Kolawolu Odunola · Follow
Published in · 9 min read · Jun 4, 2022
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Blockchain is a disruptive technology that has come to reinvent how you do things. From how corporations are structured , to helping you monetize your hobbies and to building a trustless payment system that allows you to buy and sell online. The financial sector isn’t left out, blockchain is changing the game of how you spend money, how you borrow, lend and earn money from your savings.
DeFi — decentralized finance, is one of the several use cases of blockchain, its aim is to build a financial system that is independent of the central banks and the government. With just a smartphone and the internet, you can own a bank account, transfer money around the world with no restrictions or limitations.
To fully understand DeFi, it is important you grasp how the traditional finance system works.
In centralized banking systems, all your savings and money are held and controlled by corporate entities (banks and third parties) whose main goal is to make money with your money. In fact, some banking systems are designed in a way that you pay the banks to keep your money for you (which comes in the form of different charges and transaction fees). Investopedia describes the centralized financial system as “full of third parties who facilitate money movement between parties, with each one charging fees for using their services. For example, say you purchase a gallon of milk using your credit card. The charge goes from the merchant to an acquiring bank, which forwards the card details to the credit card network.”
Also in traditional finance, the bank can deny you access to opening an account, deny you a loan even if you have a collateral, deny how much you can withdraw daily from your account.
DeFi has come as an alternative to this old system — a decentralized, transparent and easy to access financial system leveling the playing field.
By now you must have been wondering, so what is DeFi? What are the importances of DeFi? And some of my readers might be wondering what is the Future of DeFi? In the later part of this article, I will go into further details and answer all your questions.
Decentralized Finance — simply put, DeFi does not have a single definition.
Different cryptocurrencies analysts and researchers have defined it in different ways. In his notable work on DeFi titled “Decentralized Finance: On Blockchain- and Smart Contract-based Financial Markets”, Fabian Schar defined DeFi as “an alternative financial infrastructure built on top of the Ethereum blockchain. DeFi uses smart contracts to create protocols that replicate existing financial services in a more open, interoperable, and transparent way.”
Also, according to the journal published by Krzysztof Marecki and Agnieszka Wo ́ jcik-Czerniawska they compared Centralized Finance and Decentralized Finance and they have this to say “ DeFi, on the other hand, is global. This is due to the fact that it is based on a public blockchain. It is available to anyone, anywhere in the world. Regardless of the citizenship or country of residence of the participant. Since blockchain itself is decentralized, no jurisdiction can be imposed directly on it.”
Bringing these two definitions together, it is safe to define DeFi as a collection of financial products and services built on the Blockchain that allows you to perform financial transactions without a central authority or third party that can grant or deny you access to the service.
Image Source: Gemini.com
The representation at the top depicts the traditional finance system (centralized finance) while the representation at the bottom depicts DeFi.
Think of how the usual traditional banks work. DeFi provides an alternative way to do what banks and other financial institutions do — Buy insurance, get loans quickly, crypto savings, foreign exchange (in this case, instant token exchange), international money transfers, and lots more.
Let me take you through the leading real life applications of decentralized finance:
One of the major use cases of cryptocurrency is as a means of exchange or store of value. Volatility is a common occurrence in the crypto space and it can be a difficult challenge to remain liquid and avoid price fluctuation as much as possible. That is where stable coins come into play.
The concept behind stable coins that keeps them stable is that they have their value backed by another financial instrument. We have stablecoins that are backed by fiat reserves e.g TUSD. We have stable coins backed by other cryptocurrency e.g MakerDao’s DAI. We also have algorithm backed stablecoins like UST.
Due to the stability feature of Stablecoins, they are mostly preferred as collaterals by Lenders, and also as a store of value by investors and traders.
Exchanges are platforms that facilitate the buying and selling of cryptocurrencies. This means you can easily convert your Bitcoin to USDT or trade your Solana to Ethereum. Binance , Kucoin, Coinbase and others are the common types of exchanges. However, these exchanges have their setback which is that they are centralized : they have a centralized authority just like the traditional financial system. This is where Decentralized exchanges come into play. They operate by allowing users to buy, sell and control their money without the involvement of a third party. This method of operation makes it difficult to manipulate prices of cryptocurrency, reduces hacking and theft since there is no central authority in custody of the assets.
Common DEXs include Uniswap, Pancakeswap, Opensea.
Think of getting a loan in a traditional financial institution where you have to submit a loan application and wait for days or sometimes weeks before the loan officer decides if you qualify for the loan or not. DeFi solves this problem by cutting out the intermediary (loan officer and banks) and reduces the waiting period you need to get a loan.
DeFi protocols like Compound, Aave, Solend, Oasis Borrow allow you to earn fixed interest when you lend your cryptocurrency. Also, you can easily borrow against your digital currency at a fixed and reduced interest with just a few button clicks.
It is almost impossible to imagine any services provided by traditional finance that DeFi can’t provide. Decentralized Insurance works similar to how traditional insurance works. It is a way of insuring yourself against unforeseen circ*mstances in crypto space. You can insure yourself against wallet hack, exchange hack, failure in stable coin stability, smart contract failure etc.
Just like in traditional finance, you pay a premium to a DeFi Insurer to cover yourself against any unforeseen risk. But unlike traditional finance, the premium you pay here is locked in a capital pool offered by coverage providers (insurance companies). Nexus Mutual, Bridge Mutual and Insure DeFi are examples of Coverage Providers.
Yield farming is one of the interesting use cases of DeFi because of the boost it can give your portfolio. This method is what crypto holders use to maximize their returns. Think of it as you getting a reward on your savings account. Yield Farming platforms like Curve Finance, Aave rewards you with crypto by holding other tokens for a certain period.
Let me explain how it works:
If you are a long term holder of a certain token, e.g You plan to hold 100 units of Solana token for 1 year or more. Aside from getting a decent increase in value if the market value of Solana increases, you can get extra profit if you stake that 100 units of solana token into a liquidity pool instead of holding in your normal wallet.
The reward you will get is automatically calculated by the smart contract depending on the liquidity provider.
I think it will be unfair to talk about the advantages of DeFi and sidelining the risks that users have to watch out for when using a DeFi product. DeFi as an emerging field has its downsides some of which are negligible and can be solved as the ecosystem develops. Regardless of this, it is notable to mention the following downsides:
Data Source: YCharts
DeFi smart contracts are mostly built on the ethereum blockchain, it is generally believed that the limitations suffered by this blockchain will directly have an impact on the DeFi ecosystem. One of the major setbacks experienced by the Ethereum blockchain is limited scalability. From the chart above, you can see that the number of transactions processed on the ethereum blockchain is between 1,000,000 to 1,500,000 daily, broken into secs, that gives us 13 to 17 transactions per seconds.
DeFi is still in its early stage and as the ecosystem sees an increase in adoption, the number of transactions will increase daily. This means each user will have to compete for the limited space on the blockchain which can result in clogging and cause delay in transaction processing time.
From the first point above, increasing users on the ethereum blockchain means an increase in the number of transactions that need to be processed. It is common knowledge that you have to pay gas fees (transaction fees) on blockchain, which means you might need to pay a higher fee to encourage the miners. Transactions priority will be decided by the amount of gas fees and transactions with lower fees will be delayed while transactions with higher fees will be processed swiftly.
Liquidity is the ease of converting an asset to another asset or fiat. High liquidity helps in stabilizing the price of an asset because you can always trade it whenever you want.
Data Source: DeFi Pulse
But due to the early stage of the DeFi ecosystem, most projects have low liquidity and it can be difficult to convert one token to another. Sometimes this requires you increasing the gas fee.
As at when i am writing this, the total value locked in DeFi is $54.05B, which is very low compared to the market cap of traditional finance.
The truth is if you are not a crypto savvy person, it can be difficult navigating a defi product seamlessly. Sometimes you might need a crypto-native to hold you by the hand and walk you through a DeFi platform. This experience might make it difficult to attract a lot of users to DeFi.
However, this issue can easily be solved if DeFi products will carry out more UX research in order to understand the complaints of their users. Also, it will help a lot if the product’s terms of use are written in simple English compared to technical jargons mostly used by many.
Anonymity has always been one of the unique features that DeFi evangelists use when promoting the ecosystem. However, as this is a very cool feature, we can’t neglect the fact that this can be exploited by fraudsters.
According to a 2021 report by Elliptic, “DeFi users and investors have suffered more than $12 billion in losses due to theft and fraud. These losses are accelerating, with losses totaling $10.5 billion in 2021 to date, up from $1.5 billion in 2020” no thanks to the irreversibility and anonymity of DeFi. The lack of KYC makes it difficult to investigate criminals exploiting this feature to commit crime.
Aside from the Ethereum blockchain , 2021 witnessed mass adoption of other blockchains like Polygon, Solana, Avalanche and Binance Smart Chain ready to make DeFi transactions cheaper, faster and more secure.
All in all, I think the future of DeFi will be interesting due to the mass adoption it has gained in the past 2 years. The DeFi ecosystem is growing and many new projects are springing up to solve the major challenges faced by DeFi which is scalability and security.
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