DeFi: The New Crypto Banking System

Last updated on 10th January 2021

blockchain financial system

The Revolution of the Financial System

Those who closely follow the main cryptocurrencies will have observed last year the entry of several tokens into the top positions of CoinMarketCap, with names as exotic as yearn.finance, SushiSwap or Polkadot, which also present huge increases in the annual cumulative, in some cases above 500% in a short space of time.

Is a new era in cryptocurrency looming? Can Bitcoin 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 or 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 of the usual financial actions, such as loans, structured products or stock trading, can now be done through a decentralized open source network running on Ethereum.

As you can imagine, if this begins to thrive and take hold, it could be a real headache for today’s financial institutions, who would see a real parallel financial world begin to develop that is beyond their control and against which it is going to be very difficult to compete.

Without a doubt, this is Satoshi Nakamoto’s wet dream come true. And watch out because it looks like he’s serious: at the time of writing, the total value of the blocked cryptocurrencies in the DeFi ecosystem exceeds $10 billion, practically equaling the total capitalization of the third crypto-currency, Ripple.

Total value blocked in decentralized finance projects

This value has been multiplied by five 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 and it turned out to be a complete success, going from a price of $80 to a maximum of $427 a few days later, in good part helped by the support of the Binance exchange, which gave the green light to release this token.

Although it is true that Compound has not been listed until 3 months ago, it is actually a project whose origins date back to 2017, when this project developed by the economist Robert Leshner 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.

But 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.

The operation of these tokens is, in essence, as follows:

Anyone who has a cryptocurrency 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 takes into account the effect of reinvestment of profits (other protocols use the Average Percentage Rate (APR), which does not take this effect into account). In any case, it should not be forgotten that these yields are future projections that can fluctuate quite a bit.

In case you are curious, on the Compound website, you can consult the interest rates you can obtain as a lender, and also those you will pay if you are a borrower. The values traded at the time I am writing this range from near zero in Uniswap cTokens, Basic Attention Token or 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 or 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

Of course, like almost everything that happens in the world of crypts, Compound is only the tip of the iceberg of the DeFi, there are many projects around this new revolution. Let’s see below some of the most relevant projects within this wide ecosystem to follow, 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, apart from Compound (COMP), the main projects to be considered are Aave (LEND), Maker (MKR) and yearn.finance (YFI).

Exchanges

here we enter the field of protocols that allow the 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 generally in this type of project there is no native token, but instead each traded pair represents a token itself, which we can provide liquidity by buying it.

By the way, as a curiosity: the volume traded in Uniswap is starting to exceed that traded in Coinbase.

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

Risk Coverage

prediction markets, derivatives trading, 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 is already invented.

Thus, it is already possible to cover ourselves from risk with options and insurance, or even use predictive markets, with which it is possible to be protected from possible adverse scenarios.

Within this section, 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; and in the field of decentralized insurance, the references to take into account would be followed by Erasure, Opyn and Nexus Mutual (NXM). It is precisely in this last exchange that “policies” are negotiated that allow protection against failures in a smart contract.

Digital Assets Bridges

and in case you still don’t find enough of this decentralized financial innovation that we have just seen, pay attention to this last point: through what is called Digital Assets Bridges, we can tokenize any digital asset to be able to use it as collateral in financial contracts within the DeFi ecosystem.

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

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”).

crypto DeFi systemIn simple terms, the idea of Yield Farming (which could be translated as “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 (not surprisingly, in the jargon, each of these protocols is called “Money Legos”).

This may seem silly now, but in the future it may be a radical change in the way crypto-currency investors perform the so-called HODL (you know, buy and hold crypto assets in a portfolio for 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. This would be the case with Tether, a Stablecoin linked to the US dollar in a 1:1 ratio) and depositing it to act as a lender in some of the protocols we have just seen, such as 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 throw our imagination into it, we can also ask for a loan and deposit the amount received in another protocol that will give us a greater return as lenders.

Even if we are able to carry out this asset rotation process repeatedly, we can generate a snowball effect of interest that can generate 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, get 3% interest, and then automatically reinvest that interest earned in another asset through a DeFi robot, or use it as collateral for another loan.

Polkadot

Connecting Blockchains Together

Obviously the complexity of this whole DeFi ecosystem that we have just reviewed, and in general the increasing number of blockchains in the world of crypto-currencies, increases the 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 solutions that existed until now were not able to work properly: on the one hand, they are too complicated; on the other hand, they are slow, overloading the network; finally, in some cases they were not secure either. All this was the case until Polkadot (DOT) arrived.

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.

And of course this is an initiative very positively valued by the market if we examine its most recent behavior.

It currently occupies the 7th position in the CoinMarketCap ranking, with a capitalization close to 3,500 million dollars, and accumulating a rise since August of more than 100% (in particular, 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).

Evolution of Polkadot's price in relation to USDT.

Polkadot is currently in 7th place in the CoinMarketCap ranking, with a capitalization of nearly 3,500 million dollars, and accumulating a rise since August of more than 100%.

Source: Tradingview

This significant increase, as has happened with some of the DeFi projects we mentioned earlier, has been largely due to Polkadot has gone out to quote in Binance, which undoubtedly is a kind of blessing to date in the field of crypto-currency.

But, of course, there is much more behind this rise: we must bear in mind that it is a protocol that does not directly compete with the Ethereum network, is rapidly scalable and there are already around 200 projects in its ecosystem.

To top it off, the project involves Gavin Wood, a key figure in the development of the Solidity programming language on which most of the tokens of the Ethereum network are currently programmed. Therefore, it seems that Polkadot can be a winning horse in the coming months

But there is more: in the field of creating interconnection systems between blockchains there are other very interesting projects besides Polkadot. In this sense, take good note of these names to follow them closely: Cosmos (ATOM) and Fusion (FSN).

Connecting External Data Sources

Finally, another name that has made a name for itself 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, in such a way that through what are called oracles (oracles), a decentralized system through which external data is supplied to these contracts.

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. Here again we see the recurring theme of the elimination of intermediaries and decentralization, eliminating the man in the middle from data delivery.

It is clear that what ChainLink is proposing with your project is a major improvement in the way smart contracts work, and this is certainly to the market’s liking. Thus, ChainLink rose to a record high in July of this year, from $1.76 at the start of the year to $20 (although it has since corrected much of that rise), ranking 8th in CoinMarketCap, just behind Polkadot.

This token marked historical highs in July of this year, going from $1.76 at the beginning of the year to $20, which placed it in 8th place in CoinMarketCap.

Conclusion

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

To begin with, it is worth stopping for a moment 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 and who not, to one in which loans become simple programmed instructions, with no review of the applicant’s risk profile or access to his or her 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 or wallet is more than enough).

Only in some cases, such as 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 projects 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 can therefore say that a new era has begun in the world of crypto-currency, with revolutionary projects that can mean a new 180º turn of the screw in the financial sector as we know it today.

It’s true that right now we’re living a hot moment, especially in everything that bears the DeFi name, and that we may see a small puncture in the short term in the prices of tokens for these projects, but after the corresponding market adjustment, I wouldn’t rule out that many of those we’ve just seen throughout the article will be able to climb many positions in the CoinMarketCap ranking and threaten the hegemony of Bitcoin in the cryptocurrency market.

First of all, we must take into account that all these innovations have a clear winner, which is none other than Ethereum, whose capitalization will surely increase exponentially in the coming months.

Risks & Solutions

Of course, this whole new paradigm is not without its risks: hackers will always be on the prowl, both in the world of cryptocurrency and in the world of fiat money (don’t we get phishing campaigns in our email?).

However, in the DeFi ecosystem everything is foreseen and there are already multiple solutions created precisely to protect against the risk of a poor execution of an intelligent contract or the hacking of a protocol.

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

In short, this is a really interesting moment that can change the rules of the game in many ways, especially if we take into account that there are more and more signs that a massive adoption of cryptocurrencies as a means of payment for consumption could take place soon.

Progressive support & adoption of cryptocurrencies

Thus, Paypal and some banks in Europe and the US are opening the doors for their clients to buy and store their crypto assets in the same “place” where they pay their mortgage or receive their salary.

On the other hand, more and more businesses are beginning to accept cryptocurrency as a means of payment, the latest notable case being Just Eat; a trend that is surely starting to accelerate thanks to the fact that many exchanges are issuing debit cards that allow you to pay directly at any merchant by charging the expense against your cryptocurrency balance.

Finally, the recent moves by central banks are particularly striking: We have governments that have already launched their own legal tender cryptocurrency (such is the case of the People’s Bank of China with its DC/EP), as well as others that are seriously considering it (some bills in the US have already mentioned a digital dollar, although it has since been withdrawn) and others that are not yet convinced but are putting up barriers to other projects that could act as competitors (such is the case of the European Central Bank and the restrictions it plans to impose on the stablecoins or Facebook’s Libra project).

After this revolution in the DeFi and related projects, it is not to be ruled out that in 2021 we will see an intense legal battle between the fiat money of the central banks and the decentralized universe of cryptocurrencies.


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