Saturday, December 5, 2020
Home The Capital What Is DeFi: Decentralized Finance Explained. Part 2

What Is DeFi: Decentralized Finance Explained. Part 2

In the first part of this article, we laid the groundwork for better understanding what DeFi fundamentally is and what it is made up of. Now it’s time we went further and examined the actual pearls that it offers at the most practical level, warts and all. So buckle up and enjoy this quest for DeFi’s treasures with us!

Earlier implementations of DEXes followed the traditional design where buy and sell orders are matched against each other in the so-called order book. The order book database itself can be off-chain or on-chain. But what sets these exchanges apart from centralized trading places like Binance or Bitfinex is how the user’s assets are stored. With Ethereum-based exchanges, such as or EtherDelta , users maintain the sole custody of their private keys, and all trades must be authorized by them, while an exchange smart contract trustlessly stores the assets.

That was a huge step forward from custodial exchanges fraught with way too many hacks, scams, and third party risks like funds arbitrarily blocked or confiscated. But in terms of popularity, which translates into trading volumes, order book-based decentralized exchanges failed to set the world on fire. What really ignited the fire of DeFi, though, and made this idea actually popular among the trading public and beyond was the invention of reserve-based trading aka automated market makers (AMMs) and the advent of DEXes featuring this model is the new king on the block, and as of this writing, according to Dune Analytics its market share surged to over 60% in the 7-day trading volume among all decentralized exchanges, irrespective of the order matching engine. But it is not the only fish in the sea as with anything popular the space quickly gets crowded. The top dogs like , , , , to name but just a few, can take over the packmaster any moment. But what’s even more important, they are now starting to compete with regular exchanges, and that’s a big deal.

The decentralized sector of this space is largely dominated by and its flagship product — the stablecoin DAI, the primary provider of the on-chain financial stability. To maintain its peg to the US dollar, it utilizes the so-called collateralized debt position. In layman terms, the currency peg is kept through the balance of the available supply of DAI and the market value of its collateral. The higher the value, the more DAI can be created, and vice versa. At the outset, it only used Ether as collateral, but today it uses a select crypto portfolio.

There are several other projects relying on this model, for example, with its A-EUR token pegged to the euro, and featuring an EOS blockchain-based USD stablecoin. However, most other projects in this realm go with different, more flexible approaches such as elastic supply aka dynamic peg ( Ampleforth ), where the supply expands and contracts algorithmically based on demand, and self-collateralized models used by, for example, , with its BitAssets like BitUSD, BitEUR, BitGold, and similar digital assets.

As with virtually everything in DeFi, decentralized lending & borrowing is done via smart contracts which make both parties stick to their ends of the bargain. But what’s in it for the lenders and borrowers, you may ask? Given that lending requires overcollateralization at the bare minimum of 150%, with an average ratio well over 300% across the market, lenders are more inclined to loan out their assets at an agreed interest rate instead of selling them. This is a winning strategy as long as the market is on the rise, which was the case recently.

For borrowers, loans work as a hedge against sudden price drops like short squeezes. If their collateralization ratio is at 200%, the loan turns into an effective stop-loss order at 50% of the price of the provided collateral should it plunge dramatically, no matter how much below that mark. In the worst-case scenario, they can only lose their collateral and still have the borrowed cryptocurrency on hand, without suffering the negative consequences and ramifications like bad credit histories if they were to borrow from a commercial bank. Then rinse, repeat.

This space is mostly taken by three major players, which is , already mentioned , and , with dozens of smaller players. In terms of DeFi, they all leverage the same smart contract tech applied through decentralized applications (dApps) that offer market participants dynamic interest rates based on supply and demand. Aave boasts most advanced lending services which include uncollateralized loans aka flash loans, immensely popular among arbitrageurs, along with an impressive list of possible collateral types.

Cryptocurrency staking is as old as PoS cryptocurrencies are, where it is used for transaction confirmation similar to mining in Bitcoin. DeFi breathed new life into this space in the form of staking pools that set up cryptocurrency staking on your behalf, freeing you from the hassle of running the nodes yourself. There are many pools available for staking your coins offered by Staking-as-a-Service providers, but you should probably stick with if you want the staking to be done in a non-custodial, DeFi way, that is to say, your way.

With Amazon and its likes around the world stubbornly refusing to accept cryptocurrencies as a legit means of payment, DeFi also brought forth the idea of decentralized ecommerce marketplaces, and it didn’t take long to materialize as peer-to-peer platforms like OpenBazaar , district0x , and . The latter is particularly noteworthy as it features its own privacy-oriented cryptocurrency, PART, and decentralized escrow in the form of the so-called MAD contracts, which fully deserve their name standing for Mutually Assured Destruction .

In the first part, we referenced insurance as an example of a service that can be decentralized. Believe it or not, someone has already done just that, namely Nexus Mutual , a blockchain-based alternative to insurance built on risk-sharing pools. Right now it only provides cover against the theft of funds from smart contracts, for example, due to hacks, but in the future it hopes to come up with more mainstream products.

In the end, we should also mention a unique decentralized service which has no parallel in traditional finance. Smart contracts that the entirety of DeFi is built around called for the rise and advance of blockchain oracles — services that bridge together off-chain data sources and on-chain smart contracts. Dedicated blockchain platforms like and which offer such services can thus be rightfully considered part of the DeFi world.

Lack of centralized governance to set apart the good and the bad makes this space a rich feeding ground for all kinds of fraudsters. In a sense, it is a Wild West where everyone is for himself, without trade-offs or compromises. In practice, it may mean losing money, so at all times everyone should do their own research before stepping into these deep waters.

To sum it up, DeFi is far from being as simple as it might look to you after reading the piece.

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