What is it and why should I care about it?
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The world of Blockchain is full of acronyms and buzzwords which make entry into the space feel overwhelming. DeFi is the latest, and it stands for Decentralized Finance.
What Does It Mean?
Decentralized Finance is the movement to port traditional financial applications over to the Blockchain. The most common of these applications are exchanges, credit markets (to lend and borrow), asset management and synthetic assets and derivatives.
Why Should I Care?
DeFi is native to Blockchain and therefore has advantages that come with it. It is resistant to censorship since public Blockchains are readable by any party. It’s permissionless so anyone can join and create on the network, no private company or entity is in control of any product. There’s no KYC or third parties and it is completely transparent.
By this definition, it could be argued that the first DeFi product was Bitcoin. Bitcoin was created as an alternative to a financial system that consistently crashes due to greed and exploitation.
New DeFi applications enable users to buy, lend, trade and perform numerous other financial operations on the Blockchain.
Here’s a breakdown of the most popular types of DeFi applications.
What Are Decentralised Exchanges (DEXs)?
The problem with online exchanges is that they’re susceptible to hacks. History is littered with events that drained large amounts of value from the coffers of centralized exchanges. MtGox hack was the first major hack and involved an estimated 2 billion dollars being stolen. No matter how much security is put in place, centralized exchanges always carry a risk.
This is where Decentralised Exchanges come into play. DEXs are exchanges that run entirely on the Blockchain using Smart Contracts. They execute a set of rules depending on inputs and outputs. They are trustless, open, and no centralized company controls them. So long as the rules of the contract are full-proof, so is the exchange.
However, if the rules of the contract are not full-proof, funds can be lost. This was experienced during the DAO hack, in which funds were stolen because of badly coded rules in a smart contract.
There are two main types of DEX, order books, and market makers.
Order books are familiar to most traders. Buyers and sellers fill the order book with prices and set amounts. These orders get filled by other users on the opposite side of the buy/sell wall.
Liquidity can often be an issue with order book exchanges. For example, if a seller puts a sell order in for 1 ETH at a certain price, and a buyer wants to by 10 ETH at that same price, if the seller’s order was the only sell order at that price, the buyer would have to fill their order by getting the next 9 ETH at a higher price, because of low liquidity at the desired price.
This is called slippage and is caused by scarce liquidity for large quantities.
To alleviate slippage, market makers determine the price between two assets by the ratio between two pools of liquidity.
For example, lenders deposit two assets into these pools and earn interest on them. Traders trade at a price depending on supply and demand between those assets, determined by the amount in each pool.
Several market-makers gained huge popularity in 2019.
2019 Most Popular
It’s worth noting that the overall volume of decentralized exchanges is still minuscule in comparison to centralized exchanges due to ease of use, onboarding, and speed.
Why Isn’t Everyone Using DEXs?
Despite the upsides, there are a lot of downsides that are yet to be ironed out. The first of which is called front-running.
Front-running is where someone can gain information about a trade before it is executed, and act on that information. In decentralized exchanges, an observer can look for pending transactions on the Blockchain and determine price fluctuations from it. For example, if an observer can see that an address is purchasing a lot of Ether, the price is likely to go up. The observer can use this assumption to place a similar order and ensure their transaction gets bumped up the line of execution by applying a higher gas fee.
Latency is another issue. Currently, the time it takes to send data between two parties on the Blockchain is vastly higher than traditional markets. This aspect of Blockchain is improving over time as usage, research and development grow, but as it stands there’s no comparison.
What Are Credit Markets?
Credit markets allow anyone to borrow or lend against their assets. The idea of decentralized credit markets is to provide debt in a trustless manner, meaning no central trusted entity or company is needed.
MakerDao is one of the most popular credit markets in the DeFi space. It’s comprised of smart contracts that allow anyone to borrow against their crypto. For example, borrowing $100 entails locking some ETH in a smart contract vault which mints DAI stable coin (1 DAI = USD 1). To receive the ETH back, the total amount of debt must be repaid. Pretty simple stuff.
Why borrow against crypto?
Unfortunately, most utility suppliers and other companies don’t accept cryptocurrency as a form of payment (yet). However, bills and expenses still need to be paid. Entities that make money through the medium of cryptocurrency need to convert their crypto assets to FIAT currency to pay bills.
Making a lot of money from cryptocurrency can mean large capital gains tax. A common way to avoid capital gains tax is to use loans.
If you’re sure that the price of Ether will increase, you can use loans to increase your leverage. You can lend against your current Ether supply, buy more with the resulting loan and when the price goes up, sell it for more DAI. Buyback your original collateral and you’ll have your original Ether plus excess DAI from the sell.
What About Asset Management?
Starting an investment fund involves jumping through numerous hurdles. Overhead costs are expensive and regulatory processes are cumbersome. Traditional funds need to find a custodian, pay administration and operation costs, and have to constantly spend money on compliance and legal fees.
In Blockchain, spinning up a find can take minutes. It removes regulatory pain, up-front and ongoing costs. All the parameters of what it holds and how it trades can be defined in smart contracts on the Blockchain. This removes the need for a third-party custody solution. It also enables real-time profit and loss statistics.
An example of this is the Melon protocol.
What Does The Future Hold For DeFi?
Higher interest rates will drive adoption away from traditional finance and into the world of DeFi. It may take some time, but as interfaces gradually improve, the upsides will start to outweigh the downsides. New products will explode, with unlimited possibilities much like the traditional financial space.
Some players to watch out for:
A word of caution: another DAO-like disaster is inevitable in the future. Most of the products described in this article are breaking into a brand new industry, one which is unregulated and based on technology still in the Beta testing phase. Future vulnerabilities and exploits are yet to be discovered.
As with all disruptive technology, the future is bright but the road is bumpy.
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