DeFi - The Complete 101
TL; DR: A financial system is a set of institutions, such as banks, stock exchanges, and insurance companies, which provide access to financial tools like trading, savings, and insurance. Weak financial institutions, poor regulation and inadequate supervision, and lack of transparency led to the financial crisis of the late 1990s and the 2008 global meltdown. The 2008 crisis led to a loss of over $2 trillion from the global economy and in USA alone 8.8 million jobs were lost.
Bitcoin emerged in response to the 2008 crisis - a new electronic cash system that’s fully peer-to-peer (decentralised with no middlemen like banks) and trustless (does not need any 3rd party in between to provide guarantee and trust).
The DeFi movement, started by Bitcoin, was further developed by Ethereum. DeFi is an alternate financial system built on blockchain, which is decentralised, trustless, and transparent. DeFi offers similar financial tools like trading, savings, insurance, and more - but cuts out the need for traditional financial institutions and intermediaries.
DeFi is also known as Open Finance and Distributed Finance. The terminologies may vary, but the underlying principle is to remove the bottlenecks that exist in the traditional financial system and create an alternate open network.
In this article...
What is Centralised Finance (CeFi)?
What is Decentralised Finance (DeFi)?
What are the components of DeFi?
What are the DeFi Applications?
What are the metrics with DeFi?
What is Centralised Finance (CeFi)?
Before we start with DeFi, let's look at CeFi - well, that's the new terminology for the traditional financial system which most of us know and have been using for a long time now.
The banks, along with 3rd party institutions, control the money in a centralised financial (CeFi) system. Access to the financial products are controlled by the banks, entities, and the people working there.
The centralised systems are also expensive and slow - because everyone involved in the chain must handle the money and take a commission out.
Another major challenge with the centralised systems is the lack of transparency. You put your money and trust in the bank. But you don't have a transparent view of what the bank does with the money. What's worse is, if anything goes wrong, the banks can freeze your accounts and cut-off the access to your savings.
In essence, the centralised financial systems:
- decide who gets access to the financial services (permissioned),
- require you to put your trust in a certain entity (trust-based),
- are closed books and not open to scrutiny (non-transparent), and
- are slow and expensive.
What is Decentralised Finance (DeFi)?
Contrary to CeFi, Decentralised Finance (DeFi) removes the middlemen like banks, financial institutions, and intermediaries. Instead, the financial transactions are conducted over the blockchain, in a peer-to-peer way.
Anyone with an internet connection from anywhere in the world can access financial services. Using cryptocurrencies and smart contracts, DeFi provides financial services with no middlemen.
There are unique characteristics of DeFi applications, which makes them attractive compared to traditional financial services:
- Open: Traditional finance places many restrictions on participants like KYC, geographic location, license, T&Cs, etc. In DeFi, any individual could access DeFi solutions (permissionless) through an internet connection and a crypto wallet. DeFi is open for all.
- Transparent: Financial institutions are non-transparent - their books are closed to the public. In DeFi, the code for the applications is open for everyone and auditable.
- Non-Custodial: In CeFi, even though you may have access to your funds, it's the financial institutions that control the access to the funds. They can lock you out of your funds anytime. With DeFi, the users are completely in control of their funds.
- Trustless: One key reason for the financial institutions to exist is the need for trust. When two unknown parties are trading or exchanging money, the intermediaries serve as a trusted third party. In DeFi, trustless is a core and integral element. Using secure cryptography and incentives techniques, blockchains build the element of trust, with no need for a third party.
- Interoperable: Traditional financial systems are closed and don't allow free movement of assets from one bank to another. In DeFi, composability is the ability of open-source protocols to interact and combine creatively to form new products and services. Just like Lego, the idea is to stack and integrate multiple protocols, so users can freely move assets between different DeFi protocols.
What are the risks of DeFi?
Because of the benefits on the table, DeFi is believed to be the future of finance. However, DeFi isn't risk free. Like any other investment and financial instrument, DeFi carries certain risks. Broadly, the risks are:
Market Risks
The crypto market fluctuates wildly & there is the risk of losing some or the entire principle of your investments. DeFi is a new product and technology. The adoption, and therefore demand, is still not the same as traditional markets. This might mean no or low liquidity in the market.
Technical Risks
No technology is perfect, especially new and upcoming ones. Blockchain and DeFi as emerging technologies and prone to human errors and technical glitches. Even though theoretically blockchain technology is robust and hack-proof, the surrounding ecosystem, like wallets, exchanges, and marketplaces, are prone to hacking and failure.
Specific to DeFi, smart contracts are at the core of decentralised financial applications. Like any technology, smart contracts are prone to coding errors, inefficiencies, and unexpected behaviour. To complicate matters, smart contracts are immutable (cannot change) once deployed to blockchain. It becomes critical to audit smart contracts for potential flaws before deploying.
Finally, scalability is a challenge plaguing many blockchain networks. The networks suffer slowdown, unable to process transactions, because of the high demand. Many new blockchain networks are overcoming the scalability issues and existing networks are testing and deploying solutions to improve the speed.
Counterparty Risks
Like the Lego blocks, DeFi is a complicated network where many 3rd party smart contracts are interconnected. Therefore, if there's a problem in any smart contract, they "may" have a cascading effect on other smart contracts.
Many DeFi applications rely on 3rd party Oracles for information such as market price. Like 3rd party smart contract risk, glitches or attacks on Oracle feeds may have a cascading effect.
Other Risks
In many countries, cryptocurrencies and DeFis are unregulated, unclear, or regulation keeps changing. Since crypto are treated as a rapidly developing asset class, many countries also have different taxation structures.
Finally, black swan events may occur - a well-coordinated attack on the blockchain network, extreme volatility, and even users abandoning the protocol for another, or simpler systems are potential risks.
Note: Several investors have shed a lot of money in crypto. It’s advised to do your due diligence before investing.
What are the components of DeFi?
DeFi is an umbrella concept and not restricted to a single blockchain network. Ethereum, building on top of Bitcoin ideology, gave life to DeFi applications. Today, DeFi concept is thriving on many networks like Solana, Binance Smart Chain, Terra, Polygon, etc.
A typical DeFi ecosystem is a multi-layered architecture though the implementation may vary across blockchain networks. The layers build on top of each other to create a Lego-like infrastructure for new solutions to be built and developed:
- Layer 1 (Settlement Layer): The underlying blockchain network, along with the native cryptocurrency of the network. For example, Ethereum network with ETH coins, Solana network with SOL coins. The settlement layer provides the consensus mechanisms, networking, and storage functionalities.
- Layer 2 (Asset Layer): This layer comprises the assets issued on the blockchain network - both native assets (e.g., ETH coins) and project specific assets (e.g., an ERC-20 fungible token or ERC-721 NFT).
- Layer 3 (Protocol Layer): DeFi protocols are the autonomous programs built for a specific purpose. The protocol is a smart contracts that runs on the blockchain network. A protocol codifies the rules and guidelines the users must follow, along with instructions for collaborating with other protocols for interoperability.
- Layer 4 (Application Layer): The user-interface, typically a web-based application, to interact with the protocol. The application layer abstracts the complexity of the protocol layer and provides a GUI for ease of use.
- Layer 5 (Aggregation Layer): Considering the spurt in the number of protocols, aggregators, as the name suggests, provide aggregation services. This is quite like a travel aggregator website which merges information from multiple airlines or a hotel booking aggregator for hotels. Similarly, the DeFi aggregators provide services like price comparison across various protocols.
What are the DeFi Applications?
Given the benefits of decentralised finance (DeFi) many decentralised applications (dApps) are sprouting up. Not only the traditional financial products and services are being adopted into the decentralised world, but new and innovative products are being experimented too.
Let's take a brief look at the various applications and what they mean in a decentralised ecosystem.
- Asset Management / Wallets: The cryptocurrencies (coins and tokens) are digital assets. The DeFi asset management products and services provide an option to safely store and manage the crypto assets. The wallets to hold crypto can be both non-custodial or custodial. In custodial wallets, for example Coinbase wallet, the service provider owns the private keys to your wallet, and therefore, is not truly decentralised. Fully decentralised wallets like Metamask are non-custodial - only the user owns the private keys to the wallet.
- Automated Market Makers / Decentralized Exchange: Traditional marketplaces like the stock exchange are centralised and controlled by a corporation or an entity. The DeFi's answer to the centralised exchanges is the Decentralised Exchanges (DEX). The DEXes are open 24x7 and don't require the simultaneous presence of the buyer and seller to execute a trade. Automated Market Makers (AMMs) are the underlying smart contracts which facilitate the anytime trading, with no central authority. Examples of DEXes are Uniswap, Sushiswap, Curve Finance.
- Block explorers: A block explorer is like a search engine for the blockchain. The explorer is an online tool to visualise the underlying data, view past & current transactions, and various other metrics on the blockchain. Check out the explorers for Bitcoin and Ethereum.
- dAPIs: An API (Application Programming Interface) enables multiple applications them to interact with one-another via exchanging information and services. APIs are widely used by developers to build apps. In DeFi smart contracts need to interact with other applications to fetch information and services. The dAPIs (or decentralised APIs) are the APIs built for the DeFi world. API3 is a collaborative effort to build, manage and monetize decentralized APIs (dAPIs) at scale.
- DAOs: In a traditional organisation, the governance and decision making are centralised i.e., they lie in the hands of an individual or a few individuals. DAO (Decentralised Autonomous Organisation) is an effort to decentralise the governance, decision making, and influencing powers for blockchain based projects and companies. The key characteristics of the DAO are, there is no central leadership, decision making is bottom-up, and the governance is enforced by a set of rules and the community.
- Futures & Options: Like traditional derivatives, in crypto, the popular derivates products are the futures & options. Thanks to DeFi, derivatives can be created using smart contracts and with no third party. The counterparty agreements are programmatically coded and enforced using smart contracts.
a) Futures: In DeFi, futures allow traders to bet on the future price of an underlying asset (both digital or physical). The smart contract enforces the buy/sell at a given price before a specific date in the future. Popular futures protocols are Perpetual Protocol, dYdX exchange
b) Options: Unlike futures, where there is an obligation to buy/sell, options provide an option for the trader. Opyn and Hegic are some of the popular options DeFi protocols.
- Identity Management: While DeFi does away with identity, they face a challenge in their operations. Since the DeFi protocols don't collect any information about the users, they treat all users the same and are unable to offer differentiated services. Decentralised identity management solutions would give users control over their data and decide how much they want to share with the protocols. In the spirit of DeFi, the digital identity data can also be processed in a non-custodial manner. Projects like Civic and Serto are working towards decentralised identity management.
- Infrastructure: DeFi applications are like building with Legos. The infrastructure protocols offer tools, frameworks, and underlying technologies for the development of new products and services. BancorX, Infura, UMA are some of the leading names in the DeFi infrastructure.
- Initial DEX Offering (IDO): Traditionally, a start-up would approach investors to raise funds for their idea. In DeFi, IDO is a decentralised fundraising approach which pools capital from retail investors. The projects use crypto launchpads (crypto incubators) available with the DEX to raise funds. BSCPad, TrustPad, and SeediFy are some of the popular launchpads.
- Insurance: Decentralised insurance protects crypto assets in DeFi by hedging volatility risk, crash, theft, etc. It's a growing sector within the DeFi and protocols like Nexus Mutual, Opium, and Opyn are coming up with insurance products for the DeFi.
- Lending & Borrowing: Borrowing & lending is one of the popular services of DeFi because of the decentralised nature. The borrowers don't have to go through complex KYC and verification process and the lenders gets interests rates that are typically higher than the traditional bank rates. Users can borrow against their crypto assets without selling, and can get a loan while continuing to hold the asset. Aave and Compound Finance are good examples.
- Oracles: Crypto oracles are the bridges between the blockchain smart contract and the real world. The oracles provide reliable, tamper-proof inputs and outputs for complex smart contracts. The information could be anything - price inputs, gold price, weather, etc.
- Decentralized Oracle Networks (DONs): True to the spirit of decentralisation, instead of relying on a single oracle or source, DONs is a group of independent blockchain oracles that provide data to a blockchain. The data from multiple oracles is aggregated to determine the truth for that data point.
- Payments: Bitcoin started off with the goal of a peer-to-peer payment system. The goal of DeFi is to extend it further and create a network of decentralised payment, where banks and intermediaries are replaced with people. From payment processing to settlement, a variety of solutions are coming up to make payments cheaper, faster, and accessible to everyone. Ripple networks, Coingate and many more are active in the space.
- Prediction Markets: DeFi prediction markets allow users to speculate on a future outcome of real-world events. Users stake their crypto assets and earn from their accurate predictions. The prediction markets use the "wisdom of the crowd" approach to identifying future events. Unlike centralised prediction markets, the decentralised ones don't have any central authority to oversee, no restrictions on who can take part, and don't have intermediaries who might influence the results. Polymarket and Augur are few popular examples.
- Stablecoin: Crypto currencies are notorious for their volatility. This vastly impact the use of crypto for everyday commerce and as a store of value. Stablecoins are a class of cryptocurrency, designed to have a relatively stable price. Typically stable coins are pegged to a fiat currency (for example, 1 Stablecoin = $1 USD). The stabilisation is achieved through various collateral mechanisms:
a) Fiat backed collateral: For every stablecoin issued, it's backed by the equivalent fiat currency - e.g., Tether (USDT), the Gemini Dollar (GUSD)
b) Crypto backed collateral: For every stablecoin issued, it's backed by the equivalent of other crypto currency - e.g. MakerDAO (DAI)
c) Algorithmic stablisation: Algorithmic stablecoins do not use fiat or cryptocurrency as collateral. These stablecoins use algorithms to derive and stabilise the price - e.g., FRAX, AMPL
d) Commodity collateral: The stablecoins are collateralised using real-world commodities like gold, precious metal, oil, etc. E.g., DGX (backed by Gold), SRC (Real Estate)
- Staking: In traditional banking, you can lock your money into a fixed deposit and earn interest on the deposit. Similarly, in DeFi staking is a passive income generation scheme. By locking your crypto assets into a smart contract, you'll earn interest on the assets. Practically every protocol and some aggregators offer staking options.
- Synthetic Assets: In traditional finance, derivatives are assets which "derives" its value from an underlying asset or index. In DeFi, synthetic assets (synths) are a combination of cryptocurrencies and traditional derivative assets. Synthetics are derivatives that are tokenised, and each synth tracks the price of an external asset (fiat currency, cryptocurrency, commodities, etc). Synthetix, and Mirror Protocol are two leading examples.
- Wrapped Assets: One of the key challenges of blockchain networks are inter-operability, as the networks differ in functionality. To bridge distinct blockchain worlds, wrapped tokens are used. Some examples of wrapped tokens include wBTC, wETH, and wCUSD.
- Yield Farming (Liquidity Mining): Yield farming is an incentive mechanism to put an individual’s cryptocurrency assets to work and generate high returns. Liquidity providers, in yield farming protocols, stake, lend, or lock up their assets to earn rewards and higher interests.
What are the metrics with DeFi?
DeFi protocols are innovative and don't necessarily just replicate what's available in the traditional domains. Therefore, new metrics, stats, and terminologies are required to understand and interpret them. Let's look at some of the key ones:
Total Value Locked (TVL)
Total value locked represents the total dollar valuation of all the assets deposited.
Trading Volume (TV)
A 24-hour trading volume shows the value of assets bought and sold over the course of a day. Trading volume is the number of units traded in the market during a time.
Total Revenue / Trading Fees
Total revenue is a measure of the trading fees paid by the traders over a specific period.
Liquidity By Asset
Liquidity refers to how easily and quickly assets are bought or sold without affecting the asset's price. Assets with a high volume of trade are typically considered liquid.
Unique Deposit Address
A wide spread of unique addresses is a measure of the fair distribution and mass adoption of the DeFi ecosystem.
What is DeFi Tokenomics?
Your cryptocurrency project is a country with its own economy. You will launch a token to be used within your project. The monetary and fiscal policies you setup will determine the success or failure of the project.
Tokenomics (token + economics) is the tool to design and create a thriving DeFi economic ecosystem supported by tokens. Tokenomics covers the project design, fund raising, token operations, token benefits, token destruction, the governance of the project, and more.
More on Tokenomics ...
Vijay Raghunathan
Disclaimer: This is not an investment advice. DYOR (Do Your Own Research) and understand the risks before investing.