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Decentralized Finance (DeFi)

Decentralized Finance (DeFi)

DeFi is short for "decentralized finance," an umbrella term for Ethereum and blockchain applications geared toward disrupting financial intermediaries.

Overview

Decentralized Finance, more commonly referred to as DeFi, refers to digital, peer-to-peer services that allow for crypto trading, loans, interest accounts, and other services. DeFi relies on public blockchains, such as Ethereum or other cryptocurrencies. Most significantly, DeFi eliminates the need for any financial intermediaries, allowing participants to trade directly.

The DeFi environment provides valid possibilities to innovate and create DeFi services and products. DeFi is an open protocol and has potential to considerably help development in the newest age of financial solutions. The DeFi significance gathers higher significance as it can use Ethereum and allows trailblazers to make new decentralized applications for the financial area.

Role of Blockchains and Smart Contracts

Due to a core focus on smart contracts, dozens of DeFi applications are operating on Ethereum and other blockchain networks.

Commonly-used blockchains
Ethereum

Ethereum 2.0, an upgrade to Ethereum's underlying network, could give these apps a boost by chipping away at Ethereum's scalability issues.

Governance tokens

Governance tokens are separate tokens that developers create, which allow token holders to influence decisions, such as proposing or voting on new feature proposals. Advocates of governance token systems claim that they allow for greater user control, which aligns with the tenets of cryptocurrency, decentralization, and democratization. Organizations that allow users' control of their own systems are called decentralized autonomous organizations, or DAOs.

In many cases, smart contracts are able to automatically apply any proposed changes. Changes are able to be proposed, vetted, and voted on through on-chain governance and accessed by using governance tokens. In other cases, changes are applied by the team maintaining the project or by someone hired to do so.

One well-known example of a governance token is Maker (MKR), a cryptocurrency that is part of a system creating decentralized stablecoin DAI. Holders of MKR are able to vote on decisions pertaining to the DeFi protocol that DAI runs on. MKR holders can, for example, vote to change the complex economic rules governing the decentralized lending that allows DAI to maintain a stable price. Governance token holders may vote on issues, such as whether or not to raise a protocol’s debt ceiling.

Segments and applications

Decentralized Finance predominantly includes, but is not limited to, five sub-industries:

  • Lending/Borrowing
  • Payments
  • Asset Management
  • Derivatives
Lending and borrowing

Lending markets are one popular form of DeFi, which connects borrowers to lenders of cryptocurrencies. Users can make money off of interest for lending out their money.

DeFi lending protocols and platforms

Payments

Payments are essentially unrestricted in DeFi. Ethereum allows users to send or receive money from anyone around the world much like sending an email, without having to use any financial intermediaries. DeFi payments can be sent to a user either through their ENS name or account address. To send or receive payments, users will need a wallet.

DeFi payment platforms

Decentralized Exchanges (DEX)

A decentralized exchange (DEX) is a peer-to-peer (P2P) marketplace that connects cryptocurrency buyers and sellers. In contrast to centralized exchanges (CEXs), decentralized platforms are non-custodial, meaning a user remains in control of their private keys when transacting on a DEX platform.

Decentralized exchanges allow crypto holders to trade with each other directly in a peer-to-peer environment, with the possible advantages of lower barriers to entry and enhanced security. It also allows traders to keep a private key that links back to them, allowing them to maintain control of their crypto.

Automated Market Makers

Automated Market Makers (AMMs) are used to provide liquidity on DEXs. On a traditional exchange, buyers and sellers submit bids and ask prices through an order book, and the exchange clears the trade at the best price. On a DEX, AMMs provide liquidity pools.

Like most of the DeFi ecosystem, this involves staking. The AMM collects transaction fees from the DEX, which are paid by the traders on the exchange.These fees are then used to pay interest to the true owners of the assets in the liquidity pool. The AMM determines trading in the pool based on an algorithm.

Decentralized exchange platforms

Asset management

Asset management applications, such as smart portfolios or digital assets, are products used to track, manage, and/or hedge exposure through various other DeFi projects in sectors such as lending, DEX, or derivatives.

A common theme of asset management tools are accessibility, tracking ecosystems in order to make interactions and asset movement easy, safe and transparent. While some projects actively hold capital, others only track and manage capital that is spread across other platforms.

Most, if not all, asset management products include these characteristics:

  • Non-custodial—Ownership of the underlying assets is never revoked and tends to live in the wallet being used.
  • Compostable—Many of the top Asset Management projects connect to a wide number of DeFi projects, ultimately creating an end-to-end DeFi experience.
  • Automated—The growing number of Asset Management tools are automated, meaning rebalances, collateralization, and liquidations can occur seamlessly without user interaction.
  • Globally Accessible—Asset management tools are accessible to anyone regardless of their location or tax bracket.
  • Pseudo-anonymous—Asset Management products often connect through a wallet address, meaning that identity is optional to those who wish to share it.

DeFi asset management platforms and protocols

Derivatives

A derivative is a contract between two or more parties whose value is based on an agreed-upon underlying financial asset (like a security) or set of assets (like an index). These are secondary securities by default, as their value is derived from the value of the primary security they are linked to. Common types of derivatives include options, forwards, futures, and swaps.

Options

Options are one category of Derivatives where the holder of the asset gets the right, but not the obligation, to buy or sell a certain amount of the underlying asset at the strike price on a specific date.

Bitcoin options are already traded on regulated and primarily whale-focused exchanges CME, LedgerX, and Bakkt. Deribit leads the unregulated market, followed by FTX and OKEx.

Forwards

A forward contract is an agreement between two parties, a buyer and a seller, to trade an asset at a specific date in the future. The price of the asset is agreed upon at the time that the contract is drawn up.

Bitcoin forwards let investors speculate on the future price of Bitcoin. This effectively allows investors to deal out Bitcoin without currently holding the currency themselves. In trading Bitcoin, the idea would be to have buyers lock in a lower future price or sellers lock in a higher future price, meaning no actual Bitcoins are being dealt in the process. This is because Bitcoin forward contracts are settled in cash—with the buyer paying the Bitcoin value at the specified date and the seller receiving cash in return.

Futures

Futures are nearly identical to forwards, with a key difference being that they account for price changes. In a forward contract, if the value of the asset changes (in this case, Bitcoin), the terms of the contract are not adjusted and the seller must still sell the asset for the agreed upon price. With Bitcoin futures, gains, and losses are settled on a daily basis. For example, say two parties agree to make a futures contract to sell 1 Bitcoin for $10,000 in 3 months. Sometime before the contract has ended, the price goes up to $11,000 per Bitcoin. In a forward contract, nothing would change and the sale would happen by the agreed upon terms at the end of the contract. However, in a futures contract, the buyer would need to credit the seller $1,000 to their margin account to make up for the price fluctuation and would have to do further adjustments if any other gains or losses happen before the contract ends.

Swaps

Swap contracts are most similar to forward contracts. The key difference between the two is that a forward only involves a single payment at maturity, while a swap typically involves a series of payments in the future.

How forwards, futures, and swaps work

DeFi derivative protocols and platforms

Timeline

People

Further reading

Documentaries, videos and podcasts

Companies

References

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