DeFi comes from eng. “Decentralized finance” which means decentralized finance. By "DeFi" we mean all blockchain applications or protocols that offer us some kind of financial service using smart contracts, or a financial service that is not based on trust but code.
Since the main feature of cryptocurrency and blockchain is verify> trust, DeFi is based on a decentralized, distributed approach to the problem that is defined in the code and that is visible to all and cannot be changed.
So, just like Bitcoin or Ethereum, each transaction is publicly visible transparent, and the way the protocol works is strictly defined in the code.
Most of DeFi is currently on the Ethereum blockchain, so we can say with certainty that Ethereum dominates in that sector. We also find some DeFi services on the Matic, Polkadot and Waves blockchain, as well as in L2 (2nd layer) Ethereum solutions such as xDai / Stake and Arbitrum. We believe this will change drastically over time as we are in the very early stages of DeFi.
As some of the first DeFi projects, we would mention the DEX (decentralized exchange offices) of Etherdelt and Forkdelt, which had several million dollars in daily traffic at the beginning of 2018, and the Maker / Dai ecosystem, but before we go deeper into all this and what are the benefits and risks.
What are the benefits of DeFi?
You must be wondering what benefits the average user gets from this, so to name a few.
Anyone with a suitable wallet can use or participate in DeFi protocols.
Example for DEX:
You cannot or do not want to make a KYC (User Identification) on an exchange, but you want to change your ETH to USDT.
If you use DEX (decentralized exchange offices), you are not obliged to account to anyone for who you are, to give a name or information for the transaction you want to make. All that will be visible is that you have sold ETH for USDT and that you have communicated with the smart contract.
Likewise, no one can stop your transaction or prevent you from doing what you want.
DEXs work non-stop, 24 hours a day.
Because DeFi protocols are built on networks like Ethereum, they will provide the service as long as Ethereum operates, and due to the decentralized nature of the network itself, it is unlikely that they will ever be inaccessible to users.
So here we avoid a problem like “The exchange office is not working! I just wanted to sell ETH! ”
No one keeps coins or tokens in trust.
As we said earlier, all it takes to use DeFi services is a wallet, and from that same wallet we perform transactions.
The transaction is performed within a smart contract, and your coins or tokens leave the wallet only if they communicate with the smart contract or do the transaction.
The exceptions are coins or tokens that you lock in a smart contract - so you make a deposit, but the difference is that you do not give your coins to someone you trust but lock them in a smart contract, and if that contract has no flaws in the code we can say that you are safer than when keep them on the exchange.
Earnings through participation in DeFi.
Everyone in DeFi can participate as a user and as part of the infrastructure, ie they can offer their liquidity (coins and tokens) for use in smart contracts and be rewarded for it. Plenty of DeFi services offer a very affordable APY (annual return on investment) for liquidity providers.
So, in case the smart contract has no problems and is not subject to attacks it is possible to make a profit on your capital.
What are the disadvantages and risks?
Since DeFi is a fairly new concept in the world of cryptocurrencies and blockchains, there are certainly disadvantages and risks. The first problems appeared already in August 2020 during the first DeFi madhouse.
DeFi application fees
We have learned that every use of DeFi services also means communication with a smart contract, ie the network on which the service is built - most often Ethereum.
Ethereum is currently capable of digesting 16 transactions per second, which means it simply does not tolerate excessive network traffic without making transactions very expensive.
So, at the moment, Ethereum is not able to withstand that pressure without irrationally expensive transactions, unless you buy or sell large amounts of cryptocurrencies, in which case the transaction price of 10 or 100 US dollars is still negligible.
The solution to this problem is currently Ethereum 2.0 - a version that will be able to handle significantly more transactions per second, but due to slow development, many are looking at L2 / second layer (solutions on the second layer) as an option.
It also makes sense to mention xDai / Stake with its Uniswap clone - Honeyswap.
The same transaction on Honeyswap costs less than $ 0.01 as opposed to Uniswap where it can cost well over a few dollars, depending on the current network saturation.
It will be interesting to see which of the L2 networks will be dominant for DeFi, and which other blockchains will compete with Ethereum in this branch.
Problems in the code
The next problem is the so-called "rug pull" or problem in the code.
Like any program, any DeFi can have some problem within the code that can be exploited by hackers or thieves. Most DeFi protocols have their code publicly available on Github, which makes it easier to find a problem, but also to use that problem to your advantage.
Whether it’s due to poor code design, or the dependence of smart contracts on external factors such as the price of a coin or token in the market. Such attacks often occur - "oracle" attacks using flash loans (quick loans) which are used to liquidate users.
DeFi services like Aave and Synthetix that use Chainlink for price feeds have not had such problems, as their price feed (source of pricing) is decentralized and almost impossible to manipulate.
Types of DeFi applications
DEX (decentralized exchange offices) - Exchange offices are used to exchange some coin or token for another coin or token. An exchange office is a platform where supply and demand meet. The difference between a regular exchange office and a decentralized exchange office is that on decentralized exchange offices, transaction users work directly on P2P without intermediaries. Each transaction is recorded in a blockchain and takes place using smart contracts on the blockchain.
As an example, it is definitely worth mentioning Uniswap, which was practically the main topic in the summer of 2020. It is also interesting that in September 2020, Uniswap had more traffic than one of the dominant exchange offices - Coinbase.
Coinbase monthly turnover in September $ 13.6B.
Uniswap monthly turnover in September $ 15.4B.
Decentralized stablecoins - One of the most popular decentralized stable cryptocurrencies is DAI. Its value is based on the Maker / Dai protocol. Ethereum is used as collateral to create DAI stablecoin.
Lending platforms - Lending platforms allow us to borrow a certain amount of money in the form of coins or tokens in exchange for a capital deposit (which is repaid in full after the loan is disbursed) in a fully decentralized manner. For example, Aave allows us to borrow up to 75% of the value of the invested capital.
Example of Aave:
We have 100 ETH and we don’t want to sell a single coin, and we need capital for some short trade or a good investment opportunity. We deposit ETH in Aave, under “Lending,” and borrow stablecoin (such as USDT). We are still owned by ETH, but under the guarantee that we will repay the debt.
In addition, we must be careful that our "health factor" does not go too low as this could liquidate the borrowed ETH.
Tokenized goods - DeFi services that I think are important to highlight are securely tokenized goods such as “Wrapped BTC” (wBTC), renBTC, and Synthetix goods of the “sBRENT” type.
Take wBTC as an example:
When we "wrap" a part of a bitcoin, it switches from a Bitcoin blockchain to an Ethereum blockchain, ie it becomes a "wBTC" which is actually an ERC-20 token that represents the same bitcoin locked in a smart contract. The advantage of "wBTC" over BTC is that then we can relatively easily use "wBTC" in DeFi.
Thus, the relatively useless “BTC” becomes capital that can be used in DeFi protocols built on other smart contract platforms, the main Ethereum for now.
Yield farming - is a term for participating in a DeFi protocol in order to profit from it.
For example. a USDT deposit in AAVE for use gives some 20% APY (current APY approximately), which means that we get 20% annual interest on your USDT.
DeFi is a new branch in the world of blockchain and cryptocurrencies and offers us something we have not yet had through new types of financial services.
Like any "young" technology, there is great risk and potential for profit. At the moment, even more experienced DeFi cryptographers have something new and unexplored, so we suggest beginners to research what it is about and how it works before pouring the entire portfolio into DeFi.
With DeFi we enter a phase where we begin to see the full potential of the blockchain, which means more than ordinary transactions. So, this is the next step in the development of blockchain technology and it is important to be informed about the crypto market branch which alone is currently worth around $ 21.8B.