend that you look into Uniswap (which issued its own government token in mid-September), Curve Finance, Balancer, and SushiSwap (the latter is a Uniswap fork).

It should be noted that this type of project generally does not entail a native token. Instead, each traded pair represents a token itself, which we can buy to provide liquidity.

By the way, the volume traded in Uniswap is interestingly starting to exceed that traded in Coinbase.

Asset Managers: closing the loop, the protocols here allow for the addition of investor funds and automated investments in user-created management products. Within this category, we need to turn attention to Melon (MLN), Set Protocol, Zapper.fi, and Instadapp.

Risk Coverage

Prediction markets, derivatives trading, and decentralized insurance

While one might think when starting research on DeFi that investing in it can be very risky, the truth is that there is nothing to worry about since, within the ecosystem of decentralized finance, everything has already been invented and secured.

Thus, it is entirely possible to receive protection from risk with options and insurance, or even use predictive markets, which can protect us from potentially adverse scenarios.

Within this section, let’s take a look at the Augur token (REP) and Polymarket within the prediction markets; at Synthetix (SNX), which allows us to create synthetic assets, and at the MCDEX exchange, where we can trade derivatives in a decentralized way. In the field of decentralized insurance, the references to consider would be followed by Erasure, Opyn, and Nexus Mutual (NXM). It is precisely in this last exchange that “policies” allowing protection against failures in a smart contract are negotiated.

Digital Assets Bridges

In case you still don’t see enough potential in the decentralized financial innovation described, pay attention to this last point: through what is called Digital Assets Bridges, we can tokenize any digital asset and use it as collateral in financial contracts within the DeFi ecosystem.

Such is the interest roused by platforms like BitGo (386 million dollars in tokenized Bitcoin), RenVM (200 million), or the future Keep Network that, paradoxically, Bitcoins are being tokenized at a higher rate than they are being mined!

Yield Farming: Making Money with DeFi

If you’ve followed everything we’ve discussed so far, you’ll have realized that all these new DeFi protocols have created new opportunities and inefficiencies to exploit in order to make money. The search for such opportunities to maximize the performance of our cryptocurrency portfolio is known as “Yield Farming” (alternatively also called “Liquidity Mining”).

In simple terms, the idea of Yield Farming is to generate passive income from the cryptocurrencies we have acquired using these new DeFi protocols as building blocks to construct interests in a compound way. Unsurprisingly, the jargon for each of these protocols is “Money Legos”).

This may seem silly now, but in the future, it may represent a radical change in the way cryptocurrency investors perform the so-called HODL (buying and holding crypto assets in a portfolio over the long term).

In practice, Yield Farming is as simple as buying a Stablecoin (i.e. a cryptocurrency that is guaranteed or backed by the value of an underlying asset ex.  Tether, a Stablecoin pegged to the US dollar in a 1:1 ratio) and depositing it as a lender in protocols like Compound or Aave.

Thus, we can buy Tether (USDT), go to Compound, add it to the liquidity pool for loans, and obtain the cUSDT token, which indicates that we have a share in a loan made in the exchange. Of course, if we put some imagination into it, we can also ask for a loan and deposit the amount received in another protocol that will give us greater returns as lenders.

If we are able to carry out this asset rotation process repeatedly, we can generate a snowball effect of interest that can yield significant returns.

We should also bear in mind that, as these protocols develop and the connections between them become easier, we can expect to be able to make even more complex transactions. For example, a new contract could be created in ERC-20 that combines different intelligent contracts into one so that we can invest $10,000 in Compound and get 3% interest. Then, we can reinvest the interest earned in another asset automatically using  a DeFi robot or use it as collateral for another loan.

Polkadot: Connecting Blockchains Together

Obviously, the complexity of the DeFi ecosystem  reviewed and, in general, the increasing number of blockchains in the world of cryptocurrencies lead to a greater need to facilitate interoperability between blockchains. This is undoubtedly an important revolution since it would allow the exchange of information between different blockchains.

However, the different existing solutions are not able to work properly. On one hand, they are too complicated; on the other, they are slow and overload the network. In some cases, they’re not even secure. All this until Polkadot (DOT) arrived on the scene.

Polkadot is an open source project developed by the Web3 Foundation, a Swiss foundation whose aim is to create a decentralized network that allows interconnection and interoperability between blockchains in a secure and reliable way. Naturally, this initiative is greatly appreciated by the market, which we can see when  we examine its most recent behavior.

It currently ranks 7th on CoinMarketCap with capitalization close to 3,500 million dollars with  more than 100% growth since August 2020. At the end of August, this token marked highs close to 7 dollars, which meant multiplying by 3.5 times its value at that time).

Polkadot currently ranks 7th on CoinMarketCap with capitalization close to 3,500 million dollars with  more than 100% growth since August 2020.

Source: Tradingview

As with some of the DeFi projects we mentioned earlier, this significant increase is largely owed to the fact that Polkadot is quoted on Binance. This is undoubtedly a blessing when it comes to cryptocurrency.

Of course, that’s not the only reason for this rise. We must bear in mind that it is a protocol that does not directly compete with the Ethereum network and is rapidly scalable, with around 200 projects in its ecosystem at present.

To top it all off, Gavin Wood is involved in the project. He played a key role  in the development of the Solidity programming language, on which most of the tokens within the Ethereum network are currently programmed. Therefore, it seems that Polkadot will stay at the front of the race  in the coming months. Polkadot isn’t the only interesting project when it comes to creating interconnection systems between blockchains.  In this regard, twosome names to remember and follow closely are Cosmos (ATOM) and Fusion (FSN).

ChainLink: Connecting External Data Sources

One name that has become big in recent months is ChainLink. This project, created in 2017 by Sergey Nazarov and Steve Ellis, allows the intelligent contracts executed in Ethereum to interact with real-world applications. They interact  through what are called oracles, a decentralized system, through which these contracts are supplied with external data.

Thus, intelligent contracts can receive information on temperature, stock quotes, or sports results, triggering their execution when predefined conditions are met. In return, participants in the ChainLink network receive incentives through rewards for providing access to these external data sources. Once again, we see the recurring theme of the elimination of intermediaries and decentralization, doing away with the man in the middle of data delivery.

It is clear that ChainLink proposes a major improvement in the way smart contracts work, and this is certainly to the market’s liking. Consequently, ChainLink reached a record high in July 2020, from $1.76 at the start of the year to $20 (although it has since adjusted to an extent). It currently, ranks 8th on CoinMarketCap, just behind Polkadot.

Analysis

Now that we have reviewed all the relevant recent developments in the space of cryptocurrencies, it is time to reflect on them and analyze what impact all these movements may have in the future.

To begin with, we need to think about what it means to move from a paradigm dominated by centralized entities that control information and decide who to lend money to to one, in which loans become simple programmed instructions with no review of the applicant’s risk profile or even access to their personal data. Of course, I don’t think there is any need to explain at this point that it is also not necessary to have a bank account. A digital wallet is more than enough.

Only in some cases, as with Compound, the borrower is required to deposit an amount higher than the amount requested as a guarantee.

Going one step further, we are talking about a totally new world where interest rates are paid and negotiated in real time, not depending on the monetary policy of any central bank or the impact of different macroeconomic variables on that policy.

If we add to this the possibility that the blockchains of all these new projects, together with all the current blockchains, can interact with each other thanks to developments like Polkadot, the range of possibilities becomes practically infinite. Not to mention the possibility of combining the execution of intelligent contracts with data from the real world.

We therefore prove that a new era has begun in the world of cryptocurrency, with revolutionary projects that can signify a new 180º turn of the financial sector as we know it today.

It’s true that we’re living in dynamic times, especially when it comes to DeFi and everything it involves and affects. We may see a limited short-term deflation of the prices of these tokens. After corresponding market adjustment, however, I wouldn’t rule out the possibility of many of those we’ve looked at in this article climbing many positions in the CoinMarketCap ranking and threatening the hegemony of Bitcoin.

We must also take into account that all these innovations put forth a clear winner:  none other than Ethereum, whose capitalization will surely increase exponentially in the coming months.

Risks & Solutions

This whole new paradigm is not without its risks. Hackers will always be on the prowl in the world of cryptocurrency just like in the world of fiat money. What’s email phishing if not an outcome of their efforts? ). However, the DeFi ecosystem is excellent at anticipating risk. There are already multiple solutions created precisely to protect against the risk of a poor execution of an intelligent contract or a  hacked protocol.

And that’s without counting the continuous advance of the derivatives markets on cryptocurrencies such as BitMEX, Deribit, or Binance Futures, in which we can trade options and futures on a multitude of cryptocurrencies and cryptocurrency features. For example, the FTX exchange offers futures on the Bitcoin Hashrate.

In sum, this is a really interesting moment that can change the rules of the game in many ways. This becomes obvious when we consider the increasing number of  signs pointing to  impending mass adoption of cryptocurrencies as a means of payment for consumption.

Progressive Support and Adoption of Cryptocurrencies

PayPal and some banks in Europe and the US are opening the doors for clients to buy and store their crypto assets in the same “place” where they pay their mortgage or receive their salary. On other hand, more and more businesses are beginning to accept cryptocurrency as a means of payment, the latest notable case being Just Eat. This trend is accelerate thanks to the fact that many exchanges are issuing debit cards that allow you to pay any merchant directly by charging the expense to your cryptocurrency balance.

Finally, some of central banks’  recent moves  are particularly noteworthy. Some  governments have already launched their own legal tender cryptocurrency (like China with its DC/EP, supported by the central bank). Others are giving it some serious thought. A withdrawn bill in the US mentioned the digital dollar. Still others are not yet convinced, but are putting up barriers to other projects that could act as competition. The European Central Bank and the restrictions it plans to impose on the stablecoins or Facebook’s Libra project are a case in point.

In the wake of the revolution in DeFi and related projects, we can’t rule out the possibility of an intense legal battle between the fiat money of central banks and the decentralized universe of cryptocurrencies in as soon as 2021.