For the last few years, Decentralized Finance (DeFi) has been a strong trend in the crypto space. This can be expressed by the ever-growing DeFi Project count, their Total Value Locked (TVL; more on this later), as well as the attention they are getting in the media and on social networks. DeFi is home to innovative developers, forward-thinking financiers and risk-averse investors. Although exciting, keeping up with such a burgeoning sector can feel uneasy at times. Moreover, mastering DeFi fundamentals in the first place can represent considerables barriers to entry. With our DeFi Education Series, we wish to synthesize core DeFi concepts and make it more accessible for our community. In this Part 1, we lay the foundations that will get you up to speed with everything that’s been happening in and around DeFi.
How We Got to Today
The 2008 Crisis and Satoshi
Satoshi Nakamoto released the Bitcoin Whitepaper in October 2008, mere weeks after the Lehman Brothers bankruptcy sent a panic wave across worldwide financial markets. Bad risk management is largely seen as the culprit: in the early 2000’s, practically nonexistent credit checks and low requirements made it very easy for American households to obtain mortgages (with repayment periods sometimes as high as 50 years). Mortgages started to be pooled by risk level into “Collateralized Debt Obligations” (CDOs). Trading these derivatives was reserved to select investors (mostly professional funds).
The economy slowed, unemployment rose. More credit defaults kept piling up, driving more funds bankrupt. The house of cards crumbled.
This is the context in which Bitcoin was launched: very low public trust in financial institutions and internet giants (like PayPal) increasingly dominating internet payments.
Ethereum and Maker DAO
Ethereum was announced at Bitcoin Miami 2014, introducing the idea of smart contracts, made possible thanks to Ethereum’s Turing-completeness. These contracts are pieces of code that exist on the blockchain and can make transactions on behalf of users. This led to the next wave of innovations: DApps (Decentralized Applications) and DAOs (Decentralized Autonomous Organizations).
Maker was also announced in 2014, and launched in 2017. It introduced lending and borrowing on Ethereum through various interconnected smart contracts. The process was simple: depositing Ethereum ($ETH) in the Maker smart contract allows one to borrow $DAI (a cryptocurrency whose value is pegged to that of the $USD), or lend it to earn passive income (paid by borrowers). Maker started as a DApp, and later became a DAO (meaning its founding team no longer controls how the platform evolves; rather, $MKR holders are now in charge).
The advent of DeFi
Soon after Maker’s launch, DeFi was born and expanded both in variety and adoption rates.
So what is DeFi? First, “Finance’’ refers to the management of money, and can be categorized in various streams (payments, intermediation, insurance, derivatives, liquidity, etc.). Most people are only familiar with Centralized Finance (CeFi), which includes banks, insurers, insurance brokers, commodities and securities brokers, and more. What distinguishes CeFi and DeFi is governance: In CeFi, changes in strategy, pricing, product offering and more are decided by a company’s management, the board of directors, and shareholders. Consumers have very little control of the company’s direction. DeFi leverages blockchain’s features to give the power to its supporters (token holders), which are often also consumers. Indeed, anyone can submit proposals and vote on them
Therefore, any CeFi product/service could theoretically have a DeFi equivalent (it would simply need to be automated and coded in the form of smart contracts). In many cases, this currently can’t be done (either because of security concerns, technical limits, or a combination of both).
The most frequent DeFi subtypes are the following:
- DEXs (Trade token pairs on-chain using liquidity pools)
- Insurance (Coverage against loan liquidations or real-life events)
- Synthetics (Cryptoassets that mimic the price of other assets, like stocks, commodities, and more)
- NFTs (to a certain extent)
Current State of Things
At the time of writing, DeFi’s TVL (Total Value Locked) is roughly $200B, with Ethereum alone representing more than half that amount ($119B).
Benefits & Drawbacks
- Permissionless: Being blockchain-based, DeFi protocols simply require users to have a wallet on the chain they operate on, as well as a starting balance. This offers exciting prospects for the 1.7 billion people that remain unbanked to this day.
- Censorship resistant: Nobody can have their account closed or funds locked
- Transparent: Anyone can explore transactions made on a protocol, as well as change proposals and outcomes (if applicable)
- Cheap to use: Fees are greatly reduced, as everything is automated and profits are shared among liquidity providers and token holders (middlemen like escrows are eliminated)
- Accessible 24/7 (and from anywhere in the world)
- Steep learning curve: DeFi users must first be crypto-savvy, and know how blockchain works. They also need to obtain knowledge on the protocol they intend to use, as well as cybersecurity basics (to avoid getting hurt). Add to this the fact that new protocols and features are getting released every week, and getting updated on them can be very time-consuming.
- Security: With DeFi protocol, your funds are as safe as the platform you’re using. If bad-intentioned actors identify an attack vector and steal funds from a platform, these funds will be forever lost. Protocols that have been around for longer can be somewhat estimated “safe”, although they will never truly be.
- Rug pull risks: New protocols can run away with investors’ locked funds without notice, and with low chance of ever being retraced
Note on FinTech and Open Banking
FinTech (Financial Technologies) refers to a broader concept, namely a set of emerging technologies transforming how (centralized) financial institutions capture and deliver value to customers and stakeholders. The field is mostly propelled by startups FinTechs often fall in one of the following categories:
- Data capture (ex: sensors, IOT, smart products)
- Data storage (ex: cloud computing, blockchain)
- Data analysis (ex: data visualization, artificial intelligence)
Therefore, Blockchain is a FinTech but FinTech is not limited to blockchain. FinTech verticals include InsurTech (specific to insurance companies) and PropTech (specific to real estate funds and institutions).
Open Banking is generally regarded as a Fintech subcategory. It consists of using APIs to connect consumers’ bank accounts with third-party services, creating opportunities for more and better-tailored services.
Note on CeDeFi
CeDeFi (Centralized Decentralized Finance) refers to centralized financial institutions offering or obtaining decentralized finance products (ex: getting a stablecoin loan tied to legally enforceable repayment duties).
What to Expect Next
Hopefully, this article has taught you a thing or two. However, we have much more coming up. Stay in touch with us so you don’t miss our upcoming DeFi Education Series releases, which will delve deeper and discuss the following topics:
- Part 2: DeFi Stack
- Part 3: Stablecoins, DEXs, Lending & Borrowing, Insurance, and more
- Part 4: Advanced Concepts: Flash Loans, Interest Rate Swaps, Yield Hacking & More
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DISCLAIMER: Content in this article does not constitute financial advice. Cryptocurrencies are volatile assets. Always do your own research and invest at your own risk.