The world of finance, long dominated by institutional banks, is undergoing a profound transformation. This shift is driven by the massive influx of individual participants into markets and the emergence of decentralized finance (DeFi), marking the dawn of a new financial era. Let's explore what DeFi brings to the table and how it functions with cryptocurrencies.
Understanding Decentralized Finance (DeFi)
Traditional Centralized Finance
Historically, finance has been a domain managed by banks and a few institutional players. Individuals could deposit their money to generate returns through various mechanisms. However, over the past few decades, individuals have become increasingly involved, a clear sign that a paradigm shift is underway.
Banks are currently seen as facilitators or intermediaries. They are responsible for securing funds and executing orders on behalf of individuals.
Due to the large number of intermediaries, a simple card transaction with a merchant can incur fees of up to 3.5%. This happens whenever you buy an item online or in a store. This is where decentralized finance could step in.
The Rise of Decentralized Finance (DeFi)
With too many intermediaries, high fees, and a lack of sovereignty, numerous problems have been highlighted over time. Catastrophic episodes like the 2007-2008 financial crisis only made things worse.
The arrival of blockchain in 2009 with Bitcoin brought hope for an imminent change. However, it wasn't until mid-2019 that decentralized finance truly emerged and notably attracted users.
This decentralized finance, or DeFi, operating on blockchain, signifies the renewal of traditional finance. Indeed, the use of blockchain technology and smart contracts allows individuals to access financial services 24/7, 365 days a year, while maintaining control over their funds. Thus, with DeFi, most intermediaries are eliminated, and therefore, fees are also reduced, with smart contracts enabling direct interaction between buyers and sellers.
Furthermore, the use of blockchain guarantees that no single person can block another's funds. Simply put, DeFi is an evolution of traditional finance where anyone, regardless of their personal situation, can access low-cost financial services while retaining control of their funds.
Current Services Offered by DeFi
The period from 2019 to 2022 was extremely prolific for the decentralized finance ecosystem. The total value locked (TVL) on various protocols grew from $0 to nearly $100 billion in August 2022. In other words, at the time of writing, almost $90 billion is deposited in protocols and applications offering decentralized financial services. In December 2021, this figure even reached $250 billion, all in less than three years of existence!
Today, there are many services offered by multiple protocols and applications. Here is a non-exhaustive list including the most mature and widely used services in DeFi:
- Classic financial transactions such as trading or sending/receiving funds.
- Decentralized exchanges (DEXs), platforms where buyers and sellers are connected to exchange assets.
- Comprehensive wallets, similar to banks, with many integrated financial services and direct connections to multiple blockchains.
- Stablecoins, or cryptocurrencies pegged to stable values like the dollar or euro. They allow users to access all services with non-volatile currencies.
- Lending/borrowing services, enabling the decentralized lending and borrowing of assets without any justification.
- Yield farming, a complex and semi-automated activity that involves finding strategies combining several protocols to maximize returns.
- Flash loans, allowing users to borrow very large sums of money with very low collateralization. This sum is then used in a flash strategy involving many transactions (like arbitrage) and then repaid to the protocol. All within a single block.
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Key Players in the DeFi Ecosystem
Although one of DeFi's goals is to eliminate intermediaries, this doesn't mean the number of actors is reduced. Indeed, the alignment of several major players is necessary to make this concept a reality.
Blockchains: The Essential Foundations of DeFi
The transition from a trust-based, cumbersome, discriminatory, and costly finance system to a diametrically opposed one doesn't happen overnight. The change must be profound.
Blockchain technology solves the vast majority of these problems. Its decentralized nature allows for the elimination of the trust model and empowers user sovereignty. Furthermore, advanced consensus methods combined with smart contracts mean financial services can be automated and accessible permanently, securely.
At the time of writing, many blockchains offer a flourishing DeFi ecosystem. Among them are:
- Ethereum (ETH)
- Avalanche (AVAX)
- Polygon (MATIC)
- Solana (SOL)
- Fantom (FTM)
DeFi Protocols: Hubs for Financial Services
However, as performant as blockchains are, they are exceedingly bad at one thing: user interface. DeFi protocols are complex decentralized applications (dApps) that allow their users to simply access the services they offer. In the background, these protocols are powered by smart contracts, or immutable automated programs, which handle user requests.
There are thousands of protocols offering hundreds of different services on all blockchains hosting DeFi. A few of them are presented below.
MakerDAO: A Decentralized Central Bank
MakerDAO, the highest-valued protocol on the market at the time of writing, offers all the classic financial services a bank provides. Users can borrow or lend funds through its Oasis application. MakerDAO's flagship product is DAI, the decentralized stablecoin with the largest market capitalization.
Uniswap: A Stock Exchange on the Blockchain
Uniswap is the largest decentralized exchange (DEX) on blockchains compatible with the Ethereum Virtual Machine (EVM). This protocol allows its users to exchange various cryptocurrencies, constantly, without intermediaries and in a decentralized way. The use of an automated market maker allows buyers and sellers to find each other without an order book or central exchange, and liquidity is provided by other users.
Aave: Private Banks on Steroids
Aave is the highest-valued liquidity market. It acts like an international bank. With this protocol, it is possible to lend or borrow funds in a decentralized and automatic manner without credit checks.
Curve: A Decentralized Currency Exchange
Curve can be considered a currency exchange bureau. It allows for the conversion of the market's most stable cryptocurrencies in very large quantities. This ranges from major ones like Bitcoin and Ether to dollar-backed, euro-backed, or other stablecoins.
Other Infrastructure Actors Essential for Overall Functioning
Beyond the blockchain and protocols, other infrastructures are indispensable for the proper functioning of DeFi. Among them are oracles like Chainlink or Band Protocol. Indeed, the blockchain operates without recourse to trust. So how does a decentralized exchange get information about the price of the assets it offers to its users (cryptocurrencies, tokenized stocks, etc.)?
In traditional finance, we rely on centralized entities like banks, which is impossible in DeFi. This is where oracles come into play. They allow so-called "on-chain" applications (hosted on the blockchain) to access "off-chain" data from the real world, without an intermediary and in a decentralized way. This service can also be extended to on-chain data. For example, it's possible to know the price of Ether by aggregating values from several DEXs.
Furthermore, what if our two favorite applications are on two different blockchains and use different technologies? Decentralized bridges like Wormhole, WBTC, or Hop allow users to transfer their funds from one blockchain to another. This somewhat replaces SWIFT or SEPA transfers between different banks.
Risks and Adoption Challenges in DeFi
Inherent Risks in DeFi
Too often, decentralized finance is described by its actors as the El Dorado for investors. Although most of its virtues are valid, it's important to know that DeFi inherits the risks associated with its technology.
Indeed, the removal of intermediaries implies that the only authority is the source code of the protocols. Thus, like all applications, they can be targets of major attacks or hacks. This phenomenon is amplified in DeFi due to the presence of very large sums of money.
Some sites, like the Rektdatabase, track these attacks. At the time of writing, nearly $4.6 billion has been stolen by hackers. This is a significant sum that leads to the second biggest risk of DeFi: the lack of consumer protection.
On the same site, we learn that only $1 billion has been returned to affected individuals. To date, there is no viable solution to protect users from potential hacks or scams on the blockchain. The few decentralized insurance companies operating in DeFi are either ineffective or insecure (the decentralized insurance Nexus Mutual was hacked in December 2020).
To these risks can be added impermanent loss when participating in certain DeFi protocols or the tax risk linked to a lack of regulations.
Barriers to DeFi Adoption
Like any new technology, not everything is perfect. Indeed, some aspects of DeFi can put people off, causing a serious barrier to future adoption.
Among them is over-collateralization. To access decentralized lending and borrowing services, it is necessary to over-collateralize one's position. For example, if I want to borrow $1000, I will need to lock an amount greater than that sum in another cryptocurrency.
As there is no verification of the user's financial history, this step is necessary. Furthermore, when the value of the locked assets falls below that of the borrowed assets, the position is liquidated. This problem is inherent to the automation and lack of intermediary in the financial services offered by DeFi.
Moreover, these loans are often at variable rates. But unlike traditional finance, they constantly vary algorithmically based on supply and demand. Thus, it is common to see rates increase or decrease by several points in just a few days or weeks.
Finally, it is often preferable to use the protocols with the most liquidity. The problem is that these applications are hosted on Ethereum, a blockchain that saturates with every activity peak. As transaction fees do not depend on the amount sent, some users may pay more in fees than what they invest. This problem adds to the slowness of the Ethereum blockchain and its 15 transactions per second. However, many solutions have emerged to solve these limitations, notably layer 2s.
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The Future of Decentralized Finance
DeFi is a very young concept that evolves every day to improve its functionalities and solve common problems. There are already important improvement axes under development. This is called DeFi 2.0.
One of the major axes of this second generation of DeFi is security. The development of competent decentralized insurance and the possibility of under-collateralized loans are at the heart of discussions. The latter made a great leap forward with the presentation of "Soulbound tokens" by Vitalik Buterin in late July 2022.
Offloading saturated blockchains is another major point of this new finance. Indeed, protocols benefiting from the liquidity of several blockchains are under development. This is notably the case with Li Finance. Adding layer 2 solutions to this would allow for affordable and fast blockchains, ready for mass adoption.
Frequently Asked Questions
What is the main difference between DeFi and traditional finance?
The core difference lies in intermediation and control. Traditional finance relies on central authorities like banks to facilitate and secure transactions, whereas DeFi uses blockchain technology and smart contracts to enable peer-to-peer financial services without a central intermediary, giving users direct control over their assets.
Do I need technical knowledge to use DeFi applications?
While a basic understanding of cryptocurrencies and wallets is beneficial, many modern DeFi applications (dApps) are designed with user-friendly interfaces. However, comprehending concepts like gas fees, wallet security, and smart contract interactions is crucial for safe participation. The learning curve exists but is becoming less steep.
Are DeFi transactions truly anonymous?
DeFi transactions are pseudonymous, not fully anonymous. While your personal identity isn't directly tied to your public wallet address, all transactions are permanently recorded on a public blockchain. Sophisticated analysis can sometimes link addresses to real-world identities, so complete anonymity is not guaranteed.
What is 'yield farming' in simple terms?
Yield farming is the practice of locking up or staking cryptocurrencies in a DeFi protocol to generate high returns or rewards in the form of additional cryptocurrency. It's like earning interest in a savings account, but often with higher, variable yields by providing liquidity to the market.
How secure is my money in a DeFi protocol?
Security varies by protocol. While the underlying blockchain is secure, risks come from smart contract vulnerabilities, code exploits, and project-specific failures. Over $4 billion has been lost to DeFi hacks. It's vital to use well-audited, established protocols and never invest more than you can afford to lose.
Can DeFi be regulated by governments?
The regulatory landscape is still evolving. By its decentralized nature, DeFi is difficult to regulate directly. However, governments are increasingly focusing on regulating key access points, like centralized exchanges that convert fiat to crypto, and developing frameworks for decentralized activities, which may impact future DeFi operations.