DeFi 101: Intro to the Biggest Crypto Innovation of 2020
The advent of blockchain ushered in so many possibilities for finance. In the beginning, it was just Bitcoin and the idea of financial autonomy. Then came Ethereum, which proved to everyone that blockchain could be used for more than digital money. Ethereum enabled smart contracts and decentralized applications which gave an entire new life to the concept of decentralized finance (DeFi).
Smart contracts enable people to interact with new and exciting products without the need for intermediaries. Flash loans, yield farming, derivatives, and peer-to-peer trading are just a few of the slew of solutions that DeFi enables.
DeFi promises to democratize finance. Anyone with internet connectivity can access financial solutions that were previously a preserve for the uber-wealthy. And not just that, people can yield seriously meaningful returns from their savings.
This whole notion is nice and all, but we are faced with questions. What is the current state of the field? What does the future hold? This article is an attempt at answering these questions.
The Evolution of DeFi
DeFi has evolved in two waves. The first wave was the advent of stablecoins, which are a new type of cryptocurrency that are backed by real-world reserves. The idea of a stablecoin is to provide a retreat to users from the volatility experienced when holding non-stable cryptocurrencies. Stablecoins provide the security of cryptocurrency and the stability of traditional fiat currencies – a digitally synthetic dollar, if you will. An example of one stablecoin is Tether, which is currently the third-largest cryptocurrency with a market capitalization of $15.3 billion.
The second wave of the evolution of DeFi is “yield farming”. Yield farming is the hottest trend in crypto right now. It involves the lending and borrowing of cryptocurrency to and from a DeFi application's liquidity pool. Borrowers can get funds to make a lucrative trade, and lenders can get handsome returns.
Biggest forces driving the Defi trend in 2020 and beyond
Flash loans, yield farming, and crypto derivatives are some of the biggest forces in the DeFi space right now. In this section, we will familiarize ourselves with them.
#1. Flash Loans
Flash loans are a new kind of loan, backed by smart contracts and designed in such a way that the borrower must repay, making them risk-free for the lender.
This is how it works: if you take out a flash loan and default on your obligation to repay, the borrowing transaction will not complete. It may sound like a logical fallacy at first glance, but once you familiarize yourself with the use cases for flash loans, the concept becomes clearer.
One of the situations in which flash loans can be handy is during arbitrage. In an arbitrage trade, you buy an asset from a market that is offering it a low price and then immediately sell it in another market where the price is higher. This kind of trade is possible due to market inefficiencies, and so.
Nevertheless, if you take a flash loan to settle an arbitrage trade and cannot fulfill the obligation (by redirecting the value extracted from the arbitrage trade to the lender) to repay before the next block, the flash loan application will not complete - and as such, the arbitrage transaction will also not be completed.
Flash loans can also be used to finance the rather controversial act of wash trading. In wash trading, an investor places orders to sell securities, and then then buys them to create artificial trading activity.
#2. Yield Farming
Yield farming is the practice of earning interest from your crypto by staking or locking them up. How this works depends on the DeFi application being used.
Investors in traditional financial markets have options to invest in securities or tie up liquid assets in funds that have lock-up periods in exchange for a reasonable return based on the risk. In yield farming, the idea is pretty much similar - investors contribute to a liquidity pool and get redeemable tokens (the essential interest or dividend payment) in return. Yield farming can also be practiced through other forms of participation in DeFi applications provided the investor is availing their funds to a project.
The main benefit of yield farming is that you can earn easy profits if you redeem your tokens at the right time. Profit prospects bring with them risks, and yield farmers can lose their liquidity if the market suddenly drops. There are also security concerns on the code running various yield farming projects. A small glitch in code can cause the value of tokens to crash almost instantly.
#3. Crypto Derivatives
Crypto derivatives are tradable securities whose value relies on an underlying asset, which could be Bitcoins or some other crypto. In cases where the underlying asset fails to excite investors with enough volatility, derivatives provide an alternative option. Derivatives also offer investors other advantages such as the backing of a regulator and settlement using fiat currency, which makes it feel like investing in traditional securities.
There are several crypto derivatives in the DeFi market. Of these, Bitcoin futures are the most widely-adopted. Bitcoin futures are a form of smart contract which allows investors to buy Bitcoin at a set price and a set future date. Bitcoin futures allow investors to trade without buying the underlying currency, which makes it quite sophisticated.
Bitcoin perpetual futures (swaps) are another form of crypto derivative which investors can take advantage of. It is similar to Bitcoin futures, only that the future date for settling the trade is not predetermined.
Next, we have Bitcoin options - a form of derivative that tracks the Bitcoin market over time. Investing in options involves buying the rights to purchase or sell Bitcoin at a predetermined price in the future.
Now that we know some applications of DeFi, let us see where the industry is at this moment. DeFi has made some amazing strides in a relatively short time. With the majority of DeFi DApps being supported by Ethereum, the space will only expand with the launch of Ethereum 2.0. Ethereum 2.0 will feature better security and scalability for the Ethereum network. With the launch, we expect to see more innovative DeFi projects taking up space.
Projects like MakerDAO, Compound, Synthetix, Aave, Aragon, and Curve are some of the torchbearers. To understand their dominance, you only need to consider Aave and Compound protocols which currently have a combined $3.4 billion worth of assets.
Ethereum founder Vitalik Buterin agrees DeFi has come a long way. Speaking at the 2019 ETHWaterloo hackathon, Buterin opined that "Ethereum has made significant strides. I see value in the DeFi wave and I'm glad many people create such things. Going beyond finance, I'm more than sure there are many other things that blockchain is capable of."
DeFi's success has been propelled by the change it heralds. With DeFi, people will have more control over their financial lives in ways that were previously unprecedented. The ability to easily access loans, lend money, and achieve competitive returns – all in a peer-to-peer environment – is a massive prospect for people across the globe.
All one needs is a phone with internet connectivity. With this, they can side-step institutions such as banks and other intermediaries, saving money and time. Also, the need for trust is eliminated – thanks to smart contracts.
Criticism and Downsides of DeFi
Despite DeFi's highly promising future, it has not been without criticism. Some believe that the notion behind it - complete freedom - is a good idea for the so-called new world order. But they surmise it is not a good one when it comes to something that fundamentally affects people's lives such as personal finance.
Other concerns are that some DeFi projects may actually be scams that unwitting investors could fall victim to. Also, as awesome as smart contracts are, they are also vulnerable. The tiniest bug or loophole could lead to the loss of value. The examples are many. Perhaps the biggest one is the infamous DAO attack. Many other DeFi platforms have been targeted and lost assets as a result.
Then there is the inevitable issue of human error. When developers make code, they cannot perfectly predict how users might interact with the apps and platforms. Additionally, there is the issue of the unpredictability of the crypto market, which DeFi is not immune to.
The dazzling nature of the potential gains might also belie some risks. While Vitalik Buterin recognizes the potential of DeFi, he also warns against its 'flashy' side: "Honestly I think we emphasize flashy DeFi things that give you fancy high-interest rates way too much. Interest rates significantly higher than what you can get in traditional finance are inherently temporary arbitrage opportunities or come with unstated risks attached."
DeFi and Regulation
Regulation and crypto, in general, have always been a contentious issue. Governments and regulators are constantly watching the sector. And this is because bad actors like money launderers have cast a shadow over the true intentions of crypto.
Different countries have exhibited different attitudes towards it. While others have unequivocally embraced it, such as Malta, others have completely banned it, such as Bolivia. Still others, like China, have shifting stances on the subject. These attitudes naturally translate to DeFi.
To be fair, most people would rather trust banks that have an overseeing authority. While regulation would inject more transparency into the DeFi, questions abound on whether that would not undermine decentralization.
The Future of DeFi
Judging by the strides DeFi has so far made, it's not a stretch to say that it has an exciting future ahead. The popularity and acceptance of DeFi will continue to increase, especially with the launch of Ethereum 2.0 and other DApp platforms. As well, the possibilities for DeFi startups are endless when you think about the sheer array of opportunities that could be tapped. The fact that there's no rulebook means startups can break the mold and come up with market-ready groundbreaking products.