Decentralized Finance (DeFi): What Do You Need To Know?

  • 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.

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.

Defining DeFi:
“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.

Ethereum leads total numbers and activity of DeFi (source: own data)
DeFi usage remains nascent on all blockchains (source: own data)
Daily transaction volume in USD; EOS might be an outlier (source: own data)

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.

Comparison of locked money with the top 6 protocols on a monthly basis in million USD (source: own data)

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.

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.
  • 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.

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.

Summary of use cases for DeFi

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.

Remarks

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  • Blockchain knowledge: We wrote a Medium article on how to acquire the necessary blockchain knowledge within a workload of 10 working days.
  • Our two blockchain books: We have edited two books on how blockchain will change our society (Amazon link) in general and the everything related to finance (Amazon link) in particular. Both books are available in print and for Kindle — currently in German and soon in English. The authors have been more than 20 well-known blockchain experts in startups, corporations and the government from Germany, Austria, Switzerland and Liechtenstein — all contributing their expertise to these two books.
Our two books: the first one on blockchain and the society and the second one on blockchain and finance

Authors

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 (victor@vonwachter.de) or via LinkedIn (https://www.linkedin.com/in/victor-von-wachter).

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Philipp Sandner

Philipp Sandner

Professor | Lecturer | Author | Investor | Frankfurt School Blockchain Center