It’s no secret that the financial system is in need of a major overhaul.
There are over 1 billion people globally who lack access to basic banking services and about two-thirds of all adults around the world have less than $10 in their savings account. The traditional banking system is not built for these challenges and can’t reach many people, especially those living in rural areas or developing nations where there is little infrastructure to sustain a bank branch.
Could decentralized finance (DeFi) be an answer to some of these challenges?
We’re now seeing a new wave of decentralized finance projects emerge from blockchain startups such as MakerDAO, Compound and Dharma Labs who are building out their own solutions for creating digital assets, lending capital and providing credit scores respectively on top of Ethereum’s smart contract platform.
To understand how these new projects work and how blockchain technology is changing the finance industry, let’s first look to what decentralized finance entails.
Table of Contents
How decentralized finance works
The typical financial system functions on a centralized model where the financial intermediaries process customer transactions and send payments. The most common institutions in the industry are banks.
However, this system is failing to meet the needs of many people. These institutions are failing to reach those who don’t have bank accounts or the financial literacy to use traditional financial institutions.
Blockchain technology is creating a new financial ecosystem that’s radically decentralized and transparent. One of the key features of blockchains is that they allow for peer-to-peer transactions. This means that we can start to build smart contracts and applications that help facilitate financial transactions without having to rely on a centralized institution for supervision and accountants.
A DeFi system consists of two primary components: protocols for running smart contracts on a blockchain and protocols for storing data off-chain (e.g., IPFS). These are often combined with other tools like wallets or exchanges that use these systems to offer their services to the public.
The price of access to these services varies depending on the blockchain the service is running on and what services are available. There are some limitations to the use of blockchain technology in the finance industry. This can range from limited capabilities like smart contracts and loans to problems with existing regulations, fraud, and so on.
These limitations have become an obstacle to bringing a DeFi solution to market because there is a lack of trust and faith in the system and this can prevent people from adopting these solutions at scale.
Examples of DeFi platforms and coins
Uniswap is a decentralized exchange with liquidity pools. Unlike other exchanges, there are no limit orders and the system does not use order books to find matching buyers and sellers.
Uniswap is different than any sort of centralized or classic peer-to-peer trading platforms because it uses “liquidity pools.” These function as like buckets that hold various coins which can be swapped for one another at anytime when both parties make an agreement. This means Uniswap never needs settlement times due to transactions taking place between users in real time. This also helps prevent market manipulation through spoofing tactics since all swaps take place outside of central networks.
The yearn.finance API is a world-leading, decentralized lending protocol that provides network statistics publicly so users can make informed decisions about interest rates and risk levels across different cryptocurrencies.
The vault features APY comparisons as well to help you be in the know of all your options for cryptocurrency investments!
MakerDAO is a decentralized, global lending system built on the Ethereum blockchain. The DAO (Decentralized Autonomous Organization) is upheld by holders of MKR tokens who can decide what features and changes to make to Maker in order for it evolve.
MakerDAO has two main assets: MKR and DAI, which are ERC-20 tokens. MakerDAO are responsible for both creating and maintaining DAI which has become one of the most prominent cryptocurrencies within DeFi projects. Maker can be used for generating new coins, locking in crypto collateral, and generate DAI as a debt against their collateral.
Compound is an investment protocol that provides a low-risk way to invest crypto holdings. Users can lend assets and earn liquidity or take out loans using their own cryptocurrency as collateral. People who supply assets to the Compound protocol are given cTokens which can be used as collateral or to earn interest.
As Compound’s name suggests, interest begins accumulating immediately and compounds throughout each user’s entire loan duration.
The platform has been audited and formally verified, which means that it is safe for use. In May 2020, the company passed governance to COMP token holders in order to decentralize their operations.
Recent controversies and risks
As more players pour money into the DeFi space, bad actors will try to take advantage of hype by scamming users and hackers will find vulnerabilities encoded in these smart contracts.
DeFi has become an area where both good actors and bad ones are making their mark on this emerging sector that is still ripe for exploitation. As a new player with less funding than most other projects, your project may be vulnerable to attacks from either side- scammers looking to make a quick buck or malicious code written specifically for you because they found out how much token value could potentially be gained through attacking it at its inception stage. These factors could lead us into a black hole where good intentions meet greed and technological prowess meets ignorance for disastrous consequences.
Losses have already exceeded $129 million in 2020 as DeFi hackers are getting more brazen in their tactics. Last year there were no losses reported to date.
Recently EasyFi, a DeFi project on the Polygon Network, was shaken with one of the largest losses in DeFi history. The hackers managed to steal $80 million worth from EasyFi Network’s wallet.
Is DeFi worthy of the hype?
In the crypto world, there are few terms as ubiquitous in their use and as controversial in their sentiment than “decentralized finance.” It has been heralded by some as the next revolution in banking, while others have criticized it for being nothing more than a buzzword without utility.
So, is DeFi worth all of the hype?
The number of projects in the DeFi space grows rapidly with each month and there’s a lot of excitement from both the public and private sector. In the midst of this excitement, however, there are also some interesting biases and apprehensions toward DeFi from both ends of the spectrum.
The public’s bias toward DeFi is largely negative because of it being a recent arrival. Many individuals have never heard of DeFi or have only heard of it because of recent attacks on projects in the sector. These attacks have been extremely prominent in the news recently with both Raildex and EasyFi, along with others, recently losing significant amounts of money.
For those who want to invest, it can be hard to come across a project that will align with their values. Many investors in DeFi feel that they are investing into something new and thusly feel uncomfortable knowing that a project that may otherwise align with their values could become a victim of manipulation or may fail in their execution.
On the other hand, the private sector is excited about DeFi because it has demonstrated the potential to make new sources of revenue and profit. Specifically, they are interested in the potential to develop a global lending platform, the ability to manage the use of new financial instruments, and the potential to develop and offer investments in real estate, commodities, and other cryptocurrencies that do not typically align well with traditional banking channels.
In many ways, DeFi is still maturing.
It’s still at an early stage of development and not all projects are trustworthy. The real challenge is creating a trustworthy ecosystem where all the tokens on the market operate with a zero-fraud tolerance. This is the end-game.
In the future, more adoption will mean more developers and talent. The goal is to build one DeFi-based ecosystem that will be more reliable and more secure. We are working hard to create the infrastructure to make that a reality.