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Home » Crypto Classroom Lesson #14: Decentralized Finance (DeFi)

Crypto Classroom Lesson #14: Decentralized Finance (DeFi)

Decentralized Finance (DeFi) has garnered popularity and grown into one of the biggest sectors in the crypto space. According to DeFi Purse, over 500M USD is locked in DeFi applications. Applications include stablecoins, DEXs, lending, derivatives, payments, etc. DeFi is usually referred to as Open Finance, which aims to remove restrictions that limit people’s access to traditional financial services. In simple terms, DeFi uses cryptocurrencies, blockchain technology, and smart contracts to provide financial services.

Total Value Locked (USD) in DeFi on 16 July 2019


Why DeFi?

Cryptocurrencies were designed to be decentralised, transparent, trustless, permissionless and censorship-resistant. They use decentralized control as opposed to central banking systems. DeFi aims to provide permissionless and transparent financial services to anyone and everyone. The advantages of decentralised financial products are similar to the original vision of public blockchain:

Global Access to Financial Services

With DeFi, anyone with an internet connection and a smartphone can gain access to financial services. Due to its permissionless nature, users cannot be restricted geographically. Even when IP addresses are blocked, users can still access the network remotely via VPN. In contrast, most traditional financial services are limited geographically. (e.g. a North Korean citizen would not be able to open a bank account in HK)

Apart from geographic limitation, traditional financial services also favour the wealthier population. Clients with more assets typically enjoy better rates and have access to advanced wealth management tools. DeFi minimizes the inequality and users can enjoy similar services regardless of size.

Privacy and Security

With the surveillance of government agencies and large companies, our spending habits and financial statuses are closely monitored. Based on this data, merchants advertise products that “fit” our need and banks calculate a credit score that determines access to products such as loans.

In the context of DeFi, personal identity is not required to enjoy the service. The system will provide services according to the status of your cryptocurrency wallet address.

Apart from financial privacy, the use of smart contracts also minimise human error and improve efficiency. Using public blockchains like Ethereum, we can also benefit from the immutability and censorship-resistant nature of blockchain technology.

Applications

DEX

The major use of blockchain is the creation of digital currencies that do not require an intermediary to facilitate transactions. However, to exchange different cryptocurrencies, people still rely on centralised exchanges. Users are vulnerable to censorship, counterparty risk, market manipulation, etc. The current state of exchanges (CEX / P2P) is established based on trust. Either you trust the exchange or some other counterparty.

By using blockchain and smart contracts, a trusted third party is no longer needed to facilitate an exchange. A decentralised system will be the platform to ensure both parties have sufficient assets and execute the swap at the agreed price. Without the central clearing house, users have full custody of their funds and lower exposure of counterparty risk.

Lending

Centralized exchanges (Bitfinex, Poloniex, etc) allow users to margin trade cryptocurrencies. A borrowing market is built into the exchange and users can lend their assets to earn interest. The system is again trust-based; exchanges can get hacked, founders can exit without repaying users, and systems can go down. By decentralising the lending market, users can lend or borrow peer to peer. In some platforms, the market is combined into a large liquidity pool where users can lend, borrow, deposit and withdraw 24/7.

The most well-known platform that uses blockchain technology for lending services is MakerDAO. A borrower would lock up Ether as collateral and borrow a stablecoin, DAI. The borrower receives a margin call if the locked ETH falls below 150% of the borrowed value. The entire process, including liquidation, is transparent and on-chain.

TLDR
Traditional banks and Fintech companies are centralized.
Bitcoin is a decentralised form of money
DeFi is conventional financial services built on blockchain.
The most notable advantages are censorship resistance, open-source and equal access to financial services.

 

The 100+ Projects Pioneering Decentralized Finance, Consensys, 29 Mar 2019
https://media.consensys.net/the-100-projects-pioneering-decentralized-finance-717478ddcdf2

DeFi and Credit on the Blockchain: Why Loans Are Better When They’re Decentralized, Simon Chandler, Cointelegraph, 25 May 2019
https://cointelegraph.com/news/defi-and-credit-on-the-blockchain-why-loans-are-better-when-theyre-decentralized

DeFi startup offers ETF analog allowing investors to trade on trends, The Block
https://www.theblockcrypto.com/2019/07/15/defi-startup-offers-etf-analog-allowing-investors-to-trade-on-trends/

 

Written by Charlie Tsang
Trader @Genesis Block
For any queries please contact [email protected]