An overview of DeFi – A threat to traditional finance?

In this post we’ll take a look at DeFi (Decentralized Finance), a burgeoning area of cryptocurrency application, which could upend traditional finance. Here we will go through some of the most popular types of DeFi space applications.

Decentralized Exchanges

Decentralized Exchanges or DEXes are currently the most popular cryptocurrency use case. They allow users to buy and sell other cryptocurrencies without a central authority such as Binance, and Coinbase acting as middle-men. Instead the central authority is a smart contract that has been coded to facilitate the trade. As a result of this fees can often be lower than traditional exchanges, though it depends on the platform. Those built directly on Ethereum currently incur high transaction fees due to congestion on the Ethereum network.

The chart below taken from DappRadar.com shows the top 10 DEXes by size. The blockchain platform they reside on is shown under the ‘protocol’ column.

Note that Polygon is an extension of the Eth protocol, and is known as a layer 2 solution, to get around the fact the main network was getting congested resulting in high fees. Therefore 5 of the top 10 DeFi exchanges can be said to operate on the Eth blockchain. It remains to be see whether Cardano DEXEs will make it into this list once they launch on Cardano later this year.

DEXes do however suffer from low liquidity for trading pairs where there is not enough of an order book. As a result the DEXEs have started also providing liquidity services (will come to that later), blurring the line between an exchange and a liquidity provider.

Lending and Borrowing (Centralized)

The next most popular set of DeFi dApps are for lending and borrowing. These operate similar to banks in that you store your crypto on the platform (i.e. lend your crypto to them), and they will pay you interest. The platforms will then in turn offer to let other users borrow crypto.

For these to work, the lending and borrowing interest rates need to be automatically determined. Each platform has their own solution to this.

The most popular borrowing and lending platforms in crypto are still centralized (just like Binance is centralized and the most popular exchange). These are BlockFi, Nexo, and Celsius. They typically offer rates to lenders of around 8% and rates for borrowing around 10-12% for borrowing. However the range of coins you can transact in are limited.

Their decentralized counterparts are what we cover in the next section.

Market makers/ Liquidity providers / Yield farming

For those that do not operate in financial circles, this is perhaps the most complex of use cases to get ones head around.

Let’s start by explaining a market maker. Think of a currency exchange that you use to obtain foreign currency prior to going on vacation. The currency exchange will determine what the exchange rate should be and they’ll price it at a level to both remaining competitive but to make an arbitrage profit for themselves (this is why it’s best to get your holiday money before you get to the airport when there is more competition between providers).

This is an example of a market maker. Now imagine the currency exchange had to offer you a rate without knowing what others are charging. This is the challenge faced by decentralized solutions attempting to offer a similar service, and is solved by liquidity providers.

Liquidity providers and Market markers are an essential part of any financial market as they ensure that it is always possible to buy or sell your crypto when you go to an exchange, rather than waiting around for someone else to want to make the other side of the trade with you.

“With third-party market makers, the “party” is usually a hedge fund. They act as arbitrageurs, sourcing liquidity from other exchanges by hedging their positions in other markets…Liquidity Providers utilize liquidity pools rather than the traditional peer-to-peer order book. Because there are no order books, an asset’s price is kept constant in relation to its global price through a smart contract that executes a mathematical formula. Price variations depend on both the size of the trade and liquidity pool for a given asset.” (Swan Finance)

Liquidity pools determine what the price should be based on maintaining a fixed ratio of between two pairs such as Eth and DAI, and relying on arbitrage traders to spot any opportunities and trade until the pool reflects the external market

Liquidity pools are a complex topic and the subject of impermanent loss and stable coin lending is important to understand (additional sources provided at end). However I shall have to cover these in a separate post.

Liquidity pools may also utilize oracles or other prices fees in determining the price as is the case with Liqwid being built on the Cardano blockchain.

The most popular Ethereum liquidity providers are shown below. There are others that operate as both a DEX and a liquidity providers that are worth a mention these are: Pancakeswap (BSC), Honeyswap (xDai), Curve (Eth), Balancer (Eth), Uniswap (Eth) and Sushiswap (Eth).

In addition there are several other market aggregator solutions that sit looks across liquidity pools and serve to offer users with optimal yields. Yearn finance is the most popular example of this.

Oracles

Oracles act as a trusted source of external data to the DeFi ecosystem, and provide data as a service. This can be anything from price data to liquidity providers mentioned previously or it could any other type of data. For example a weather related Oracle may provide a farming insurance smart contract data on the number of rainy days that occurred in a particular region.

Chainlink on the Ethereum blockchain is by far the most popular Oracle. With the Cardano platform several Oracle solutions are being built such as Charli3, Ergo, and Wolfram.

Derivatives

These are smart contracts based on on an underlying financial asset such as a security or an index. Common underlying instruments include bonds, commodities, currencies, interest rates, market indexes, and stocks.

Thanks to the advent of smart contracts, tokenized derivatives can be created without the need for a third party. Counterparty agreements are programmatically encoded, drastically reducing the risk for malicious activity. This trend has allowed retail investors to take advantage of opportunities previously restricted to those with brokerage accounts or specialized knowledge. (DeFiRate.com)

Synthetix is the most well known example in this category. Their platform allows you to trade, stake and borrow an array of different cryptos, equities and commodities. They do this by creating synthetic assets tied to the price of the real world asset. This Forbes article is worth a read for those wishing to learn about this innovative yet potentially disruptive space.

Summary

We touched upon some of the biggest topics of the DeFi space but by no means all of them, such as the image below shows. What is clear is that decentralized finance solutions built on blockchains are showing strong momentum, and threaten to disrupt traditional, centralized, finance.