The world of decentralized finance has seen unprecedented growth since launching just over three years ago. Here we explore what catapulted the industry into the spotlight, and why analysts are predicting that DeFi is destined to disrupt the traditional financial sector. Before we dive in, let’s first cover some of the basics, starting with what DeFi is.
What Is DeFi?
Decentralized finance (DeFi) is an umbrella term that is used to describe various blockchain-based applications and systems that automate traditional financial tools, making them trustless and transparent in their operations. Through the implementation of blockchain technology, DeFi applications are able to cut out the middleman for activities such as purchases, insurance, loans, derivatives, crowdfunding, betting and more.
Through the use of smart contracts (digital agreements that execute once predetermined criteria have been met), DeFi applications are able to execute effectively with no need for human interference. DeFi, previously known as Open Finance, has seen much innovation when it comes to finance-based applications (dapps), creating a wider and more effective crypto ecosystem.
So, what is DeFi? In a nutshell, platforms across the DeFi space allow users to lend or borrow funds from peers, trade crypto assets, use derivatives to speculate on price movements, insure against risks, and earn interest and returns through various avenues.
Due to the nature of the Ethereum platform providing smart contracts and dapps creation, most DeFi apps are built on the Ethereum blockchain. In fact, over 96% of all DeFi apps are built on the second largest cryptocurrency’s network, with the rest spread over platforms like Binance Smart Chain (BSC), Tezos, Polygon and Polkadot. Below are some examples of the most popular DeFi applications that have been created to augment the industry, and contribute to its success:
- Stablecoins. These cryptocurrencies are pegged to fiat currencies to provide price stability in the market.
- Decentralized exchange (DEX). These types of exchanges cut out the middleman and allow users to trade directly with each other, whether trading crypto to crypto or crypto to fiat, etc.
- Lending platforms. Decentralizing the process of loans, lending platforms facilitate the loaning process through smart contracts, replacing banks and other financial intermediaries.
- Wrapped Bitcoins (WBTC). A process that makes it possible to send Bitcoin to the Ethereum network, allowing the funds to directly enter Ethereum’s DeFi space. Through WBTSs users can earn interest on lending Bitcoin to the various lending platforms.
- Prediction markets. These markets allow users to bet on certain outcomes for future events and automatically execute the results, cutting out any intermediaries.
- Initial DEX offerings (IDO). These crowd sale events are the successors to ICOs (initial coin offerings) and are hosted on DEXs (decentralized exchange).
While the apps listed above create a foundation for the DeFi industry, in turn, these concepts below have materialised and filled the gaps in between:
- Yield farming. Involves users staking their tokens in various lending pools and by providing liquidity they, in turn, receive returns.
- Composability. A term used to describe the nature of open-sourced DeFi apps providing the building blocks for alternative apps to be “composed”.
- Liquidity mining. A form of yield farming where apps reward users with free tokens for engaging in their platform.
- Money legos. This concept revolves around grouping together several DeFi apps to build new financial services and products (similar to how lego blocks are blocked together to build various shapes).
The Rise And Rise Of DeFi
Decentralized finance was created with the vision of banking the unbanked, to provide financial instruments to those that would otherwise have little or no access to it, all while leaving centralized financial institutions out of it.
Attributed with being the first of its kind and the first foundation of DeFi, MakerDAO was launched in December 2017. The stablecoin-based lending platform allows users to borrow DAI and earn interest through a series of smart contracts that facilitate the loan, repayment, and liquidation processes. By the end of December 2017, the DeFi industry was worth $48.5 million.
In a short wave after this, the innovation within the industry skyrocketed, with releases of DeFi dapps, networks, protocols, and platforms coming out at neck-breaking speeds, so much so that by 31 May 2020 the industry value crossed the $1 billion mark for the first time.
In June 2020, the lending and borrowing platform Compound launched. As many platforms followed Compound’s lead, this ignited what has become known as the yield farming phenomenon. Just three months later, Bloomberg reported that the DeFi industry made up “two-thirds of the crypto market in terms of price changes.”
Through these innovations, the industry has developed into a more advanced financial system and has reached a pinnacle point in its maturity that is proving it to be a viable substitute for traditional finance solutions.
According to Financier Worldwide, the three biggest contributions to the financial market from the DeFi space has been:
- the creation of monetary banking services (digital currencies that are pegged to a fiat currency, known as stablecoins),
- the pooled lending and borrowing platforms,
- the enabling of advanced financial instruments (prediction and derivative markets, decentralized exchanges and tokenization platforms).
Since May 2020 the DeFi industry has grown from an overall value of $1 billion to a whopping $80 billion. To put it another way, there is now double the amount of ETH locked in DeFi protocols than there is in centralized exchanges (CEXs).
Top DeFi Projects Changing The Landscape
With over 400 DeFi projects currently available, and counting, there are a number of stand out ones that help to provide a bigger picture of the industry. Below are several projects that have provided outstanding innovation and functionalities within the DeFi ecosystem.
MakerDAO (MKR) - one of the earliest decentralized finance (DeFi) projects centred around borrowing DAI and earning interest.
Compound (COMP) - is an advanced borrowing and lending protocol that secures the loans through the use of over-collateralization.
Aave (AVE) - Similar to Compound, Aave is a borrowing and lending protocol but instead provides uncollateralized loans, more in line with the traditional financial sector.
Synthetix (SNX) - allows for the creation and trading of derivatives on a wide range of assets (stocks, currencies, commodities) through its derivatives issuance protocol.
Uniswap (UNI) - is a decentralized exchange (DEX) that uses smart contracts and automated liquidity protocols to facilitate the exchange of crypto assets.
Yearn.finance (YRN) - provides an autonomous protocol that searches for the best yields across the DeFi space and automatically invests in them.
DeFi Disrupting Traditional Financial Sectors
Products and services in the global financial sector were designed in the Industrial era and have seen little innovation or product development since then, despite huge advances in software development. While various fintech services have provided some innovation, they all need to plug into the same financial sector in order to operate, curtailing any developments seemingly achieved.
DeFi provides a new space built on trustless and transparent blockchain technology which replaces the “trust layer” of finance. DeFi trades in financial intermediaries like asset management firms, banks and insurance companies replacing them with code and software.
Catering to both developed and emerging markets, DeFi is able to provide greater product innovation and liquidity to financial markets, a wider variety of choices to consumers and is able to reduce the costs of transactions. On the other hand, it provides the emerging markets with otherwise unattainable financial services to people that don’t fit into the “traditional” banking system as well as a more stable store of value in the form of stablecoins.
“Decentralized Finance (DeFi) is likely to have a significant impact on how banks operate in the future – and even has the potential to shift the structure of the whole financial system at a macroeconomic level.” - Benedikt Eikmanns, Prof. Dr. Isabell Welpe, Prof. Dr. Philipp Sandner
The world of decentralized finance has also been celebrated for providing small businesses with tools to successfully operate in larger markets, particularly in the small loan and remittance sectors. The industry is able to provide these smaller businesses in developing markets with tools that the traditional banking sector is not providing.
Processes are much easier to scale across a small business’ ecosystem and don’t require the preceding relationships or centralized processing practices of the current banking system.
Through DeFi applications, businesses can easily exchange trustable data across their own systems in an automated manner. This in turn disrupts the traditional banking sector, drawing SME’s business away from the centralized monopolies and into the decentralized realm of DeFi.
DeFi And Regulation
While cryptocurrencies have been in the financial regulatory bodies line of vision for some time now, only recently have these firms started to focus on DeFi. Due to the decentralized nature of the industry, intermediary financial institutions run the risk of losing out on income while others are concerned about the bad actors in the space. Or perhaps, due to the fact that DeFi is shaking the foundations that the central banking and financial regulation systems were built on.
Recently, U.S. Senator Elizabeth Warren called for the Financial Stability Oversight Council (FSOC) to implement a “coordinated and cohesive cryptocurrency regulatory strategy.” Looking further than just the DeFi industry, she also called for regulations for stablecoins, ransomware attacks, the operational risk to banks, and highlighted numerous hedge funds’ unrestrained exposure to cryptocurrencies.
While the regulatory bodies fight to provide a legal framework for the mushrooming growth that DeFi has displayed, many traditional financial firms are taking action to participate in the industry. Even Goldman Sachs is trying to enter the game, requesting the SEC to grant them permission to provide an “Innovate DeFi and Blockchain Equity ETF.”
The Future Of DeFi
While blockchain technology deeply drove technological innovations, DeFi is set to provide the same growth in the financial sector. Taking into consideration this is already well underway, in May, over $150 billion was invested in DeFi assets when the market hit its peak (largely due to the rising prices of Bitcoin and Ethereum at the time).
Here at Oobit, we provide access to several DeFi markets, bypassing complicated onboarding processes by offering credit and debit card payment options. Instantly gain access to DeFi tokens like Chainlink (LINK), Compound (COMP), Elrond eGold (EGLD), Maker (MKR), Synthetix (SNX), The Graph (GRT), Uniswap (UNI), yearn.finance (YRN), and more.
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