Decentralized finance, or DeFi for short, is a rapidly emerging sector that seeks to disrupt the traditional financial industry with blockchain-based tools and services that supplant banking, investing, and trading services. Today there exists a DeFi alternative for almost every traditional finance service, and more are launching every day. In this article, we’ll touch on the origins of DeFi, its major use cases, how it compares to traditional finance, and its future potential.
As with nearly everything in the crypto ecosystem, it all started with Bitcoin. In its early days, Bitcoin was primarily thought of as a decentralized, peer-to-peer payment network. And while that’s still true today, Bitcoin has evolved into a store of value primarily. That’s left room in the ecosystem for a more flexible and feature-capable protocol; enter Ethereum. Unlike Bitcoin, Ethereum allows for applications and protocols to be built on top and is what ultimately allowed for the rise of DeFi. Think of Ethereum like the iOS or Android operating system on your phone and DeFi is the collection of apps built on top, that live on your home screen. The latter is not possible without the former.
- Lending and borrowing is the most widely used application within DeFi, according to DeFi Pulse. Lenders can deposit their assets into a smart contract, making them available to be borrowed, and earn interest in return. Borrowers typically need to deposit collateral worth more than the loan amount and maintain this collateral above a specific loan-to-value ratio. All of this occurs without any 3rd party as the smart contract acts as the intermediary.
- Stablecoins are a type of digital asset that has its value pegged to another asset to reduce volatility. Stablecoins are most frequently pegged to fiat currencies like the US dollar (USD) or Euro (EUR) and are used pervasively throughout DeFi.
- Decentralized exchanges, DEXs for short, are digital asset trading platforms that operate without a centralized authority. They most commonly take the form of automated market makers (AMMs), which use a formula to set the price for trading token pairs within a liquidity pool.
- Yield farming involves locking up digital assets in return for rewards which are automatically delivered by a smart contract. The most common practice is often referred to as liquidity mining where a pair of assets are deposited into a liquidity pool. And a return is generated from the trading fees of the pool and passed back to the liquidity providers.
- Derivatives are a type of financial instrument whose value is based on the valuation of an underlying asset. The most common types of derivatives are forwards, futures, options, and swaps. These allow sophisticated investors and institutions the ability to execute more exotic investment strategies.
A popular analogy is to think of each of these use cases as a ‘money lego’. The open-ended and permissionless nature of DeFi protocols allows you to stack them together just as you would a lego set. This results in efficient and creative financial products for DeFi end-users.
One difference between DeFi and centralized finance is the absence of a third party. While centralized finance often relies on an intermediary to execute transactions, DeFi uses smart contracts to do the same. DeFi is also permissionless, meaning it is accessible to anyone, at any time of day, and from any location. In centralized finance, users must sign up, submit to KYC (Know Your Customer) requirements, and be approved to participate in the system. The final difference is the custodial status of the assets. In DeFi, users self-custody their assets and are fully responsible for their safekeeping. In centralized finance, the institution acts as the custodian on the user’s behalf.
The growth in DeFi over the past 18 months has been remarkable. There are various methods of measurement but the most widely used metric is Total Value Locked (TVL), which measures the dollar value of assets locked within smart contracts.
As of now, the lending and borrowing protocols cumulatively have the most TVL, but that could and likely will change in the future. The DeFi ecosystem is notoriously fast-paced and capital has proven to follow incentive offerings and new opportunities. The quickly evolving landscape is one of the major challenges when building or investing within DeFi.
With global interest rates near historic lows, there is insatiable investor demand for yield and DeFi offers attractive rates. While the standard interest instrument for most investors and institutions — the 10-year U.S. treasury bond — currently yields roughly 1.5%, stablescoins within DeFi protocols often generate triple or quadruple that rate. There are also investors and institutions making equity investments in DeFi given the innovation and disruptive market potential. Often these deals are executed via an over-the-counter (OTC) sale meaning the parties agree on a set of negotiated deal terms, as opposed to transacting through a public exchange. For example, see the recent Index Coop OTC sale where the DAO raised $2.25 million in USDC (a dollar-pegged stablecoin) in exchange for selling its native token, $INDEX.
Given the market size of the financial service industry and the product-market fit that DeFi protocols have demonstrated, the future potential is promising. Imagine a decentralized, open alternative to every financial service you use today — savings, loans, trading, insurance, and more — accessible to anyone in the world with a smartphone and internet connection. Yes, there will be obstacles to overcome and bumps in the road as the ecosystem matures, but DeFi is a movement that is undoubtedly gaining momentum.
Disclaimer: This content is for informational purposes only, you should not construe any such information or other material as legal, tax, investment, financial, or other advice.