What Is DeFi?

BeginnerNov 21, 2022
DeFi is a financial system open to global users, including lending, trading, minting, insurance and other services.
What Is DeFi?

1. What Is DeFi?

2. Six Sectors of DeFi Ecosystem

3. Advantages and Risks of DeFi

4. Two Application Scenarios of DeFi

5. Prospects of DeFi

6. Conclusion

DeFi is a financial system open to global users,with programmability, openness and transparency, anonymous transactions and other characteristics. After several years of development, it has become an important part of the global financial system. Users can freely participate in DeFi financial services without identity authentication, and there are no restrictions on age, region, assets, etc. All DeFi services are created and maintained by users, who only need to create their own blockchain wallet to participate in free transactions.

1. What Is DeFi?

DeFi stands for Decentralized Finance, that is, "blockchain + finance". Blockchain, as the underlying development protocol, builds various financial service scenarios on its basis, such as lending, trading, minting, insurance, contracts, lottery and other financial services, so as to achieve decentralization, open source, queryability, anonymity and allow anyone in the world to freely participate.

The financial services in DeFi do not rely on financial institutions such as brokers, exchanges or banks, but use smart contracts on the blockchain to match transactions. Decentralized governance is adopted from the protocol layer, data layer and application layer. Users can use the DeFi service by connecting to the blockchain wallet, and no central institution can prevent transactions and deny access. In traditional finance, users need cumbersome procedures such as identity authentication, background investigation and credit report evaluation, so as to collateralize or lend/borrow assets, but in DeFi, they can easily complete the loan in a few minutes as long as there are enough collateralized assets in their wallet.

For example, user A has 10 ETH in his wallet, 1ETH = 1000 USDC, and he needs 5000 USDC. In this case, he can choose the loan protocol AAVE and first deposit 10 ETH, which is valued at 10,000 USDC according to the price ratio of ChainLink Oracle. On the AAVE platform, the MAX LTV (maximum loan-to-value ratio) of ETH is 85%, which means that 8500 USDC can be loaned, so the demand is fully met. After the loan, user A can pay the interest on time, and there is no time limit.

2. Six Sectors of DeFi Ecosystem

The development of DeFi can be traced back to the birth of Maker DAO in October 2017. So far, hundreds of DeFi products have been launched. The whole ecosystem of DeFi is mainly divided into six sectors: stablecoin, trading layer, Oracle, infrastructure, revenue aggregator and wallet.

2.1 Stablecoin

For cryptocurrency, it is very important to measure its token value,  and in DeFi, this is mainly solved by minting stablecoins. Presently, the mainstream way is to mint by pegging with other assets (such as USDs), such as the common USDT/USDC/DAI, etc. Their prices are basically flat with the USDs, fluctuating within a few cents. With stablecoins, other assets (such as BTC/ETH/SOL, etc.) can form a trading pair with it and circulate freely in DeFi.

2.2 Trading Layer

All DeFi protocols are upper-level applications based on public chains, such as Ethereum, Solana, Avalanche and Binance Smart Chain; different public chains have different consensus algorithms and performance, mainly reflected in trading speed and gas fee. Currently, Ethereum is still the most secure and ecologically sound public chain in the network, but between its limited performance and high gas fee, other public chains are also rising rapidly. However, with the development of Ethereum Layer 2 technology, more DeFi applications will choose Layer 2 as the base protocol. Among them, Ethereum is responsible for the security and stability of the network, and Layer 2 improves the performance of the public chain as a whole and reduces the trading costs.

2.3 Oracle

Oracle is an important way to calculate the price ratios of assets in the DeFi protocol. By capturing the real-time price of token assets in major exchanges (such as Binance, Coinbase, FTX, etc.), a recognized asset price is obtained through an algorithm, and then the price is synchronized to the chain to provide a real-time price ratio for the DeFi protocol. It is a significant bridge between the off-chain market and the on-chain market. Presently, ChainLink's Oracle is mainly used to calculate the price ratios.

2.4 Infrastructure  

As an application layer, DeFi is based on the sufficient improvement of various infrastructures, such as public chain, Oracle, stablecoin, AMM market making and cross-chain bridge, which is also the reason for the full outbreak of DeFi in 2020, because this is the time when various infrastructures begin to be sufficient.

2.5 Revenue Aggregator

DeFi has a large number of projects , and there are interest spreads between different lending platforms and exchanges. In order to maximize revenue, a revenue aggregator has been generated. It will switch between different protocols according to different rates of return, providing users with more benefits.

2.6 Wallet

Wallet is the portal for users to enter the blockchain ecosystem, and it is also one of the most important components of the DeFi ecosystem. It mainly plays the role of storing assets, trading assets, transaction query, accessing Dapp, etc. Users can use various Dapp applications in the blockchain only if they have a wallet. . Wallets are divided into hardware wallets and software wallets. Presently, the mainstream software wallet is MetaMask.

3. Advantages and Risks of DeFi

To have a deeper understanding of the significance and advantages of DeFi, we need to know what problems exist in traditional finance at present. The details are as follows:

1)  The threshold for participating in financial services is high, and some people cannot open bank accounts or use financial services;

2)  The conditions for opening financial services are harsh, and any financial services need to be reviewed and controlled by government authorities, which makes the financial service products on the market single and cannot meet the diversified needs;

3)  The central institution intercepts most of the profits, and the return obtained by investors is limited;

4)  User data is controlled by centralized institutions;

5) The government and centralized institutions can shut down financial services at will, and investors' assets are not under their own control;

6)  The trading time is controlled by the central authority, and users cannot trade freely anytime and anywhere;

7)  The financial service process is cumbersome, and it may take several days to realize asset transfer, and the intermediate transaction cost is high.

In this case, users' participation in financial services is heavily restricted, which highlights  the advantages of DeFi. Compared with traditional finance, the advantages of DeFi are as follows:

1)  Anyone can participate. Users only need to link their wallets to use all financial services;

2)  There is no policy threshold, as long as there is an idea, anyone can create their own financial products through open-source protocols;

3)  Most of the returns are obtained by users, and the platform only receives a small part of the transaction fee, which is open and transparent, and users have the right to choose;

4)  Anonymous transactions without  revealing the true identity of users;

5)  The transaction can provide 7x24 service, which can be carried out at any time and anywhere;

6)  The transaction is decentralized without too many cumbersome processes, the transaction speed depends on the network efficiency, and most of them can be confirmed in a few seconds;

7)  Users' assets are under their own control. As long as the private key is kept well, there will be no risk of theft;

8)  The transaction is open and transparent. Based on the blockchain protocol, anyone can view the data and the operation of the protocol.

But meanwhile, as an emerging field, there are also many risks in DeFi, as follows:

1)  Because of anonymity and unregulated, there are problems such as money laundering and illegal market transactions;

2)  Contract vulnerabilities often occur. Due to open-source code and insufficient contract audit, the protocol is often attacked by hackers;

3)  Projects are vulnerable to suffer flash loan attack: in some lending  projects, hackers attack the algorithm of the protocol and the price ratio mechanism, making the mainstream assets of the platform to be lent away;

4)  When the liquidity provider adds funds into the liquidity pool, due to the fluctuation of market price, it will cause impermanent losses;

5)  Fraud  projects running away will empty the liquidity pool, making the price of assets investors bought nominal.

In addition, some DeFi projects are deployed on centralized servers, and irresistible factors such as policy supervision, natural disasters and war may also interrupt the service of DeFi. Presently, DeFi is still an emerging technology, and there are many risks, so we should be cautious when investing and using DeFi products.

4. Two Application Scenarios of DeFi

As of July 8, 2022, the TVL (Total Value Locked) of DeFi was $51.9 billion, of which the TVL of lending was $27.7 billion, accounting for 43.73%; The  TVL of Decentralized Exchange (DEX) was $22.9 billion, accounting for 44.12%.

4.1 Lending

Lending, as the name suggests, means lending target assets through collateralized assets. In traditional finance, it is generally to mortgage houses, cars, etc., and then lend fiat currency, while in DeFi, it is to collateralize tokens to lend another token.

The DeFi lending platform is mainly composed of lenders and borrowers. First, the lender adds the assets to the lending platform, then the borrower collateralizes its own assets, calculates the value of the assets according to the price ratio mechanism of the Oracle (such as ChainLink), and finally lends the corresponding proportion of the target assets according to the platform algorithm.

Both lenders and borrowers will receive token rewards from the platform. This process is also called Lending & Single-Asset Vault. In the process of lending, the borrower will pay the corresponding interest, and the lender will receive the main part while the protocol creator receives the other part. Presently, the main lending platforms include AAVE, Compound, IronBank, MakerDAO, etc.

4.2 Decentralized Transactions

Decentralized transaction, also known as DEX (decentralized exchange), is a concept proposed by relatively centralized transactions. In the centralized trading platform, the trading parties make deals through the order-pending platform provided by the intermediary institutions, and the user's funds are stored in the wallet of the centralized institutions. As the chips are in the hands of centralized institutions, people find that the currency price is easy to be manipulated by institutions and the market is opaque, so someone proposed to replace the third-party trading platform through smart contracts to match transactions, and the decentralized trading platform came into being.

DEX is different from the order-pending transaction of centralized transactions. It provides prices for both parties through the way of liquidity pool pricing. However, if the price is not deep enough, it may not be able to make a deal, so AMMs (automatic market makers) emerge. They provide sufficient funds to improve the liquidity and transaction rate of each Dapp (decentralized application).

Who is responsible for AMM? Generally speaking, it's anyone who has spare money. It only needs to deposit the trading pairs (such as BTC/USDC, ETH/USDC, etc.) composed of the idle assets into the designated DEX (such as Uniswap) to earn the handling fees of platform transactions and the reward of platform token UNI. This process is called liquidity mining.

For example, in the ETH/USDC trading pool, there are 1000 ETH and 1000000 USDCs, then 1ETH =1000 USDC.

If user A wants to provide 10 ETH liquidity for the pool, user A needs to add LP into the pool in a ratio of 1:1000, and 10 ETH and 10,000 USDC need to be prepared.

If user B wants to buy 500 ETHs, without considering the sliding point (the difference between the expected price of the transaction and the transaction execution price), it needs to trade at the price of 1ETH=1000USDC. After the purchase transaction is completed, the number of ETH in the pool is 1000 - 500 = 500, and the number of USDCs is 1,000,000 + 500, 000 = 1,500,000. At this time, the price of ETH becomes 3000 USDCs.

DEX has developed rapidly,  starting in 2020 and reaching an all-time volume peak of $309.7 billion by May 2021, with  the number of users participating in DEX transactions reaching $5.3812 million. Presently, due to the poor market conditions, the trading volume has experienced a sharp correction.

5. Prospects of DeFi

As a new financial system and model, there are many factors affecting DeFi’s development, including infrastructure, ecosystem applications, policy supervision, etc.

5.1 Ethereum 2.0 Upgrade

Presently, the ecosystem application of DeFi is mainly built in Ethereum, and Ethereum beacon chain, as the first step of the ETH2.0 roadmap, is committed to introducing a safer and more environment-friendly proof of stake mechanism for the consensus layer of Ethereum network. After the upgrade, Ethereum will transition from POW (proof of work) to POS (proof of stake), which will significantly reduce the issuance speed of ETH and is likely to lead to deflation of ETH. It is estimated that the upgrade will be completed in August 2022 or later, and the upgrade of ETH2.0 may promote the next bull market of ETH and DeFi.

5.2 Development of Layer 2

Layer 2 is also another catalyst for the future of DeFi. Ethereum, as  a Layer 1 blockchain, is responsible for the security and stability of on-chain data, and Layer 2, as an application layer protocol, is responsible for improving the performance of the application layer, reducing gas fee consumption, and significantly improving the transaction speed. This makes the future DeFi ecosystem interaction cheaper and faster than ever before, and enables the new DeFi protocol that could not be implemented on Ethereum before (such as the decentralized exchange in the order-pending form). And most Layer 2 projects can also launch their own tokens and quickly stimulate the growth of users. We look forward to seeing some turning points in the future to promote the greater development of Layer 2.

5.3 Complementarity with Other Tracks

NFT, GameFi, SocialFi, DAO, metaverse and other tracks will also provide ecological support for DeFi. Such as the NFT token and trading on AMM, the creation of NFT collateralized loan contracts, the rental service of in-game assets, and the land financialization in metaverse are all application  scenarios that can be imagined in DeFi.

5.4 DeFi Index

Another opportunity for rapid growth in the DeFi market is the index: in the traditional financial field, S&P 500, FTSE100 and other indexes have experienced a huge growth period. This has not been shown in the field of DeFi, especially because the nature of smart contracts allows users to easily create a wide range of indexes, from DeFi blue chips, metaverse to NFT. Smart contracts also allow automatic rebalancing of these indexes. Therefore, we look forward to seeing more and more DeFi related indexes in the future and a rapid growth.

5.5 Compliance Management

The current unclear rules stifle innovation, and the environment is not friendly to the DeFi development team and users. However, with the introduction of reasonable regulatory policies, there will be a friendlier and more directional policy environment. Meanwhile, it will also make DeFi mainstream and access a broader user demand market. There is reason to believe that  this day will come sooner or later.

5.6 More Traditional Financial Institutions Will Join

Although each chain has a functioning DeFi ecosystem, with the maturity of cross-chain bridge technology, the interaction between major public chains must be the trend in the future. DeFi will also attract funds from most banks, hedge funds, other financial companies and even the whole country in the future. It's hard to say what will happen to the price of DeFi in the short and medium term, but when the world realizes what is being built in this field, another  rise of the DeFi market can be expected.

When market attention shifts away from price, long-term developers will continue to create value and constantly put forward new ideas, which will provide nutrients for the next market cycle. In these seemingly calm times, it is extremely important to keep up with the latest trends and turn our attention back to the infrastructure construction of DeFi.

6. Conclusion

DeFi is a new financial system, which changes the operation mode of the traditional financial system, and can stimulate any user with financial needs in the world to participate in it, so that superior financial services can be accessible for ordinary people. After a round of bull market development, presently, DeFi ecosystem application has been relatively mature, and its feasibility has also been verified by the market. As the basic sector of major ecosystem applications, DeFi will precipitate and iterate in the next period of time, and more innovative and subversive products will be launched at the right time. Stay tuned!

Author: Toby
Translator: Joy
Reviewer(s): Hugo, Jiji, Yuler
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