What is DeFi (decentralized finance)?

If you want to know why DEFI is a promising blockchain direction, then after reading the article, you must understand what DEFI is and why there has been so much talk about it lately.

To better understand what DeFi is, we must first look at how the traditional financial system came into being. Although sometimes it seems that the money we are used to has always been with us, this is far from the case.

Brief history

Initially, people exchanged goods and services. But with the formation and development of human society, our economy was also formed and developed. The emerging currency facilitated the exchange of values. Subsequently, the money helped to introduce innovations and increase the level of economic productivity. However, for the sake of this progress, it had to sacrifice a lot.

Historically, central authorities such as governments have issued the currencies that underlie our economy. It assumed that central banks and financial institutions would carefully regulate the amount of currency in circulation. As the scale and complexity of our economies grew, these central governments gained more and more power as more people trusted them.

You trust your government not to print more money overnight. You trust your bank to keep your money securely. And, when it comes to investing, you entrust your assets to a financial advisor. By transferring control of your money to others, you hope to earn a profit. But the sad truth about our current economic system is that the power that comes with that trust is not always used for good.

We often cannot influence how corporations manage our investments, and our governments drive the economy. In most cases, investors receive only a tiny part of the income from the risks taken by centralized authoritative structures.

DeFi is LEGO smart money (LEGO set)

To clarify, we can draw an analogy with the famous LEGO constructor. In the case of Lego, you start with a bunch of little bricks. How you collect Lego bricks to build something new is up to you.

The same can be said about Smart contracts. With every new DEFI project, product or service launched on the Ethereum blockchain platform, and you have another “money” building block. Lego in your collection. By bringing together existing DeFi components, you can combine, modify or create new effective financial instruments based on these building blocks.

In order to unite DEFI projects, there is an open community Defi network. One of the essential principles of this community is compatibility with other projects. There are 12 projects in this community: MakerDAO, Compound, KyberNetwork and others. Thanks to the complex effect and compatibility between projects, DEFI community members form the so-called “smart” money.

Tokens code is an excellent example of this smart money in action. The Compound project is a money market or, in other words, a lending service on the Ethereum blockchain platform. When you contribute DAI stablecoins to the Compound, you receive tokens cases that carry value – both your DAI in the Compound and any interest you receive from lending. Because cDAI is a token, you can send, receive, and even use it in other smart contracts. The smart money in action looks like this: we deposit Ether into MakerDAO to generate DAI tokens, then DAI is delivered to Compound, and then the received tokens cDAI can be used in other decentralized applications.

For example, you can exchange ETH for tokens cDAI in any DEX and start earning interest instantly by simply holding your purchased cDAI. In addition, since you are free to choose how and with which smart contracts to interact on the blockchain Ethereum, you can use a decentralized exchange aggregator like DEX.AG to compare and trade the best prices on all popular DEXs, all in seconds.

DeFi (decentralized finance) is an ecosystem of applications that provide financial services without centralized control over the use of cryptocurrencies. The ecosystem is based on distributed networks, the most common of which is blockchain. Hence, Ethereum is ideal for application deployment. This area of digital technology is now rapidly developing and includes various services – lending, insurance, stablecoins, derivatives, and crypto exchanges. The EthereumTrading.pro editors offer a detailed overview of the features and components of DeFi.

DeFi Challenges

DEFI is trying to change the usual foundations

Decentralized finance, or DEFI for short, is aimed at creating a financial system open to all and minimizing the need for trust and dependence on central authorities. Technologies such as the Internet, cryptography and blockchain give us the tools to collectively create and manage the financial system without the need for controlling centralized authorities.

An excellent saying among the blockchain community: “Don’t trust, verify”. In blockchain networks, you, as an individual, can verify every transaction that is recorded on the blockchain. DeFi allows everyone to take responsibility for their financial well-being.

Almost all DeFi applications are built on Ethereum, the world’s most popular programmable blockchain platform. Ethereum is a blockchain network that generates a shared ledger of digital values. Instead of a central authority, network participants decentralized control over the issuance of Ether (ETH) – the network’s cryptocurrency.

Developers can program applications on the Ethereum platform that can create, store and manage digital resources, also called tokens. These applications are called smart contracts, that is, “smart” contracts, or decentralized applications – an abbreviation for DApps. These are contracts or agreements binding on the Ethereum blockchain platform. More specifically, applications or scripts only work as programmed initially on the Ethereum network. Thanks to this, people worldwide can build complex irreversible agreements without intermediaries.

Decentralized finance allows the building of more sustainable and transparent financial structures. Moreover, anyone with internet access can also access smart contracts built on the blockchain Ethereum and further interact with them. At the same time, most smart contracts are made based on open source codes and are also compatible with already working “smart” contracts. Thus, users can check the smart contract code and choose the most appropriate services.

The difference between decentralized and traditional finance

DeFi can perform almost all the same functions as traditional banks, but it is much more efficient and convenient. Decentralized finance makes it possible to open deposits, use loans, and trade, all without the need to trust centralized organizations. Services are provided through decentralized applications (dApps), mainly deployed on the Ethereum platform. At the same time, to work with dApps, it is not necessary to have a deep understanding of Ethereum technologies, although it will never be superfluous.   

If we compare traditional and decentralized finance according to the main criteria:

• System of payments and transfers. Bank transfers from one country can take several days and involve significant fees. In addition, it is a complete lack of privacy. Cryptocurrencies underlying the operation of DeFi do not need intermediaries; transfers are carried out as quickly as possible (on the Ethereum network – from 15 seconds, with a commission of approximately $0.02). The benefits are obvious;
• Availability. Banks impose strict customer restrictions when opening accounts, lending and using other financial services. More than 1.5 billion people worldwide do not have access to banking services, and DeFi is guaranteed to make life easier for them. To use them, you only need the Internet;
• Centralization. Banks provide a relatively high level of security for storing funds, but not 100%. And the fall of a large bank necessarily entails a large-scale financial crisis. Decentralized organizations manage DeFi protocols, and this gives confidence that some people will not be able to make decisions on their own;
• Transparency. The average investor has no idea how the funds in his bank account are used. As far as DeFi is concerned, the source code of protocols developed on public blockchains is entirely transparent to all users and open to audits.

DeFi protocols are code, and it always executes precisely as programmed, the same for every participant without exception. Therefore, any vulnerabilities or flaws in the code are immediately apparent.

The DeFi movement aims to solve traditional finance’s main problems: low transaction speed, control of regulators, high commissions, and limited availability. It can eliminate these differences and provide access to every person’s financial transactions without censorship.

MonolithosDAO platform experts identified the three most important advantages of Decentralized finances. The first is decentralization, thanks to which control over the ecosystem belongs to all participants at once, transactions are fast and transparent, and there are no intermediaries. The second is management with the help of smart contracts. And the third is the availability of open source code, which can be used at any time to form other services based on previously checked and finalized.

Some examples of popular working DeFi applications

To better understand decentralized finance and how it works, let’s look at some examples of popular functional DeFi applications.

There are many different products and services in the DeFi ecosystem, some of which you may find similar to traditional financial services but with a decentralized internal architecture.

Perhaps the most popular and fastest-growing DeFi sector is lending and lending platforms such as Compound. Like in a bank, users deposit money and earn interest from other participants borrowing their funds. However, in the case of DEFI, the assets are digital. Smart contracts link lenders to borrowers, enforce loan terms, and distribute interest. And all this happens without the need to trust each other or the intermediary bank. By eliminating intermediaries, lenders can ultimately earn higher returns and better analyze risks, thanks to the transparent operation of the blockchain.

Tokens, called stablecoins, are also critical to the DeFi ecosystem. Since cryptocurrency is very volatile, this fact dramatically hinders the creation of sustainable financial products. However, stablecoins solve the problem of volatility. Stablecoins are tokens that carry a specific value, usually pegged to a fiat currency such as the US dollar. For example, as Part of the MakerDAO DEFI app, the DAI token is a USD-pegged stablecoin backed by Ether (ETH). For every $1 DAI token, there is $1.50 in Ether secured in MakerDAO’s DEFI smart contract as collateral.

Another type of popular DeFi application is the so-called decentralized exchanges (called DEX for short ). DEXs are cryptocurrency exchanges that use smart contracts to enforce the rules of trading and transactions and the safe circulation of funds. When you trade on the DEX, there is no exchange operator, no registrations, no identity verification, and no withdrawal fees.

How DeFi is used

Decentralized finance has found its way into more than ten main areas – and there is no doubt that this list will continue to grow. So let’s take a closer look at each of them, and you will see why exactly the DeFi principles in them fell into place as much as possible.

Stablecoins (stable coins)

Stablecoins were created to reduce the high volatility of digital currencies (sometimes as high as 10% per day), and the exchange rate was permanently pegged to fiat currency. One of the first centralized stablecoins is Tether (USDT), pegged to the US dollar.     One of the first centralized stablecoins was USD-pegged Tether (USDT). It is trendy, yet it has one major drawback – the owners are forced to trust the company issuing the coins that there are dollar reserves in the corresponding volume.

Decentralized stablecoins are issued by the method of over-collateralization (” super security “) by decentralized autonomous organizations. They work in public registries, and anyone can freely check their stock. A stablecoin cannot be called an application, but it is an essential component of most applications from other categories, so it was considered initially.

Decentralized stablecoin Maker

Maker is a platform for generating stablecoins, that is, cryptocurrencies pegged in value to fiat money. In addition, the MKR functional token serves to govern by public voting.

Maker is considered one of the essential protocols in crypto because it issues DAI stablecoin, pegged to the dollar through cryptocurrency backing.

The main reason Bitcoin and Ethereum cannot yet be used as everyday currencies is their high volatility. The cost can change by 25% in one day or 300% monthly. A stablecoin is a collateralized cryptocurrency whose value is stable against the dollar or another fiat currency. Maker developers believe such coins are necessary to implement Blockchain technology principles fully.

A Maker is a smart contract based on Ethereum’s platform. A created token based on the site Dai, equivalent to the US dollar. Also, any participant can use their Ethereum assets to create Dai.

MKR is a governance token. MKR holders are responsible for making decisions about risky activities that affect the system’s future. Therefore, it makes sense for users of the Maker platform to keep some of these tokens.

The Maker platform operates by the principles of DAO or Digital Autonomous Organization. It means that artificial intelligence is used to control, regulate and stabilize the value of Dai. But there is also a human element. The Board of Holders meets weekly to discuss measures to be voted on and implemented by the network; these meetings have been held since the inception of Maker and make MKR token holders primarily responsible for the system’s fate.

Anyone can use the Maker platform to create Dai by depositing collateral assets into the system in exchange for Dai. These assets are then returned to the holder when the debt is paid off.

Essentially, Maker is a half AI, a half-human system that tries to take the best qualities from there and from there.

Token will play a more significant role after the system upgrade than it does now. At the moment, it gives the right to vote in the development of the network, and the future, it will also act as a recapitalization resource. If insufficient collateral for debt positions (CDP) is inadequate, the MKR offer is automatically diluted and sold off, and enough funds are generated to rebuild the collateral.

Deposits and loans (landing platforms)

Loans and deposits using cryptocurrencies are not new, but initially, such platforms were only centralized, and they are still in demand. Of course, decentralization brought a lot of unique and valuable things to this area.

Traditional financial systems assume that the client has a bank account to be able to take out a loan and deposit money at interest. At the same time, a significant part of the world’s population does not have an account, nor does it have the opportunity to open it. And this is not the only problem. Good credit history and a stable official income are required to obtain a bank loan from a bank.

DeFi lending is based on the concept of credit pools when some users invest in cryptocurrency to receive interest. In contrast, others can take a loan secured by cryptocurrency with a loyal interest rate without any solvency checks. In this case, the pledge itself serves as proof of security.  

Insurance

Tokens in smart contracts are potentially vulnerable, as hackers want to gain access. Of course, the code of most popular projects is checked for vulnerabilities, but the risk always remains.

Insurance is needed to compensate for losses in the event of unauthorized hacking, especially when it comes to large sums. Nexus decentralized insurance protocol developed Mutual, which offers insurance for any smart contract running on the blockchain Ethereum.

Derivative contracts/synthetic assets

We are talking about derivatives – contracts, the value of which is determined by the weight of underlying assets – cryptocurrencies, indices, stocks, commodities, bonds, etc. Traders use derivatives to hedge the risks of transactions.

Currently, derivatives are traded mainly on centralized exchanges, but DeFi platforms for this purpose are already emerging; for example, –  protocols for synthetic assets whose functions are to track the value of underlying assets and gain access to them without purchasing them.  

The most extensive DeFi protocol for derivatives is Synthetix

DeFi trading protocol Synthetix (Derivatives Liquidity Protocol) is a new financial instrument that allows the creation of synthetic assets, offering unique derivatives and access to tangible assets on the blockchain.

Synthetics capture price movements for popular cryptocurrencies, fiat currencies, stocks, commodities and more with zero slippage.

Synthetic assets, or synthesizers, are assets the community has voted to exist and can be represented as fiat currencies, cryptocurrencies, stocks, commodities, and anything else with a price.

Synthetix supports decentralized perpetual futures markets, options markets, trade coordination markets, and more.

Decentralized Crypto Exchanges (DEX)

Centralized exchanges, such as Binance or Coinbase, mediate trading and store user assets. Clients have no control over their funds, and if the business is hacked, there is a risk of financial loss.

To solve this problem decentralized DEX exchanges have been created, where users can exchange assets without trusting anyone to store them. Examples of such businesses are dYdX, Binance DEX, and Uniswap. They operate based on the blockchain, do not store confidential client data on servers, and provide only service for matching orders to purchase and sell assets.

Transactions

One of the central values of cryptocurrencies and decentralized systems is the direct transfer of assets between users without the participation of intermediaries, which means without delays and overpayments. With the advent of DeFi projects, there are even more opportunities for implementing various exciting solutions.

One can cite the Sablier project, which changes the configuration of payments – now, instead of the usual transactions, these are peculiar flows. It gives quite a lot of potential possibilities that are highly accurate.

Issuance of tokenized securities

Such DeFi projects decentralize the issuance or creation of securities to avoid recourse to intermediaries (in traditional financial structures, these intermediaries are usually played by investment banks). The tokenized securities market involves the issuance of tokens that have the properties of securities (they are called security tokens ). It is noteworthy that they fully comply with securities laws.

Usually, security tokens are backed by assets or give the right to a share of the issuer’s profit.

They can also be:

• debt instruments;
• investment instruments;
• digital shares of this or that asset;
• derivatives.

One of the advantages of security tokens compared to standard stocks is increased liquidity – they can be split into smaller units. Thus, even despite the low liquidity of the underlying asset, the tokens related to it can be very liquid.

Securitize, and Polymath is examples of platforms that provide functionality for issuing tokenized securities and their further management, up to communication with investors.

Lotteries

A non-standard but quite reasonable use case for DeFi is to transfer control over the lottery prize fund to a smart contract on the blockchain. Then, you can easily link the lottery app with other dApps to create a complete framework.

Participants pool their funds into a single pool, and then the total capital is transferred to a DeFi lending application. Finally, the interest received is transferred to a random winner at a specific interval. Immediately after the winner is determined, the smart contract returns to everyone his contribution; thus, the lottery is a win-win.

PoolTogether is one such protocol.

Investment portfolio management

Portfolio management ensures maximum income by controlling existing financial assets and their timely redistribution. There are:

• Active – when the goal is to get a specific profit not less than a given standard;
• Passive – when the goal is simply to get the possible profit without specific requirements.

 Separate DeFi projects allow the implementation of decentralized passive portfolio management. Thanks to their transparency, a user can always know how his funds are being managed and what income and expenses he may have. 

An example of a service for managing an investment portfolio is TokenSets.

 Markets with Peer-to-Peer Predictions

In many jurisdictions, gambling and the betting industry on events (sports matches, elections or other events) are prohibited. However, it led to the formation of a kind of decentralized forecast market. Augur is an example of such a platform, where anyone can bet on specific events and sell or buy shares with potential profit. And for example, a platform like Numerai even uses artificial intelligence and trade prediction algorithms. Bets are accepted on any forecast; the amount of remuneration depends on the initial amount and the accuracy of the estimates.

Is it challenging to use DeFi services?

Even though applications are open and available to everyone, one of the main problems can be individual training and user experience. Blockchain developers are currently working on this in the first place. For example:

• Argent wallet eliminates the need for seed -phrase to restore access to the wallet, allows you to conduct free transactions on the Ethereum network, is equipped with integration with Compound and other DeFi projects;
• Gelato Finance allows clients to program actions, such as “buy ETH at $210” or “send 0.5 ETH to such and such address on August 27”;
• The DeFiZap application also removes many of the complexities and issues associated with DeFi products and allows you to access several services at once based on one transaction;
• Cryptocurrency insurance apps have already been mentioned. It is an excellent way to increase the safety of keeping savings in credit protocols, although it slightly reduces profitability;
• There are DeFi yield optimizers that remove the need to switch between different projects to find the best yield. iEarn, idle. finance, etc. distribute assets independently between applications on the blockchain Ethereum;
• Paraswap, DEX.AG and several other services solve the same problem, but with regards to liquidity – instead of looking for the best-decentralized exchange for trading, the client can trust these services, which aggregate the liquidity of all demanded platforms and automatically distribute orders;
• Some DeFi protocols provide the ability to mine while working with them. So, Compound distributes COMP tokens among all lenders and borrowers. Synthetix spreads SNX for collateral. Balancer distributes BAL to users who participate in the creation of liquidity pools. There are many such projects. Thus, using the main functionality, you can also receive passive income.

Developments appear very actively, and there are answers to all the common difficulties that users have. Undoubtedly, over time there will be an application combining all the user-friendly functions.

Risks of using DeFi

Not everything is so perfect. Decentralization can be different.

There are varying degrees of decentralization regarding DeFi application services. The point is that, in truth, not everything can and should not be completely decentralized.

As mentioned earlier, stablecoins are popular in DeFi. But not all stablecoins are as decentralized as DAI. Many of them are tokens, which are deposits in fiat currency. For example, for every USDC stablecoin, there is $1 in a bank somewhere.

Theoretically, you can “tokenize” or create a token representing any real asset on the blockchain. However, it is where things get a little less black and white because while you can trade, send, and receive these tokens on the blockchain, you cannot physically eliminate the need to manage or redeem assets in the real world.

Take, for example, buying a house and writing on a blockchain. Suppose someone tokenizes a document of ownership to their home, puts it on a decentralized exchange, and you buy it. Without the proper legal system and legislation on your side, you cannot simply force that person to leave your home, whether or not you own a digital version of that home. In its current form, to resolve the dispute, you will have to somehow resort to your country’s judicial system.

In short, there are limits to the technology, and sometimes the lines of DeFi applications start to blur. Over time, laws will adjust to the changing financial system, and Devi’s place in this world will become more apparent. On the other hand, it’s safe to say that DeFi is already being used by many people and continues to be actively developed. Over half a billion dollars of Ether has been locked in DEFI applications.

Thus, despite all the advantages, there are also dangerous aspects of decentralized finance. However, it is understandable because the technologies used are relatively new. The main risks include:

• Hacking smart contracts. Humans write code, and humans can make mistakes. In this regard, it makes sense to use only those platforms that are verified by well-known auditors, including OpenZeppelin, Quantstamp, ZK Labs, etc.; although even then, there is a possibility of a critical error;   
• Liquidity and credit risks. Due to the instability of the cryptocurrency, with a sharp drop in the underlying asset, the system may collapse. DeFi protocols provide solutions to such problems through the provision of over-collateralized loans;   
• Lack of funds for lending. With specific collateral, you can get a loan in DeFi much more modestly than in a traditional financial institution;
• Fake oracles. Initial information (cryptocurrency rates, etc.) is provided to Blockchain Protocols from external systems, often centralized. It will execute the smart contract incorrectly if the source is unreliable. To address this risk decentralized source alternatives are being developed;
• Centralized control over development. Like it or not, one team is engaged in creating the code. Even the fact that developers often involve users in the process can cause problems due to their incompetent intervention; 
• It’s hard to find someone responsible. The principle of decentralized control does not always work as initially intended. All users are equal, but among them, some aim at the collapse of the ecosystem or are simply passive and are not going to participate in the process (which often causes no less harm than the actions of attackers).

Due to the over-hype around DeFi, some believe that DeFi is a bubble, similar to the 2017 ICO boom. But the direction seems so promising that it must assume that soon the hype will calm down, and the technologies will begin to be systematically applied in practice.

Defi website pulse is the ranking of the most popular DEFI applications. In addition, you can track where and how much Ether, or stablecoins, is locked there.

Advantages and disadvantages

Pros

• Speed and low cost of operations in decentralized networks;
• The immutability of the information recorded in the blockchain;
• Transparency and openness for audit;
• Lack of centralized management; everything works on pre- programmed smart contracts;
• No one can edit the contract in their favour unnoticed by the rest;
• The DeFi market is available to anyone with an internet connection, regardless of country of residence or other factors.

Minuses

• Centralized development, as a result of which the quality of smart contracts depends on one team;
• Risk hack smart contracts;
• Smart contract may contain an error, and after it works, it is technically impossible to cancel the erroneous operation;
• Open source code allows hackers to study the contract and look for loopholes for attacks;
• Scalability of DeFi applications depends on the characteristics of the blockchain on which they are located.

Conclusion

The topic of decentralized finance is almost endless. Today, hundreds of applications in the field of decentralized finance have been created and are successfully operating. Some became very popular in in a matter of months, like Compound or Uniswap. Large companies have not ignored the potential of DeFi; for example, the Binance exchange launched a decentralized platform Binance DEX.

DeFi applications and projects can benefit residents of states with weak or unstable economies. For example, in Argentina, it even proposed to give people a salary in DAI in connection with the horrendous inflation of the national currency. Services are also popular in developed countries due to the offer of a more profitable and affordable lending system and the fact that they open up new opportunities for interest income from investments.

That’s probably all. We hope that now you understand how DEFI applications work, what they are for and why this is an up-and-coming area, which, in my opinion, is worth studying. After all, this is essentially the birth of a new financial system built on the blockchain. Suppose the Ethereum platform’s long-awaited update and the POS transition are successful. In that case, it will solve the scalability problems, the commission will be lower, and the transaction speed will be many times higher.

We think the whole ecosystem will increase significantly, new developers will come, and new applications will appear. And the direction of DEFI, respectively, will gain an even larger audience of users.

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