DeFi or decentralised finance is, in its purest form, using the blockchain to remove the need for a middleman. Instead of a bank, insurance company or a broker, smart contracts are used to settle financial agreements.
Smart contracts, for a quick refresher, are tamper-proof digital agreements that are carried out on the blockchain. For more on the blockchain click HERE.
Very basic real-world example -I have a nice and shiny limited edition £5 coin from the 2012 Olympics in London. I am approached online by someone from the other side of the world who wants to buy this limited edition coin. We don’t really want to use a platform for the trade as the fees are really high and we have to also take into account postage and import/export fees. I do not have a coin collection FYI, I am more of a stamps man myself.
By trading peer-to-peer and anonymously this creates a trust issue. Not only that but if anything goes wrong with delivery or the buyer says they haven’t received it, at least one of us is going to lose out. High risk-low reward.
Similar transaction in DeFi – I have 1 Beefy Finance token (BIFI) and another person has the USD equivalent, let’s say $1000 for easy numbers. To be able to trade this peer-to-peer using a decentralised exchange, I can send 1 BIFI to a smart contract on the blockchain. This is verified by all the nodes supporting the network and leaves no room for doubt. The ‘buyer’ sends $1000 USDT (Tether) to the smart contract. Again, this is verified and as both sides have settled their part of the digital agreement, the tokens are traded and enter each other’s wallets. The transaction costs less than $0.10 for each person and no one loses out, it is instant and both sides acted in a way that didn’t require trust.
Now, this is a very basic example of peer-to-peer trading in DeFi but the possibilities are endless. Let us take a look at how these DeFi protocols came about and how they are reshaping the financial world for the better.
Brief History and use cases of DeFi– Like everything in cryptocurrency, DeFi is evolutionarily linked to Bitcoin. Bitcoin was released in 2009 to disruptive the financial industry as we know it. Proving people with a trustless and permissionless digital currency that is owned by everyone and controlled by no one.
Vitalik Buterin the Ethereum founder then uses the underlying blockchain technology to build on that idea. What if it isn’t just a digital currency that can be decentralised and removed from the prehistoric institutions? Well, that’s what Ethereum set out to do in 2015 and continues to do today. In building a platform in which decentralised apps and other cryptocurrencies could be built on, this leads to the birth of the DeFi industry before we even knew it. We have a full What is Bitcoin and What is Ethereum breakdown on our blog page -blogmates.
In with the Ethereum ecosystem now in full swing, Maker in 2017 releases DAI a stable coin that holds its value at $1. The first development of Maker/DAI allowed its users to deposit ETH into a smart contract and receive DAI as a loan against their deposit. This loan is an over collateralised debt meaning the amount of ETH locked in the deposit smart contract is larger than the amount of DAI you would receive.
So why would you want to do that? Well ETH in 2017 and even now is an appreciating asset meaning it is increasing over time. DAI on the other hand is stable. If you were to think that ETH would increase higher than the interest you needed to pay back from your loan. You would be better off spending DAI as opposed to your increasing ETH.
If the repayment is 15% annually in MKR (the token required to repay the loan) then you would hope that ETH increases greater than 15% in the year which in 2017 was always going to happen.
So are there any under collateralized lending platforms in DeFi? Well yes… more on that later.
2018 sees the release of the first version of Uniswap (UNI) the first peer-to-peer/person-to-person (P2P) decentralised exchange (DEX) that didn’t operate on an order book model. A fun fact about the developer of UNI, his name is Hayden Adams and prior to UNI, he had no software programming experience. He learnt Solidity, the Ethereum programming language ‘on the job’. The project was actually given an Ethereum Foundation grant to allow the DEX to develop and grow.
The inception of a P2P DEX allowed users to trade directly without the need for a centralised exchange. For how this works head to our what is Ethereum article HERE. The long and short of it is, Uniswap allowed users to deposit their tokens in liquidity pools. Users coins that they have deposited are then used to facilitate trades on the DEX. In reward for users depositing tokens to be used, they were paid interest. The interest was generated by the exchange fees when a person executed a trade. Smart stuff.
Compound Finance – More recently in 2020 there has been an explosion in the DeFi space and it could be traced back to one token in our opinion COMP. Compound finance developed a smart contract platform which allowed P2P lending and borrowing. Similar to how you can take a loan at a bank or you can lend to a P2P lending platform and receive a small interest. But, again this is the DeFi world. There is no need for the bank or the middleman. It can be argued that this is in fact peer-to-contract lending, but more on that later…
Users who deposited their funds to be lent out would be rewarded in COMP tokens. These payments fluctuated between each smart contract and regularly reached double digits XX%. Try getting that at a bank or lending platform.
For example, if users were to deposit ETH to be lent out, the incentive may be 11% annually. Whilst depositing USDT may give you an 8% annual% payment. The demand for each asset was linked to the returns. So if there was suddenly a higher demand for USDT in this example from borrows, then the 8% may increase.
As this is all settled on the blockchain using smart contracts, there was no tampering from any parties involved in the agreement. There was no way to shift the contracts to favour those who were in power. The market was the decision-maker.
This lead to another phenomenon called yield farming. If the USDT% reached higher than the ETH%, yield farmers would chase the highest APY%. This generates an oversupply of tokens to the higher APY% pools and thus decreases the APY% accordingly. The next demand for each specific token is anticipated by the yield farmers to ensure their funds are in the pool before the heard comes in and drives the APY down again.
If done successfully and with the use of stable coins such as DAI, USDT and others, the returns for big lenders is great. Added to this the utility of the COMP token would increase and hence their payments in COMP would be greater as a consequence.
The COMP token then had added use and was used as a governance token. This effectively allows its holders to shape the vision and trajectory of Compound Finance. Purely decentralised away from biased decision making. Those holding the token are incentivised to vote on what is best for the project as their token value will appreciate.
All this, running on software and built on the blockchain. Amazing.
YFI and yield farming – After the development of other DeFi lending and borrowing platforms such as AAVE, Cream Finance and Maker’s – Oasis, Andre Cronje a computer scientist who notoriously finished his 3-year degree in 5 months, built and released Yearn Finance. Yearn or YFI, sought to yield optimise, meaning, it would actively seek the best yields from all the DeFi lending platforms and automatically move your deposited funds to the best one. This was revolutionary in my opinion.
What happened next was crazy. The tokenomics of YFI lead to it being extremely scarce with only 80,000 total supply. The token again is a governance token which would eventually lead to the network and protocol running completely by the holders of the token. This is a DAO or a decentralised autonomous organisation. Cronje himself has stated many times that the token “has no financial value”, although the market didn’t agree with him. From its launch, in August 2020 the initial value was $32… Now it is $31,284 at time of writing with its all-time high reaching $43,873 and over $1 Billion market cap. All this in space of a few months. We intend on releasing a full article on YFI next week.
AAVE and next-gen DeFi – Another giant in the DeFi space is AAVE. It is another lending and borrowing platform similar to Compound Finance but with its differences. It is worth a look at how AAVE developed from its original name of ETHlend (LEND).
In late 2017 to raise money for the project, the LEND team used another string in the DeFi bow: ICOs. ICOs are initial coin offerings. With stocks, a can go public with an initial public offering or IPO. In cryptocurrency and DeFi, everything is decentralised.
This ICO raised a moderate by ICO standards, $16.2 Million to help progress the project. The team quickly realised their model of P2P lending and borrowing was dependant on both sides of the fence being available. If there was an excess of lenders and not enough borrowers then the protocol and smart contract took time and was less than ideal.
Looking at Uniswap and Compound Finances model of using a pool of coins from depositors (lenders) which were then accessible from borrowers whenever they needed instant access, the team rebranded as AAVE. This model isn’t exactly P2P but more peer to contract as the lender’s deposit funds into a smart contract. Borrowers then access these funds from the pooled assets contract. The AAVE model was a lot more efficient than the previous LEND protocol.
For people to be able to borrow from the smart contract then they will have to deposit funds that are over the amount than they wish to take. This again is over collateralised debt. If repayments were not made the smart contract can redistribute the over collateralised funds from the borrower to the lenders.
It is looking really positive for AAVE and their platform. There is currently $4.5 Billion locked into AAVE depositors pool which is available to borrow. In June 2020 the financial conduct authority in the UK approved the protocol for an EMI. This license allows AAVE to “issue electronic money and provide payment services”. This could open the DeFi lending platform to the fiat market.
So what was all that about under or no collateralised loans? Well AAVE has now made it possible for another person to put down the collateral for you to take out the loan. Think of this as a guarantor. Effectively allowing one person to take the loan from the protocol if another person supplies the collateral.
What are the benefits of all this? – If you are still failing to see how the benefits of this outweigh the regular financial industry we would recommend reading our Why is Bitcoin important article HERE.
DeFi protocols allow access to funds without the requirement for KYC. KYC or Know Your Customer is one of the biggest contradictions in the crypto space. The whole idea behind decentralisation and permissionless systems is that anyone can get involved. Using DApps like MetaMask and Trust Wallet allow access to these next-generation financial opportunities to the 2 billion unbanked people around the globe. Countries without great financial infrastructure can now access these DeFi protocols with the only requirement being an internet connection.
There is currently $34 billion locked in DeFi across all platforms. To put this into context in July 2020 there was $980 million this time last year. The growth is huge and the possibilities and use cases are endless. With AAVE leading the way with regards to commercial application and regulatory acceptance, this will pave the way for future DeFi protocols becoming mainstream. Mortgages? Under collateralised loans? Derivatives linking securities to the blockchain? They are all being worked on. It’s just who can execute them the best.
The majority of these DeFi projects are built on Ethereum. There is an obvious congestion issue on Ethereum at the minute. Given the gas fees that are required to carry out all these smart contract executions on the blockchain are extremely high at the minute, it could be argued that DeFi will blossom even more upon the release of ETH2.0. This upgrade to Ethereum sets out to reduce congestion, increase scalability and consequently reduce fees. This is when we could really see DeFi come to life as it will be more accessible and tolerable to everyday users.
To summaries, DeFi or decentralised finance is a sector of the crypto world that seeks to disrupt the current financial industry by utilising the trustless and permissionless technology that underpins all tokens: the blockchain.
Some really useful resources for DeFi are –
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