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What is DeFi? Decentralized Finance Explained

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Decentralized finance (DeFi) is one of the hottest topics of crypto in the last year. The year we left behind had a bum in platforms offering DeFi services. In this article, we will try to get the decentralized finance explained.

MakerDAO, the decentralized lender has seen significant growth and adoption of their stablecoin Dai, but this is only a product among DeFi products built on the Ethereum platform regardless of the system’s scaling problems.

Explaining DeFi can be a little tricky because of the fast movement in the innovation of the ecosystem which is hard to follow.

What is DeFi?

DeFi is basically traditional finance services or tools built on a public blockchain, actually on Ethereum to be more specific. Those DeFi protocols are mostly open-source platforms that issue digital assets on a public blockchain making easier access to financial services due to the censorship-resistance nature of public blockchains.

However, the full decentralization in finance might have it’s downwards.  This is why many DeFi platforms issue their own digital assets among the traditional financial services they offer. In other words, it is like some decentralized blockchains with their own digital assets interacting with traditional finance products.

DeFi products cover many areas of traditional finance but let take the lending protocols. The 3 platforms MakerDAO , Dharma, and Compound have 80% of the lending market share according to a binance research as of June 4th 2019 with more than $450 million locked on Ethereum.

ETH DeFi - What is DeFi? Decentralized Finance Explained

But financial sectors that DeFi is becoming popular among open source lending protocols are also market prediction protocols, stablecoins, trading platforms and marketplaces and token issuance platforms.

Open Finance Lending Protocols

The open lending protocols are the most popular service among the DeFi services and this massive attention is due to the rise in use of Dai and other lending platforms like Dharma and Compound Finance.

The advantages these platforms offer are huge compared to the traditional lending services the traditional banks offer.

What Decentralized Finance Lending platforms offer more than traditional lending systems are:

  • Easily integrated with digital assets for lending and borrowing
  • Possibility to use digital assets as collateral
  • Instant operations and new was to secure loans
  • No credit history checks, making possible for more people to access the lending services
  • Automation of operations which reduces the costs of the service

To secure the lending process platform MakerDAO and Dharma rely on the trustlessness that public blockchains like Ethereum offer. This way it reduces the risks while lowering the fees.

Open lending is exclusive to public blockchains like Ethereum, however, this implies some long term complications while expanding the service all over the globe. MakerDAO actually has the biggest share on this market and while its popularity has grown also proposals to increase the fees have grown in order to keep its digital currency stable against the USD, and all this because of scalability issues.

On the other side, other lending services like BlockFi enable their users to borrow or lend cryptocurrencies but use traditional finance procedures to secure their lendings by doing credit checks behind the scenes.

Decentralized Prediction Markets

One of the most intriguing finance tools are those to predict market movements. While being a complex thing it has also big potential. Decentralized prediction markets like Augur that was launched back un 2018 is a censorship-resistant built on Ethereum as a smart contract and Gnosis is following the same example.

These are not a new thing since prediction markets have been present in traditional finance but what the above-mentioned platforms bring new to the market is the censorship resistance that public blockchains offer.

Stablecoins

Stablecoins are getting every day more popular with new models of issuing tokens usually pegged to the USD and sometimes gold or other assets including cryptocurrencies. Stablecoins are tokens issued on the blockchain that maintain their stable value against the pegged asset.

An example of stablecoins collateralized by cryptocurrency is Dai, MakerDAO stablecoin which I pegged to ETH, but not at 100% rat bun at 150% rate, which means that if you deposit 150$ worth of ETH you get 100 Dai. An interesting fact is that the platform has only borrowers because the lender is the protocol itself than mints/ burns tokens.

The most popular stablecoins collateralized by 100% are Tether, USDC, and Gemini. However, these models are based on un trust and transparency provided by the issuer showing audits that prove the reserve of the assets pegged to the stablecoin.

In any case, stablecoins does not make any sense for crypto advocates because stablecoins are centralized blockchain-based cryptocurrencies that go against the main concept of crypto. Companies behind the stablecoin earn interest from funds deposited in USD in their bank accounts from users that buy their stablecoin. Collateral in these bank accounts should be 1:1 to the stablecoins issued, but this is a thing that is hard to be verified.

Decentralized Exchanges (DEX) and Open Marketplaces

When we speak about exchanges in open finance what is intended always are decentralized exchanges (DEX)  or peer to peer exchange platforms. Unlike traditional crypto exchanges like Coinbase or Bittrex, DEX s are exchanges where users do not need a third party in order to use the exchange neither a third party can interfere in what they do on a DEX exchange.

One of the oldest decentralized exchanges is Etherdelta and the most popular decentralized exchange is IDEX. Another protocol to build decentralized exchanges is 0x.

Not every exchange that claims to be decentralized and non-custodial is truly that way so users should do their own research before trusting their claims.

Open marketplaces on the other side are some sort of exchanges for non-fungible tokens (NFTs) like crypto collectibles. An example of that are Cryptokities or parts of land in the Ethereum-based game Decentraland.

Peer to peer marketplaces have a considerable long term potential and could be used in the future to tokenize real-world assets.

Digital asset Issuance Platforms and Investing

Issuance platforms not excluding exchanges too have become popular especially with the unclear regulations in the space.

Popular ST Issuance platforms like Polymath and Harbor offer all the necessary legal and technical framework in order to launch security tokens on the blockchain. They prepare the security token contract according to their standards (i.e., ST-20 and R-Token) and offer compliance and liquidity for the launch on their  Issuance platforms or crypto exchanges. tZERO is an example of Dual exchanges/issuance platforms which was launched in summer 2019.

Also, asset management platforms like Melonport have become popular due to the possibility to manage crypto assets on an interface built on IPFS that runs on the backend in the Ethereum blockchain as a smart contract.

Issuance platforms and asset management platforms will increase in popularity over time while other big players especially institutional investors get more interested in the open finance that blockchain makes possible.

Summary

There are a lot more products of DeFi and open finance platforms including custodians insurance, infrastructure, etc.

Defi products are high-risk assets and research and understanding are always required before getting involved. However, the future of DeFi looks bright and will probably innovate the traditional financial system.

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About Author

Ethan Hunt

Bitcoin Maximalist and Toxic to our banking and monetary system. Separation of money and state is necessary just like the separation of religion and state in the past.

Disclaimer: All content found on 7bitcoins.com is only for informational purposes and should not be considered as financial advice. Do your own research before making any investment. Use information at your own risk.

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