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Home The Capital DeFi — The hottest area in Crypto

DeFi — The hottest area in Crypto

Why DeFi is set to change the crypto market and lead to mass adoption

Photo by Thought Catalog on Unsplash

DeFi v Centralized finance

DeFi is an abbreviation for decentralized finance, as opposed to centralized finance which is the system we all use today. Our banks and financial institutions all work on a central basis. Currency is controlled and issued centrally, our investments, savings, deposits and borrowings are likewise managed centrally. Let me provide you with two examples of centralized finance in action.

Baby steps towards a decentralized system

The invention of Bitcoin was the first step in the decentralized process. Bitcoin decentralized the issue of money and its storage, however, the system still relies on a centralized system. Without a centralized exchange, it would not be possible to buy and sell bitcoin for cash, or as it is called in the crypto world — fiat. If everything was priced in bitcoin then the need to rely on exchanges would no longer be relevant but that scenario is a long way away — as we shall see shortly, there are a number of partial solutions emerging aimed at reducing the reliance on centralization. One such solution we have covered in this article is called a decentralized exchange.

Trust based systems

However, despite Bitcoin’s reliance on centralized functions, it is one of the most decentralized coins in existence. Many others, such as the stablecoin Tether for example rely on the honesty of the people managing the project. In other words, people buy USDT (Tether’s stablecoin cryptocurrency) and the money is deposited into a bank account. The managers of the coin have control over that bank account and how that money is invested etc. This represents a centralized system working in a decentralized environment. Centralized systems are trust-based. We have to have a certain amount of trust that the banker is not going to run away with our money or pay us a lower return on our savings than we are entitled too. DeFi is a non-trust based system, with some obvious limitations. We will come back to this later to see how this is all made possible, but suffice to say at this stage, the holy grail is a decentralized system where there is no trust involved.

Decentralization is made possible by smart contracts

DeFi includes digital assets (as we saw with bitcoin), protocols (these are the different blockchains), Dapps (decentralized apps) built on blockchains and smart contracts. Over the next few years, many many more valuable uses are going to be found for the smart contract. Smart contracts play a central role in the whole DeFi sector.

Here is how they work

Users transfer a token or currency into a digital program that runs code to automatically validate specific conditions. Once reviewed, the smart contract automatically settles whether to transfer the asset to a new party, return to the existing party, or some other combination. There is no human intervention. There is no risk of a bad actor running off with your cash or deciding not to repay your money on time. There are other risks obviously such as an external hack, but that is another story, which we will consider later.

Blockchain and DeFi

The first blockchain was Bitcoin. Ethereum, which is another blockchain-based on a similar architecture to Bitcoin, but with a different purpose, was launched in 2015. The majority of DeFi applications run on Ethereum. Let’s take a look at Ethereum and consider its significance in the DeFi space.

Ethereum v Bitcoin

Bitcoin was the first-ever cryptocurrency and money transfer system, built on and supported by a distributed ledger technology called blockchain. Ethereum took the technology behind Bitcoin and substantially expanded its capabilities including and most significantly allowing users to create decentralized applications on that particular blockchain.

Why is DeFi so important?

DeFi provides users with the opportunity of controlling their own assets thus reducing or even eliminating the need for trust.

Open lending protocols

This is a digital money lending platform built on blockchain. Open lending platforms or protocols have become the most popular in the DeFi space. Like a bank, users deposit their money and when someone else borrows the digital assets, they earn interest. The smart contracts dictate the loan terms, connect lenders and borrowers, and are in charge of distributing interest. Due to the transparency of the blockchain and that there are no middlemen, the lender earns higher returns and more clearly understands the risks.

An example

This is how a lending platform works in practice. Let’s use the popular lending platform Compound to demonstrate this.

Why is DeFi going to lead to mass adoption?

Now investors are able to earn interest from their cryptocurrencies. Most commentators have been comparing Bitcoin to gold, going as far as calling it ‘digital gold’. Of course gold is a non income producing asset.

What are the top three protocols right now?

Most DeFi applications require capital to be deposited, often in the form of loan collateral or liquidity in a trading pool — locking up value — the best measure of adoption is TVL.

Choice is exploding

In the last six months 17 DeFi projects have received funding for their projects, in July there were 6 deals alone. Poloniex is the most active exchange having listed 11 tokens. This is a hot market as you can see. The low point was 13 March 2020 when TVL sat at $571 million, today it stands at nearly $9bn. There is further to go.

Practicalities

Let’s examine how the user can participate in this market by examining four of the biggest cryptocurrency exchanges. Firstly, In order to take advantage of a DeFi lending platform, you must be able to transfer coins purchased on a central exchange to your own wallet (see Ethereum wallets above). However, some exchanges allow you to access these platforms within their own wallets as you will see below.

Binance

Binance, the largest exchange, has recently entered the market and offers between 5.8% and 12% to lenders. The security of the funds is guaranteed by the exchange. In this case, the minimum to stake is 100 DAI. The 12% relates to staking 100,000 DAI (DAI is worth $1.021). This is a reasonably hassle-free service.

Coinbase

Through the Coinbase wallet, you are now able to lend out your crypto and earn interest on DeFi apps, including Compound of which Coinbase is an investor.

Robinhood Crypto

Unfortunately, if you buy cryptocurrency through Robinhood, it is stored by them, and you are unable to take advantage of the DeFi apps at this time.

Poloniex

One of the largest and most popular exchanges in the world, it provides the largest amount of trading in BTC. There are at least eleven DeFi related governance coins now listed on Poloniex which you can trade.

The risks and regulation

Lawyers and analysts say that the apps operating in the DeFi arena are vulnerable to coding bugs and hacks. They also say that most are untested at scale and are unregulated. Critics warn the technology could be the next bubble in the crypto world, similar to the ICO bubble. Britain’s FCA told Reuters it regulated some crypto-related activities, looking at them on a case by case basis. Even decentralized platforms may be subject to regulation, it said last year. However, as recently as August 2020, Aave (another popular lending protocol)was granted an Electronic Money Institution licence from the FCA which boosted confidence in their project significantly, their token rose in value by 40% on the day of the announcement.

Other DeFi areas

Much of this article covered the lending protocols. There are a few other very promising areas which we will consider too.

Stablecoins

We touched on the stablecoin Tether briefly above. The tether coin is minted by a blockchain, however the custody of the fiat, which provides the collateral behind the coin, is centralized. Thus posing a counterparty risk. Tether and similarly structured coins, such as USDC, are called collateralized stablecoins and do not figure in the DeFi equation although you can obviously participate in it by owning these coins.

Decentralized exchanges

Online centralized exchanges include the likes of Binance and Coinbase, however, as with all centralized systems, there are the risks of solvency, price manipulation, and compromising of the exchanges online wallet. Decentralized exchanges, on the other hand, provide the potential of offering a transparent trading experience.

  • dYdX — a fast expanding DeFi app which offers a whole range of products.
  • Ox is an open protocol that enables the peer to peer exchange of assets on the Ethereum blockchain.

How decentralized is DeFi really?

The billion-dollar question is, how decentralized are all these DeFi projects.

Takeaways

  1. Smart contracts form the basis of DeFi.
  2. DeFi is a move away from centralization to a decentralized finance system, but there is some way to go to achieve this.
  3. Lending protocols have the potential to make investing in cryptocurrency attractive to the mass market.
  4. Investors should base their cryptocurrency purchasing decision on whether they will have access to the best DeFi platforms. Remember certain exchanges don’t offer access to these apps.
  5. Decentralized exchanges have a long way to go before they become user friendly, however they are an area to watch as like lending protocols, they offer attractive benefits to the mass market, making the whole process of buying and selling more transparent and cutting out the middleman.
  6. The DeFi apps operate on a new technology, blockchain. It is still unproven and bugs and hacks are likely to occur but that is the price you pay for being early to the party.
  7. There are always regulatory risks attached to new technologies — there will definitely be some protocols that step on regulators toes. There is also the issue of whether the governance tokens represent a security or not.
  8. Governance tokens have added an extra gloss to an already attractive market — this has caused a bubble but that shouldn’t be a worry as long as investors select the well financed and competent teams behind the best platforms.
  9. Finally remember that any investment in DeFi is a bet on the viability of cryptocurrency. If you are a believer then lending to a DeFi platform to maximize your investment return is a no brainer, subject to taking the necessary precautions obviously.

Financial advice

Fraud Stamp does not provide financial advice. Our articles, reports and blogs provide educational information which you should use to supplement your existing knowledge base.

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