In our modern financial system there is a strong centralization on our central banks. The financial crisis of 2008 in particular makes it clear that the stability of entire currencies depends on selected decision-makers.
A first countermovement against this centralization of power was the publication of the Bitcoin in 2009. Satoshi Nakamoto planned a countermovement to the established financial system with the probably best known cryptocurrency – a way into decentralization. But Decentralized Finance (DeFi) was not to gain relevance until the introduction of Ethereum. Smart contracts make it easy to program and design digital money. The combination of decentralization and programmability is now a megatrend – DeFi.
What is DeFi?
DeFi stands for Decentralized Finance and describes a special ecosystem in the blockchain area. DeFi is usually based on a blockchain technology that supports Smart Contracts. The currently most important blockchain solution for DeFi applications is Ethereum. Already today, interested parties can find numerous decentralized applications (DApps) that focus on the financial sector.
Such a DApp is comparably easy to create and can be programmed as desired. The developers can use different functions and thus publish an individual result. After implementation on the blockchain, a DApp is independent and decentralized. If you take a closer look at the source code of a DeFi app, it consists of numerous if-then statements.
The programmed instructions are stored decentralized after implementation – an adaptation is no longer possible. Another advantage of a DeFi application is its efficiency. The combination of Smart Contracts and crypto currencies makes these applications particularly efficient. Normally, the costs amount to only a few cents – even with higher investment amounts.
Who can use DeFi?
DeFi is not a special feature that is only available to certain groups of people. Rather, these applications are based on a public blockchain, so that nothing stands in the way of their use. Accordingly, it can be said that DeFi is suitable and available for everyone.
Nevertheless, interested parties must provide a requirement – an Internet-capable terminal and a wallet must exist. The Wallet is a kind of bank account for storing the crypto currencies. The most popular wallet in the DeFi sector is the MetaMask Wallet. This is available for the browser and has proven to have clean and secure processes.
Probably the most important address for a general overviews of the DeFi markets are Coingecko.com and DeFiPulse.com. On those websites interested parties will find an overview of the largest and most important DeFi projects.
Maker is still probably the most popular DeFi service. This is not surprising, as around 50 percent of the available capital in the DeFi sector flows into the Lending Service. Especially since 2019, the DeFi market has been growing at an extraordinary rate – after all, this is one of the largest applications for block chain technology.
However, it is also apparent that “Assets under Management” (AUM) have been growing continuously since the introduction of DeFi-DApps. Only the corona crisis in March 2020 caused the market to correct. However, as more and more investors are looking for ways to realize returns on the cryptos held, high growth rates are likely to continue in the coming years.
Advantages and Disadvantages of DeFi
More and more investors are investing their cryptos via corresponding DApps. Compared to centralized financial services, these services are available around the clock. Accordingly, there are no limitations in the registration or verification of the created account.
Furthermore, there are no requirements for turnover. Thus, all stakeholders, from students to investors, can easily invest in the selected product. There are the following advantages and disadvantages.
The Advantages of DeFi
- Always available
- No access restrictions
- Even small amounts are supported
- Open Source based DApps
- Complete transparency
- Introduction of new financial services
The Disadvantages of DeFi
- Crypto currencies required
- Wallet Compulsion
- Risks uncertain
How can DeFi be applied in Practice?
Already today there are numerous fields of application that illustrate that DeFi is a strongly growing sector in the block chain area. In the following we have listed a selection of the most interesting application cases.
Furthermore, although this sector is still very new, decentralized payments are already playing an increasingly important role. In principle, DeFi enables the processing of decentralized payments between two contracting parties.
One of the most relevant approaches describes the bundling of payments. Instead of executing numerous individual transactions, these are bundled into a single, larger transaction. This approach appears to be relevant for the future, especially considering the rapidly increasing number of microtransactions.
DeFi enters the Financial World
However, real-time payments are also an issue that is shaping the entire sector. For example, a service or the provision of a work service could be paid for directly. The separate creation of an invoice or the payment of the salary at the end of the month would thus be eliminated. Sectors and people who are dependent on high liquidity are the main beneficiaries.
Suitable Payment Solutions on a DeFi Basis:
Request Network: decentralized payment network for apps and individuals using Ethereum and IPFS.
xDai Chain: Ethereum-based network with the xDai token linked on US dollars
Groundhog: Toolbox for creating crypto-based subscriptions
OmiseGO: Interoperability and scaling solutions for payments over the Ethereum network
Raiding: Ethereum off-chain scaling solution for immediate and cost-effective payments
Ink Protocol: decentralized reputation and payment protocol
From an international perspective, around 1.7 billion people do not have access to their own bank account. Accordingly, these people are currently completely excluded from the traditional financial business.
They are not able to take out loans from banks. In particular, the lack of credit data and numerous personal details prevent them from taking out new loans. The lending and borrowing of crypto-currencies enables an effective elimination of the problem. Thus, lenders can lend money when lending and make it available to borrowers as a loan. In return, the lender receives interest from the borrower.
The special feature of this approach is that a dedicated account is not necessary. All transactions take place on the corresponding blockchain and are therefore stored securely and transparently.
Furthermore, DeFi also focuses on the development of stablecoins. Especially classic crypto-currencies show a high degree of fluctuation, so that an investment for new investors seems comparatively difficult. Stablecoins, on the other hand, are based on the price of a real asset and thus guarantee a higher price stability.
One of the most popular Stablecoins is the US Dollar Tether (USDT). From the official statements of Tether it is clear that 1 USDT has a deposit of 1 US dollar. However, the proof of the corresponding capital has so far always been rather problematic.
At this point we would also like to point out that a Stablecoin is not a product of Decentralized Finances. Stablecoins are simply necessary to implement numerous DeFi applications.
Known Stablecoins on a DeFi Basis:
- Dai: A USD Stablecoin based on the Ethereum and managed according to the MakerDAO system
- USD Coin: A USD supported stablecoin as ERC20 token from Circle
- Gemini Dollar: Stablecoin with a 1:1 hedging through US Dollar
- Monerium: A provider who plans to spend digital money on Ethereum that is secured by assets, repayable and regulated
- Reserve: A protocol with three types of assets: reserve stablecoin, reserve share tokens and security tokens
Exchanges and Trading Places
If we take a look at the current crypto market, the centralization of market power catches the eye of the resourceful investor. So far crypto-marketplaces like Binance, BitPanda, Coinbase or Kraken dominate the market. Classically, the purchased coins and tokens also flow directly into the wallet of the respective provider. Investors who do not have their own desktop, smartphone or hardware wallet simply do not control their own coins.
On the other hand, decentralized exchanges, so-called Decentralized Exchanges (DEX), are gaining in relevance. Instead of executing a transaction on a traditional exchange, investors can use the services of a DEX. The provision of liquidity can also be an attractive option for investors to achieve a return.
Well-known Infrastructure Platforms on a DeFi Basis:
Connext: free, open source P2P micropayment infrastructure based on Ethereum
Settle: web-based operating system and dashboard for decentralized finances
0x Protocol: open protocol for P2P exchange of digital assets
Uniswap: decentralized Ethereum dApp for the smart contract-based exchange of ERC-20 tokens
Ren Protocol: RenVM enables the linking of block chains and ensures interoperability for the exchange of assets.
One industry that has to continuously face new regulations is the gambling industry. Many users find the offers rather untrustworthy and the company headquarters abroad contribute the rest. Many users expect that the once deposited assets are lost afterwards. The development in the DeFi area is intended to counteract this trend and promote decentralized management of player credits.
Well-Known Gambling and Lottery Models based on DeFi:
PoolTogether: Random allocation of income from the lending pool to investors
What Opportunities does DeFi offer and where are the Limits?
In view of the problems that people have had in the past as well as in the present with the traditional banking and financial systems, DeFi is an important and indispensable development. The advantages of DeFi are particularly important in this respect:
Unrestricted access: Even today, more than 1.7 billion people do not have access to their own bank account. Consequently, these users cannot access the services of the traditional financial world. For people in the industrialized countries this problem is hardly conceivable, but for people from developing countries it is a reality. DeFi decentralizes the entire financial system and enables this new user group to access financial services.
Efficient and cost-effective: Transactions, especially cross-border transfers, are expensive and inefficient. In addition, they usually take several days to complete. This circumstance is a nuisance, especially for internationally operating companies. With the help of DeFi, transactions can be carried out faster and more cost-effectively.
Always-on: In contrast to a classic bank, a block chain has no service times. The services are continuously available and guarantee a continuous service level.
Alternative banking: A study commissioned by Facebook in 2016 shows that 92% of the millennials distrust the classic banking system. The reasons for this are the high inflation rate, the rising costs for banking services and the strong centralization of power to a few market participants.
DeFi – these Risks exist
Although DeFi can fundamentally change banking and numerous financial market-related services, at the same time there are inherent systemic risks.
Base layer risk: The base layer of a DeFi application is the block chain – such as Ethereum or Tezos. In the past, there have been several attacks on the network. Ethereum was congested, so that open transactions did not fit into the next block. Accordingly, the waiting time in the network is continuously increasing. The popular block chain game CryptoKitties is a well-known example of this phenomenon.
However, DApps may require that transactions take place within a certain time window. Although this is possible via Ethereum, this requires an increase in the transaction fee. This scenario is particularly devastating for applications that rely on microtransactions, as high transaction fees affect usability.
Even during the coronary crisis of 2020, the high transaction fees caused malfunctions in the DApps. Immediately after this event, the use of DeFi services decreased. However, the update of Ethereum 2.0 is intended to improve scalability and thus solve this problem as far as possible.
Liquidity risk: There are several blockchains which are suitable for DeFi use. Accordingly, there are several crypto currencies that are used in DApps – the most popular ones are ETH, DAI or LINK.
For buying and selling these cryptos, the DApp internal reserves or DEXes can be used. However, there is the system-immanent risk that this liquidity is not available in sufficient amounts. If the liquidity is too low, the liquidation of options would not be possible.
Technical risk: In principle, a smart contract is a chain of if-then conditions. Accordingly, these can be as simple or complex as desired. However, it can be said that particularly complex contract constructions are also more prone to errors.
Moreover, the concatenation of DApps is another risk. In the past, hackers exploited the concatenation of different applications to gain access. Faulty programming can also increase the risk of hostile attacks.
Compromise: Developers and administrators of a DApp pose another risk. They have immediate access to the code and can make changes. Accordingly, the developers should appear trustworthy and keep the private key to the Smart Contract safe.
Conclusion: DeFi can solve Problems in the Future
In the future, DeFi will be able to solve many problems of our known financial systems. However, there is still a long way to go and there are a number of hurdles to overcome. For example, the question of the regulation of Decentralized Finance still arises. Although the financial instruments should remain as free as possible, governments are demanding more control over the financial industry. Also, the fees for initial deposit and withdrawal of cryptos are not low. Accordingly, market participants must take these into account when calculating the investment.
Furthermore, it is currently apparent that DeFi applications are not yet fully decentralized. Many established applications like Tether can even be described as centralized. So far, it is mainly early adopters who have found their way into DeFi. For a mass adaptation, the technology would have to evolve further. The scalability of the base layer used is particularly important.
If these open points receive sufficient attention during development, Decentralized Finance could become an important cornerstone of the modern financial world.
Complex tax law in some countries