Decentralized Finance (DeFi): What Do You Need To Know?
Overall, the blockchain-powered space of Decentralized Finance (DeFi) is still nascent but offers a compelling value proposition whereby individuals and institutions make use of broader access to financial applications without the need for a trusted intermediary. Especially people previously without access to such financial services could benefit from this development. Even more so, DeFi promises a full-fledged capital market. At this point in time in a minuscule format thought. But it grows. — Authors: Victor von Wachter, Philipp Sandner
- DeFi favors network effects, the true innovation is created by uniquely combining the applications.
- While it may be difficult to determine which blockchain protocols and applications will get the most usage long-term, currently the advanced decentralization, programmatic flexibility and the truly enthusiastic developer base gives Ethereum the lead.
- For Ethereum, going forward, the fate of adoption of DeFi is tied to the scalability and usability of Ethereum.
- DeFi has yet to prove it is a true improvement. Currently, the usability is unintuitive, risk-adjusted pricing is non-existent and the liquidity cannot compete with the centralized alternatives. Nevertheless, we are bullish that these are issues of a nascent ecosystem.
Note: All data and examples as of 30th November 2019.
What’s the buzz about DeFi?
DeFi has become a trending topic in the blockchain community. In contrast to the decentralization of money through Bitcoin, DeFi aims for a broader approach of generally decentralizing the traditional financial industry. The core of the initiative is to open traditional financial services to everyone, in providing a permissionless financial service ecosystem based on blockchain infrastructure.
“An ecosystem comprised of applications built on top of public distributed ledgers, for the facilitation of permissionless financial services.”
Broadly speaking, DeFi is an ambitious attempt to decentralize core traditional financial use cases like trading, lending, investment, wealth management, payment and insurance on the blockchain. DeFi is based on Decentralized Applications (dApps) or protocols. By running these dApps on a blockchain, it provides a peer-to-peer financial network. Like lego building blocks, every dApp can be combined with each other. Smart contracts work as connectors — comparable with perfectly specified APIs in traditional systems.
The rise of DeFi
While the initiative to open finance is generally blockchain agnostic, it flourishes on more flexible blockchains (i.e. programmable smart contracts) as well as with a healthy developer base. Today, nearly all DeFi projects are being built on Ethereum, making it the standard default blockchain for many dApps. Taking a look at the average data of November, Ethereum dominates existing blockchains in amount of applications, application activity, user activity and also in volume traded/locked (with limitations). The large transaction volume on EOS is a phenomenon throughout the year, and is often considered as a benefit of zero transaction costs, thus possibly inflating transactions. Regardless, it indicates that zero transaction costs are an attractive goal to support DeFi development on the blockchain.
In a nutshell, other competitors for the DeFi are currently far away as they either lack a healthy developer base (IOST) or true decentralization and thus core benefits of the blockchain (EOS). Some simply lack both. This raises the general question, whether DeFi can also be replicated on the most famous blockchain protocol. Contrary to popular belief, dApps are indeed possible on Bitcoin but programming them is much more complex.
By design, Bitcoin emphasizes security, something that is very important in financial infrastructure. Hence, Bitcoin might be suited for a robust, albeit notably smaller DeFi ecosystem. Bitcoin’s most successful DeFi application is so far the Lightning Network. The second layer protocol has been developed over the past years and is based on a technology called state channels. The Lightning Network allows for ultrafast and cheap payments and has seen impressive growth in 2019, with already more than 6000 active users and USD 6.2 million locked in the network. Other notable Bitcoin dApps are in the are of decentralized exchanges like Bisq or Sparkswap.
While it may be difficult to determine which protocols and applications will get the most usage long-term, currently the advanced decentralization, programmatic flexibility and the enthusiastic developer base gives Ethereum the lead. As a result, Ethereum-based dApps will be the focus of this report. DeFi projects now account for a substantial share of Ethereum’s sprawling ecosystem. Particularly with respect to Ether (ETH) locked in smart contracts, which is often used as a measure for growth in DeFi sector. The amount of ETH locked is collectively worth over USD 680 million (roughly 2.5 million ETH). In terms of volume locked, MakerDAO dominates across the major applications, with Synthetix, Compound, InstaDapp, Uniswap and dYdX following behind. However, over the past few months, MakerDAO’s dominance started to drop and the other platforms have been collecting volumes. Increasingly the DeFi technology stack has become more integrated as dApps combine layer 2 services with each other (e.g. InstaDapp).
It is very important to note that the fuel keeping DeFi running is ETH and DAI. The Ethereum-native Ether is needed to pay for blockchain transaction fees and it is also the easiest cryptocurrency to convert into other currencies. DAI is a layer 2 creation on the Ethereum blockchain and offers the benefits of a stablecoin: being fully decentralized, synthetically pegged to the USD and thus inherently less volatile. A major driver behind the success has been the ability to circulate DAI between different DeFi protocols and to use it as a unit of account on these dApps.
What are now the core benefits of DeFi?
DeFi is built on top of a blockchain. Often the blockchain is referred to as a general infrastructure layer, consequently, DeFi can be viewed as a cluster of second layer applications. This allows DeFi to inherent the core property of decentralization. It is important to note, that this only holds if the blockchain itself is decentralized. Fulfilling this pre-condition, the core benefits of opening finance are shared with the core benefits of blockchain:
- True decentralization allows censorship resistance, worldwide participation regardless of social status and dispenses trusted third parties.
- Utilizing blockchain as technological infrastructure allows relatively speedy and low-cost transactions/settlement, the immutability of the financial contracts, and contract automation.
- DeFi applications generally allow that the user remains in possession of the private keys. This is referred to as non-custodial in the blockchain ecosystem. The user is in full control of the money without a trusted third-party.
- Increased ecosystem transparency and thus price and market efficiency. Minimal principal-agent risks, as asymmetric information are non-existent and the personal interests are governed by a transparent protocol.
- DeFi favors network effects, as a lot of innovation is generated by uniquely combining different projects in layer 2 or even layer 3 applications.
As an example, one of the largest active DeFi contracts locks USD 10 million, without a bank account, without a third-party, and the customer is always in possession of the underlying cryptocurrency.
Put this in contrast to the traditional financial industry, where enormous resources are allocated for a system of trust creation, which comes at the cost of heavy centralization (e.g. the too-big-too-fail banks), transparency (e.g. the 2007 crisis) and censorship/discrimination in many countries. Further, the system fails to keep up with the pace of the digital age: a cross-border transaction on average takes 3 working days and costs ~6.8% fees.
Then why hasn’t it yet skyrocketed?
Nevertheless, the adoption of DeFi currently lacks behind the promising theory. For a broad adoption of decentralized applications, DeFi has to overcome major obstacles.
- The DeFi ecosystem is a field of technical experiments and innovation. Accessibility is global but yet unintuitive in terms of UX. Furthermore, as it is based on cryptocurrencies, converting traditional currencies into cryptocurrencies has to be done as a pre-requirement.
- The liquidity is outpaced by centralized alternatives. This is important as liquidity is pivotal for efficient pricing in the financial industry. In fact, most protocols are currently unable to compete as efficient low-fee competitors. In the light of double-digit stability fees, MakerDAO is currently not used as a permissionless credit provider but rather it serves as a decentral way to create leverage in Ethereum. By converting ETH to DAI and reinvesting this into ETH, this follows the centralized strategy of leveraged long positions.
- Products are overcollateralized: as there is currently no credit scoring or shared collateral, many products must be overcollateralized (sometimes as high as 150%), which reduces the leverage for professional traders or the opportunity to obtain access to capital that the user does not own. Traditional credit scoring based on identity or sophisticated deleveraging systems, liquidation algorithms and insurance funds allows a high capital efficiency in centralized systems. This should be an avenue of research.
- The technical risks, such as bugs in smart contracts or blockchain layer, are tough to detect because of the novelty of these approaches. By design, false or fraudulent transactions are irreversible on the blockchain.
- Further, there are operational risks, due to the failure/manipulation of price feeds (so-called oracles) and complex governance protocols.
- DeFi poses a potentially systemic risk arising from the interdependencies of DeFi protocols. This can be observed at MakerDAO’s too-big-too-fail status, arguably the most critical piece of infrastructure within DeFi given space’s reliance on oracles and stablecoins. Despite this, MakerDAO is open source and mostly decentralized which at least in part neutralized the too-big-too-fail argument. Yet at present, market participants are faced with few viable alternatives to the dominant lending protocol and its oracles.
Some of the following issues on Ethereum itself could potentially create issues for DeFi:
- Network congestion: In times of high usage, Ethereum has had a few clogging issues on its blockchain. If the network gets congested, a transaction can remain in a pending state, which ultimately results in market inefficiency and information delays.
- Transaction costs such as on-chain gas fees: as transactions are competing based on gas fees, transactions with lower gas fees may be left pending at lower priorities.
- Timing issues as the state of the blockchain is updated on average every 15 seconds, this is very uncommon for traditional finance. In DeFi interest and prices are calculated per block and for robust operation, it requires stable block mining.
Even if these issues are related to Ethereum specifically, similar issues can exist on any blockchain. Specifically, Ethereum sometimes faces these network performance issues owing to its popularity and usage. On the contrary, most of the other existing blockchains do not currently face scalability issues simply because they do not have enough traffic or are much more centralized by design, allowing for higher speeds and better performance. Yet, we believe, that most of the raised issues are explained by the nascency of the open finance industry. These applications remain in an experimental stage and are expected to mature, solving many of the current key issues.
Different Use Cases of DeFi
DeFi is an umbrella term for decentralized permissionless financial infrastructure, thus a variety of customer-facing applications can be found. Among the most interesting fields currently, are borrowing/lending and exchange protocols. The table list a set of different DeFi use cases sharing the central benefits of DeFi.
Interestingly, the provision of financial services for the cryptocurrency ecosystem is currently approached from two angles: either centralized or decentralized. For example, the exchange of two currencies can be conducted centralized (e.g. Coinbase) as well as decentralized (e.g. IDEX). Also, dollar-pegged stablecoins exist in a centralized (e.g. USDT mapping the USD on the blockchain) and decentralized format (e.g. DAI, synthetically mapping the USD on the chain at this point in time).
Let’s take a look into the future
While the stack of decentralized financial apps has become broader, the projects have struggled to gain traction beyond the users already familiar with blockchain and Ethereum. Thus the growth in 2019 can be mainly explained by blockchain enthusiasts.
Given the above-mentioned roadblocks, in particular, the accessibility and thin liquidity, DeFi is currently a space of innovative experimentation instead of professional financial operations. Nevertheless, this can be said for the majority of the crypto ecosystem.
To fill the gap between theory and practice DeFi has yet to overcome its core roadblocks: Low liquidity, unintuitive UX and accessibility, capital inefficiency, hidden risks, and regulation have somewhat stifled adoption. Owing to its nascency, these issues might be mitigated as the industry matures. Promising solutions are already on the way making 2020 an exciting year to follow.
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Victor von Wachter is product manager and blockchain engineer at the Swiss Smart Valor Digital Asset Exchange. His fields of interest are primarily blockchain protocols, STOs, and DeFi at the intersect of business, technology and data. His research at the Technical University Munich contributed to the development of the ERC1400 and ERC1410 Security Token Standard. You can reach him via email (email@example.com) or via LinkedIn (https://www.linkedin.com/in/victor-von-wachter).
Prof. Dr. Philipp Sandner has founded the Frankfurt School Blockchain Center (FSBC). From 2018 to 2021, he was ranked among the “top 30” economists by the Frankfurter Allgemeine Zeitung (FAZ), a major newspaper in Germany. He has been a member of the FinTech Council and the Digital Finance Forum of the Federal Ministry of Finance in Germany. He is also on the Board of Directors of FiveT Fintech Fund, 21e6 Capital and Blockchain Founders Group — companies active in venture capital financing for blockchain startups and crypto asset investment management. The expertise of Prof. Sandner includes crypto assets such as Bitcoin and Ethereum, decentralized finance (DeFi), the digital euro, tokenization of assets, and digital identity. You can contact him via mail (firstname.lastname@example.org) via LinkedIn or follow him on Twitter (@philippsandner).
References and further articles
Delphi Digital. Decentralized Finance (DeFi) — Thematic Insights (2019)
Kyle J Kistner. How Decentralized is DeFi? A Framework for Classifying Lending Protocols (2019)
Multicoin Capital. Investment Thesis (2019)
Binance. Binance Research DeFi I (2019)
Bizanc. Decentralized Finance (DeFi), have you ever heard? (2019)