Decentralized finance (DeFi) refers to the fast growing movement of non-intermediated financial service offerings with a domain that extends into savings, loans, trading, insurance, payments, asset tokenization, decentralized exchange, KYC/AML assurance, and many more verticals. Some of the key advantages that distinguish DeFi from traditional, centralized financial service offerings include the following:
DeFi service offerings are implemented via code that is publicly viewable and auditable on their respective blockchain networks. This essentially disables the fiduciary requirement of trust between users and traditional financial service providers. Effectively, anyone has the option to gain an unobscured understanding of services, as well as their underlying functionality and infrastructure. Moreover, privacy-related concerns are minimized by the pseudonymity of transactions given that users are only identifiable by an address as opposed to any attributes of their real identity.
- Strong flexibility
The code that governs the agreement between DeFi service providers and users (i.e. – smart contracts) operate similarly to APIs: they can be called from any interface of a user’s choosing. For example, if a user isn’t fond of one dapp’s user-interface, they can elect to use the same service and its associated functionality through another interface of their own choosing.
- Unparalleled accessibility
The decentralized applications (dapps) that facilitate DeFi service offerings are essentially available to anyone with an internet-enabled device. This paired with significant transaction cost savings makes DeFi substantially more effective for providing financial services for unbanked users, who are often neglected by traditional service providers due to their inability to pay exorbitant intermediary fees. This accessibility extends to the development aspect as well: anyone is able to design DeFi dapps for consumer use with no formal gatekeeping processes.
Related to the flexibility of DeFi applications, it’s worth noting that entirely new services can and have been created through a combination of existing DeFi applications. As one example, decentralized exchanges, asset tokenization, and insurance can be combined to create a P2P synthetic asset exchange platform. Another example could involve alternative savings, asset management analytics tools, stablecoins, and a lending/borrowing infrastructure to create a wealth management platform. In effect, the number of possibilities of such novel services are vast considering the amount of potential combinations of existing DeFi services.
It’s worth noting that the large majority of DeFi platforms operate via the Ethereum blockchain. However, many DeFi platforms are beginning to emerge with native blockchain infrastructures and may rise to prominence over time.
Finally, it’s important to distinguish between DeFi and a seemingly similar term referred to as “open banking”. Open banking revolves around a banking system where third-party financial institutions have pipelines for user financial data through APIs, which enables a shared network of account data between multiple institutions or companies. One example might be a budget planning startup pulling data from a person’s bank accounts and credit cards to formulate a customized financial plan for users. The key difference is that open banking ushers in new product and service offerings that operate within the traditional financial system, whereas DeFi instantiates an entirely new financial system independent of the traditional system. Essentially, drawing an analogy to open banking, DeFi would represent “open finance”.
One of the key metrics associated with measuring the growth of DeFi space is the Total Value Locked (TVL): the collateralized assets required to use many DeFi dapps and services. As of writing, the TVL of the DeFi space is roughly $3.67B (USD), with 28.08% of DeFi’s total TVL being dominated by the leading DeFi lending company, Maker. DeFi’s TVL has grown fairly linearly until March 2020, when it reached roughly $560M after briefly crossing the $1B threshold in February. Since March 2020, DeFi’s TVL has ballooned exponentially, almost sevenfold, to its current level. Segmented by service and sector leader, DeFi’s total TVL can be broken down as follows:
|TVL (USD)||Service||Sector Leader (dominance)|
|$572.2M||Decentralized exchanges||Balancer (41.56%)|
|$292M||Asset management||WBTC (57.89%)|
Use-Cases & Examples
There is a large multitude of service offerings and companies that currently exist in the DeFi space. Ten specific verticals and examples of companies operating within them are described as follows.
Alternative savings offerings aim to provide higher yields on idle user deposits than existing financial instruments, such as bank savings accounts or certificates of deposits (CDs). This often involves user deposits being issued by DeFi platforms as credit in a global, pseudonymous borrowing/lending network. Typically, user deposits are heavily collateralized to hedge against the risk of borrower default or attacks in any form, and exhaustive testing is employed to manage any platform-related technical risk. Users may incur interest rate risk based on the fluctuating nature of the prevailing interest rate at the time of withdrawal.
A prominent example of a leading DeFi company in this space is Dharma. Marketed as the “world’s first crypto-bank”, Dharma enables its global network of users to instantly deposit and withdraw stablecoins (i.e. – DAI) at a 4.4% APR; more than 73x greater than the FDIC-calculated average APR on traditional savings accounts in the United States. Dharma takes a tenth of the total interest generated by user deposits as its fee, and users can transact for as little as $0.01 from any country in the world as long as they have an email address and internet connection.
Lending and Borrowing
DeFi lending/borrowing platforms aim to provide non-intermediated loans between people, groups, and businesses. Akin to the example above, users are able to deposit assets, typically stablecoins, and yield interest on those assets commensurate with the risk profile and level of utilization their assets achieve within a larger pool of credit. Given the variance in risk profile and utilization level among different service offerings, DeFi lending/borrowing platforms tend to offer a wide range of possible APRs.
One prominent DeFi lending/borrowing platform is Nuo, backed by Consensys Ventures and Kyber. Nuo gives users the ability to create fully-collateralized debt reserves that they can then issue instantly and pseudonymously (i.e. – with addresses being known) to a network of borrowers. For their most transacted stablecoin, USDC, Nuo offers lenders 9.2% APR on their reserve assets. To date, Nuo has created a secure, transparent, and efficient debt market with over $44.02M in reserves and $39.40M in outstanding loans from over 32,333 transactions.
DeFi payment platforms aim to create an open infrastructure for secure, fast, and cost-efficient ways to send and receive cryptocurrency via any internet-connected device and wallet. These platforms typically charge a fee per transaction significantly less than their counterparts within the traditional financial system. The applications of this specific vertical are wide-ranging, encompassing disparate functions such as accounting payroll, remittances, and larger B2B transactions.
For instance, Sablier is an ERC-1620 based “protocol for real-time finance”, enabling companies to get rid of the hassle involved with payroll administration by “streaming” stablecoins (e.g. – DAI, USDC, etc.) from a one-time payroll deposit pool to employees based on predefined time intervals executed by a smart contract. The time intervals can be customized for each employee, ensuring that they have a continuous stream of earnings to service their specific expenditures.
Automated Financial Organizations (AFO) & Frameworks
Note that a Decentralized Autonomous Organization (DAO) refers to a blockchain-based organization that is governed digitally through a smart contract based implementation and that is directly controlled by users with a limited management hierarchy. Users cooperate to transact on DAOs via a largely self-enforcing and open-sourced protocol. At its core, an AFO is simply a DAO designed for any use case involving financial service offerings. Some DeFi companies harness the highly-interoperable nature of DeFi to provide a framework that developers can use to build their own AFOs.
For example, Akropolis is a DeFi company with a mission to create “decentralized and autonomous community economies”. One of their service offerings, AkropolisOS, enables developers to start and scale complex AFOs through a flexible Solidity framework built using the OpenZeppelin SDK. AkropolisOS also grants developers access to Akropolis Pool, an undercollateralized credit pool that developers can tap into for their AFO, allowing potential users of their AFO to borrow/lend from Akropolis Pool via the developer’s AFO interface.
Staking Service Providers
Blockchain networks that employ the Proof-of-Stake (PoS) consensus mechanism require third-party validators that create, propose, and vote on blocks added to the network, with an influence that is proportionate to the number of network tokens a given validator owns (i.e. – their stake). In exchange for serving as a validator node on the network, the validator receives financial rewards in the form of the network’s token. Staking service providers allow validators to offload the technical aspects of staking to the service providers typically in exchange for a percentage of the validator’s staking rewards. This effectively democratizes the staking process beyond only those technically capable of implementing and managing the staking process.
Certus One is an example of a staking service provider with enterprise-grade validation architecture that has staked over $120M on public PoS networks such as Cosmos and Terra, as well as for enterprise clients including Libra, Hyperledger, and Corda. In addition to their core validator management and support services, Certus One has also implemented a software key management service (KMS) that allows clients to set up and run secure, high-bandwidth, cloud-based validator nodes without the traditional hardware requirements.
DeFi-focused financial analytics platforms focus on the discovery, analysis, and communication of insightful patterns in the financial data that underlies DeFi protocols. Investors and related stakeholders ultimately use the insights derived from these data patterns to drive their decision making processes (e.g. – portfolio allocations, etc.).
DeBank is a DeFi-based financial analytics platform that allows users to track their DeFi portfolio holdings and the state of the space as a whole, as well as explore and compare various DeFi service offerings in real-time. For instance, users can track the average yield received by lenders/borrowers across twenty different stablecoins as well as among numerous prominent lending/borrowing platforms such as Compound, Aave, Maker, and dYdX. DeBank also provides a comprehensive description, list, and ranking of companies across service offerings such as DEXes, stablecoins, lending, margin trading, and more.
Decentralized Exchanges (DEXes)
In the same vein as the decentralized technology that underlies cryptocurrencies, many believe that the process of exchange itself should also be decentralized. A DEX is simply a cryptocurrency exchange that enables P2P trading of cryptocurrencies without fund custody being transferred to an intermediating central authority. This is different from traditional centralized exchanges in which users deposit funds and then receive IOUs from the exchange to freely trade on the platform, with the exchange effectively acting as a custodian of user funds. Akin to the benefits of decentralized networks, DEXes offers users benefits such as:
- Waiving the requirement for trust in third-party exchanges
- Eliminates the need for users to disclose personal details; enhances user privacy
- Decentralized hosting means reduced risk of hacks and server downtime
One example of a prominent DEX is AirSwap, which provides frictionless P2P trading with no fees, no deposit/custody requirements, and no information signups. They’ve also been rated the leading Ethereum DEX, provide easy onboarding for makers at any trade size/price, and provide an intuitive user-interface. AirSwap also provides a suite of developer tools for integrations into third-party platforms.
Margin trading refers to using borrowed funds from a broker to trade a financial asset; the asset serves as the collateral for the broker’s loan. Investors use margin to buy financial asset positions in volumes that they otherwise couldn’t with their own account balances. In return, investors are obligated to pay the broker loan interest payments at predefined intervals at time until they liquidate their position, at which point the broker collects the remaining principal before the investor realizes any proceeds from the liquidation. It’s important to note that the broker has the authority to close out a position or call for additional deposits to pay down the loan in certain situations.
Certain platforms such as DDEX provide a decentralized marketplace for margin traders and brokers to match off-chain and settle margin, spot, and lending transactions on-chain in a secure and transparent manner. Lending and borrowing is done through decentralized lending pools, where lenders pool assets into smart contracts and borrowers take secured loans from this pool. This feature allows interest rates to be dynamic, fluctuating as a function of supply and demand. DDEX uses stablecoin-based price oracles for accurate, real-time USD asset prices, and manages liquidation events through a third-party initiator that triggers a smart contract event. If the criteria for liquidation in the smart contract are met, the borrower’s collateral is sold in a dutch-auction style process, maximizing the spread collected by the borrower until all the collateral is recouped. Any risk incurred by lenders due to a potential rapid loss of collateral value is hedged by an insurance pool composed by a percentage of ongoing interest payments. Finally, DDEX provides limit orders, stop-loss orders, position adjustments, and over 10x leverage on trade orders.
Prediction markets are exchange-traded markets that allow people to speculate directly on a wide variety of different events, including: 2020 presidential election results, the winner of the 2020 NBA Finals, a COVID-19 vaccine release date, actors most likely to play a particular character in an upcoming movie, and more. Users are able to place trades based on their estimations of the likelihood of events, with generally prevalent views of outcomes yielding lower payouts in comparison to more contrarian views; as with traditional betting markets. It’s worth nothing that large companies and institutions often use prediction market data as proxies for public perception, which informs their management’s decisions and objectives.
Perhaps one of the most prominent prediction market platforms in the DeFi space is Gnosis, a platform which grants market participants the ability to:
- Create crypto assets (i.e. – conditional tokens) that represent information about future events with conditional outcomes and integrate these assets with other applications
- Trade said crypto assets based on estimations of their likelihood of occurring via Gnosis Protocol (i.e. – fully permissionless DEX)
- Hold digital assets in one of the most trusted platforms on the Ethereum network and the only formally verified smart contract wallet (i.e. – Gnosis Safe Multisig)
Gnosis uses a dual-token mechanism to lower barriers to entry for users and encourage continuous platform use. The GNO token is the native token of the ecosystem, tradable on several major exchanges with a fixed total supply of 10,000,000 tokens. The purpose of GNO is to generate OWL tokens, which are obtained by locking GNO in smart contracts. Once generated, a single OWL token can be used to pay $1 USD in Gnosis’ platform fees. Gnosis allocates some of its fees towards its ecosystem fund, which is used to drive dapp adoption by providing teams with funding, mentoring, marketing, and bespoke solutions via Gnosis’ products and protocols.
Asset tokenization makes non-digital, traditionally illiquid assets such as real estate, private equity/venture capital portfolios, commodities, art and many more such asset classes available to retail investors through representative cryptocurrencies known as security tokens. These security tokens are issued through security token offerings (STOs), and represent units of ownership of the underlying asset that can be traded in secondary markets. In addition to significantly increased accessibility, asset tokenization facilitates benefits such as greater liquidity, faster and cheaper transactions, as well as increased transparency.
One prominent example of an asset tokenization platform is Harbor, recently acquired by cryptocurrency custodian BitGo and backed by the likes of Andreesen Horowtiz and Pantera Capital. Harbor aims to transform the alternative investment experience through its suite of service offerings for issuers and broker-dealers, including the following:
- Digital Subscription Platform: Harbor automates the process of investor onboarding and subscription processing to accelerate closings and minimize drop offs
- Investor Portal and Dividends: Harbor streamlines investor communications and reporting, and issues investment dividends through its proprietary SEC-registered Harbor Digital Transfer Agent
- Marketplace as a Service: Harbor improves fund marketability and provides liquidity options to investors through a private marketplace with greater accessibility to a wider investor audience
Given the historic growth of DeFi service offerings to date as shown by the examples above, it wouldn’t be unrealistic to say that potentially every financial service that exists in the traditional, fiat-based framework may be rebuilt via the crypto-ecosystem. That being said, there are certainly challenges that may likely stifle the growth of DeFi that need to be addressed prior to widespread adoption.
Smart Contract Failure Insurance
In the event of hackers exploiting vulnerabilities in the smart contracts that underlie many DeFi services, many service providers are looking to implement insurance to protect against significant user losses in the future. For instance, one recently launched company, Nexus Mutual, aims to provide DeFi service providers with a decentralized form of insurance (i.e. – a community-owned insurance alternative) against such smart contract failures. Members of the community pay a nominal fee in ETH and are entitled to a share of any capital held in excess of that used to finance claims. Nexus’ premier product, Smart Contract Cover, lets members buy protection in NXM (Nexus’ native token) against financial loss caused by another’s misuse of a smart contract. NXM is also used for platform governance and to incentivize honest risk/claim-assessment. For risk assessment, members stake NXM to indicate confidence in a particular smart contract’s security. Stakers are rewarded if coverage is bought for that contract, but the stake may be slashed if the contract is deemed unsafe. In terms of claims assessment, members are rewarded for staking NXM in support of legitimate claims and penalized for supporting fraudulent claims.
Existing DeFi solutions rely heavily on the use of safeguard collateral, often times overcollateralizing assets to boost investor confidence in various service offerings. The growth of unsecured borrowing/lending for DeFi services will likely require a more developed identity system so that borrowers can build up credit and increase their borrowing power, akin to traditional creditworthiness metrics like FICO scores. It’s worth noting that such an identity system is still implementable while generally maintaining the user anonymity associated with DeFi, as service providers like Akropolis implement pseudonymous borrower creditworthiness ratings using borrower account addresses.
Many existing dapp projects are labelled as decentralized, though technically are still controlled by developers with capabilities to disable dapps through their master keys and modify key components of the platform without user consent. Moreover, in some stake-based voting systems on DeFi platforms, a disproportionate amount of power is often allocated to platform users with the largest stakes, which lies contrary to DeFi’s key feature of decentralization. Such examples outline some of the current areas of improvement as it pertains to decentralized governance on dapp platforms, which are principally intended to be governed by platforms’ decentralized user base collectively as opposed to any centralized entities.
Over time, there has been an emergence of projects geared towards this decentralized governance, allowing project stakeholders to collectively vote on project decisions/implementations before any changes are made by dapp developer teams. Moreover, in the case of stake-based voting, the influence of the largest stake-holders is systematically mitigated through various technical mechanisms on many platforms. This form of decision-making typically is manifested in two ways: on-chain and off-chain governance. The former refers to platform changes that are made immediately and automatically following a voting process among the platform’s community. The latter refers to manual changes made by the core development team following a voting process that strictly adhere to the results of the voting process on the platform.
User Interface/Experience (UI/UX)
Initially, blockchain dapps were built to serve a niche community of blockchain enthusiasts and developers that weren’t overly concerned with dapp design. While technical implementations and use cases clearly demonstrated the potential of DeFi service offerings to this demographic, the nuances of mainstream usability were more of an afterthought. However, newer iterations of DeFi dapps like Dharma have emerged with sleek, user-friendly designs that seem to be encouraging the growth of these service offerings among more mainstream audiences.
Additionally, it’s worth noting that cryptocurrency wallets will likely serve as the primary driver of user experience among all mainstream users’ digital asset activity in the future. Effectively, they will allow users to monitor and interact with their funds across all the DeFi protocols they participate in (e.g. – alternative savings, margin trading, payments, etc.) from a single interface.
Clarity of Ecosystem
Currently, it is daunting for many mainstream users to navigate not only the disparate, potentially unfamiliar verticals within the DeFi space, but also the sheer number of service providers and dapps within each vertical. While various DeFi service ranking/listing sites exist, they have historically been geared towards demographics already familiar with blockchain and cryptocurrency (i.e. – blockchain enthusiasts/developers). Mainstream adoption would likely require an improvement in users being able to find the best dapps for their bespoke needs and use cases in an efficient, convenient, and simple manner.
Due to the technical implementation of blockchain networks (i.e. – the consensus process), they tend to be slower than centralized data storage networks in aggregate. This speed cost is ultimately externalized to dapp users in the form of longer transaction settlement times. DeFi developers and users will likely need to continue to strike a balance between reasonable transaction times and the level of decentralization (i.e. – via their consensus protocol) they’d like blockchain networks to have as service offerings are expanded and refined.
DeFi offers users an unparalleled alternative to the traditionally high-fee, exclusive, opaque, and non-user-centric service offerings historically provided by large, centralized financial institutions. Moreover, the flexibility and interoperability of DeFi services mean that users have a significantly wider swathe of service options to choose from based on idiosyncratic factors such as their risk appetites, interface preferences, available capital, jurisdictional regulatory considerations, and more. With continued growth and development in the space, both in terms of the Next Steps described above and beyond, widespread user adoption of the previously described DeFi service offerings will likely pose a considerable threat to incumbent financial institutions over the next five to ten years.
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