The current financial system has been bull-ing for quite some time now, since the Gold standard was eradicated to be exact. The endless printing of money by central banks have enriched many, however at a high cost for society leading to issues like debasement and rising inflation. In an effort to re-establish sovereignty and power to the everyday person alternatives have sprouted such as decentralized finance, or DeFi.
DeFi is an open-source technology alternative to the current financial system. With its vast and rapidly growing products and services decentralized finance allows anyone to to be able to borrow, save, invest, trade with, earn interest and more.
The term Defi originated from a Telegram chat back in 2018 between Ethereum developers and entrepreneurs. However the first DeFi application originated back in 2009 when the Bitcoin genesis block was created. Bitcoin’s rules, like scarcity and openness, embedded in its code, which allows users to control their finances without any intermediary intervention. This invention set the stage for many more exciting blockchain evolutions to erupt.
Why is DeFi becoming popular?
With the total value locked (TVL) in DeFi contracts hovering around $200 billion, one could speculate that decentralized finance is still in its nascent stages. What makes DeFi unique and prosperous is its use of blockchain technology to operate under algorithmic governance rules and regulations embedded into the software (code). In contrast the bureaucratic system relies on social hierarchies to regulate and enforce the law. In essence, with the use of smart contracts buyers, sellers, lenders and borrowers are connected and allowed to interact as peer-to-peer without the need for centralized authorities mediating.
Besides DeFi’s core aspects of its multilayered non-custodial, open source, transparent and decentralized solution, decentralized finance has technical layers which make up the standard DeFi stack:
What Are the Components of DeFi?
- Settlement Layer: The bedrock of DeFi is the ability to integrate the public blockchain with a native currency. The settlement layer does exactly that, as it allows cryptocurrencies or tokens to complement decentralized apps (dApps) helping users to earn passive income or interest through activities such as staking. Furthermore, it can also be used for transparent governance (voting rights), or connecting and exchanging with other centralized and decentralized marketplaces.
- Protocol Layer: In essence the protocol layer is vital for achieving sufficient and scalable liquidity. It helps to contain the rules and regulations for actions like sending, receiving and formatting data, which allows entities or developers to interact, scale, and improve services for the end-users.
- Application Layer: Another important component of the DeFi ecosystem is the application layer which provides services via dApps (explained later). It is commonly used in web3 apps, including loan services and decentralized exchanges (DEXes) such as Aave, Uniswap and PancakeSwap.
- Aggregation Layer: The final layer acts as the uniter of apps and resources from the previous layers to further strengthen the end-user experience, convenience and utility.
What is Ethereum (ETH)?
Ethereum is a popular blockchain platform that can run smart contracts. Its native crypto token (ETH) is the second-largest cryptocurrency by volume. Ethereum serves as the backbone of the decentralized finance (DeFi – link to DeFi article) sector, where developers can create decentralized applications (dApps – link to dApps article), which enables the peer-to-peer lending and borrowing of crypto assets. All of this is made possible thanks to Ethereum’s smart contract functionality, which automatically performs functions that in centralized finance are usually performed by third parties (intermediaries, a.k.a. middlemen).
Ethereum as a currency
Ether ($ETH) is used as cryptocurrency just like Bitcoin. It can be an investment asset or and/or means to purchase goods and services. Its fluctuations in value are correlated to the current value of Bitcoin.
Ethereum as a technology
Ethereum provides a solid foundation for DeFi smart banking, decentralized applications and other blockchain services. The operational cost for transaction services in these dApps is called gas. Transaction fees are paid in gas and their amount depends on the complexity of the application or the current workload on the Ethereum network. Extremely high gas fees is one of the biggest barriers to Ethereum’s potential for mass adoption by businesses, as well as by people.
What is the future of Ethereum?
Ethereum’s popularity and growth of the DeFi ecosystem has incentivized innovation to new highs in the blockchain space. Unfortunately, the high fees have led to other competitors entering and gaining market share in the smart contract blockchain market such as Polkadot, Solana and Avalanche. However, Ethereum developers (led by Vitalik Buterin) understand the network’s pain points and have scheduled major updates. They have announced the ETH 2.0 upgrade that is supposed to occur in 2022. It will help the Ethereum network with finally solving its congestion and scalability issues, which in turn will significantly reduce ETH’s gas fees.
One of the oldest projects on the Ethereum blockchain launched in 2017 is MakerDAO. It functions as a protocol which allows users to issue a decentralized Stablecoin – DAI – pegged at 1- to- 1 to the value of the U.S. dollar by using digital assets as collateral. This creates an opportunity for anyone to take out a loan without relying on centralized entities, as well as hold dollars in the form of USDC, USDT and other stablecoins. Through its lending protocol and Dai Stablecoin, MakerDAO initiated the ignition of a new, open, permissionless financial system, from which many new financial protocols (Uniswap) launched, in turn increasing the dyinamic and interconnected ecosystem.
What are dApps?
Decentralized applications (dApps) are digital applications or programs build on a blockchain network. They are similar to regular apps, only decentralized. Most dApps are built on the Ethereum blockchain. They are distributed and executed through smart contracts, which makes transactions between two parties seamless, quick and free from the control and interference by any single authority.
Difference between centralized and decentralized apps
Centralized apps are owned by a single company which sends and receives data back and forth from the company server.
Decentralized apps use the blockchain, or a peer-to-peer network of computers, to engage in transactions directly with one another. The user pays a fee in the form of cryptocurrency to the developer to gain access to the source code, also known as smart contract, without revealing any personal information.
It is recommended to use dApps on mobile devices, as the user experience is more convenient. It is fairly simple, one has to connect their blockchain wallet, which in turn provides access to the thousands of dApps out there.
Pros and Cons of dApps
The advantages of dApps are their ability to safeguard user privacy and to resist censorship. They achieve that through smart contracts. Smart contracts allow anonymity by cutting out the middleman in any transaction. Blockchain projects running their own dApps are finding new opportunity frontiers into sectors such as social media, banking, gaming, online shopping, finance to name a few.
Blockchain technology and dApps in particular are still in early stages. They are scratching the surface of a wide range of positively overwhelming possibilities. Currently, their scaling is a problem which can overload a network, causing congestion and transaction slowdowns. Another barrier to the mass adoption of dApps could be the necessity to develop a user-friendly interface as well as the ease of implementing ongoing enhancements and updates.
Why is DeFi Important?
Outlined below are the many issues in the traditional financial system and the solutions DeFi has to offer:
- Opening a bank account is not possible for everyone.
- Being denied access to these services can prevent people from opportunities.
- A bank or intermediary can block users’ transactions or freeze their funds.
- Most financial institutions use their clients’ data against them.
- Governments can step in and impose restrictions on markets.
- Trading hours depend on the global time zones
- Some international transfers can be very timely
- Financial institutions usually charge premium fees and commissions
- The user is presented with complete autonomy and independence of how they spend their money
- Their fund transfers happen at worst within several minutes.
- The ability to be anonymous when making a transaction.
- Markets never sleep.
- Transactions can be pseudonymous or anonymous.
- The network and infrastructure are open to anyone.
- Markets don’t close.
- Created on a system of transparency, anyone could audit or inspect a products data
What is DeFi? Top DeFi Projects
Founded in 2018, Uniswap is a decentralized finance protocol and exchange (DEX) which facilitates automated transactions between cryptocurrency tokens on the Ethereum blockchain through the use of smart contracts.
Curve is an automated market maker (AMM) similiar to Uniswap, however with a focus on trading Ethereum compatible Stablecoins. Curve users provide liquidity via stablecoins to the Curve pool from which they earn income from transaction fees.
Aave is a platform which lets users lend and borrow crypto tokens.
As we mentioned before, MakerDao allows lending and borrowing via Dai, a stablecoin linked to the US dollar. Since its launch it has become one of the biggest decentralized applications on the Ethereum blockchain.
What is DeFi Staking and Yield Farming?
DeFi staking refers to the locking of tokens or digital assets through a smart contract for a specific period of time, earning passive income. The amount of interest that is provided depends on the duration and total amount of assets locked-up. The end-user becomes in essence a transaction validator in the chosen DeFi protocol. The more validators a network has the higher the security, faster transaction speed and overall functionality of the platform. An example of a popular DeFi platform is Fantom, which has created a calculator to estimate the potential returns: https://fantom.foundation/ftm-staking/.
Yield farming involves lending or staking cryptocurrencies in exchange for interest, fees, and other rewards measured in terms of annual percentage yields (APY). Compared to staking which is suited for low risk takers and beginners, yield farming is risky but can bear huge earnings. You can read more about it here.
What is DeFi? Proof of Stake
Aligned with the process of staking crypto assets, Proof-of-Stake (PoS) is a consensus mechanism which selects transaction validators. The core feature of the Ethereum ecosystem Proof-of-Stake is an alternative to the energy-intensive Bitcoin based Proof-of- Work (PoW). PoS system is designed to increase the speed and efficiency while reducing the fees.
Below are some of the important components of Proof-of-Stake:
- Staking and mining are similar in nature. The network participants earn rewards when they add the most recent batch of transactions to the blockchain.
- Stakers, transaction verifiers, lock-up their digital assets for a chance to add a new block of data to the blockchain and in turn receive a reward.
- Depending on the size of the assets staked with a minimum of 32 ETH necessary to become a validator and their lock-up period, the network chooses the validators.
- Staking is a great way to contribute to a blockchain’s security and efficiency, as well as earn additional income via commision and fees.
- Stakers have a say in deciding the upgrades or future changes to the network.
DeFi 2022 and Beyond
Blockchain’s ability to implement many functionalities, such as DeFi, cryptocurrency, dApps, NFTs, others, show the complexity and the myriad of opportunities this technology offers. Governments around the world are trying to decide whether to embrace or reject ground-breaking decentralized functionalities such as DeFi. Sooner or later blockchain’s many advantages will most likely encourage businesses and individuals to embrace and support its mass adoption on a global scale. As the technology and ecosystem continues to mature, so too is there an increasing amount of decentralized solutions for most financial services.
We hope you’ve enjoyed reading our DeFi Guide. If you wish to read more about the Blockchain space, please feel free to check out our blog.