DeFi Explanation
Introduction:
DeFi has been driving
a cryptocurrency resurgence since 2020 with no sign of stopping. But, what is
DeFi and how does it work? Decentralized finance (commonly referred to as DeFi)
is a blockchain[1]based form of finance
that does not rely on central financial intermediaries such as brokerages or
banks to offer traditional financial instruments. Instead, it utilizes smart
contracts on blockchains, the most common being Ethereum. So, now that you know
what it is, how can you utilize this new technology in your own business?
That’s exactly what we’ll take a closer look in this special report. DeFi
Explained: Special Report 5 DeFi Explained As mentioned on the introduction
page, DeFi stands for Decentralized Finance. This means that the financial
services are carried out on a blockchain instead of through a brokerage or
bank. In today’s financial world, financial institutions act as guarantors for
any transactions. This gives them immense power over your money. Decentralized
Finances are services with no central authority controlling them. Decentralized
exchanges allow for peer-to-peer cryptocurrency transfers with no middleman.
Forkast News calls it “the merger between traditional banking services with
blockchain technology.” DeFi involves taking traditional elements of the
financial system and replacing the middleman with a smart contract. DeFi
Explained: Special Report 6 This means DeFi needs a decentralized
infrastructure to run on, like the Etherium blockchain. This blockchain is a
do-it-yourself platform for DAPPS or Decentralized Applications. About 96% of
DeFi protocols operate on Etherium, although a small number have migrated to
competing blockchains because of increased speed. In decentralized
transactions, the typical overseers of those transactions (banks, stockbrokers,
government institutions, etc.) are replaced by blockchain. Because users don’t
need to transfer their assets to the exchange, decentralized exchanges reduce
the risk of theft from hacking of the exchanges. They’re also more anonymous
than exchanges which require your identity on all transactions and can prevent
price manipulation or faked trading volume.
DeFi’s goals are to utilize
technology to remove intermediaries between parties in a financial transaction.
Its components are stablecoins, use DeFi Explained: Special Report 7 cases, and
a software stack that allows the development of applications. This
infrastructure and use cases are still in development, though plenty of users
have jumped on the DeFi bandwagon. DeFi Explained: Special Report 8 The Rise of
DeFi DeFi’s origin is often traced back to 2015, when a platform called
MakerDAO allowed people to utilize cryptocurrency for collateral on their
loans. DeFi, like the traditional cryptocurrencies, promises to do away with
the unnecessary intermediaries like banks and stockbrokers. This viewpoint Is
fueling the market lately. Bitcoin was created in 2009 as an alternative to
traditional finance (and financial authorities like banks and stockbrokers),
but many limitations still exist. hile Bitcoin was meant to function like
money, its functionality depends on a network of new central authorities that
are acting much like the institutions they were meant to replace. Miners, node
operators, wallets, and exchanges—these authorities are showing a distinct
proclivity for acting just like banks and stockbrokers. DeFi Explained: Special
Report 9 In other words, Bitcoin doesn’t seem to be truly decentralized. A true
decentralized system should be run by the people alone. Bitcoin has given us
glimpses of this but has ultimately fallen short of its goal. With DeFi, there
are no central authorities and protocol are run by smart contracts designed to
eliminate foul play. The open financial network is trustless and decentralized,
facts that have attracted many investors. DeFi Explained: Special Report 10 DeFi’s
Top Applications Now that we’ve explained what DeFi is and what caused its rise
in popularity, let’s look at some of the more notable applications for this
protocol. Decentralized Exchanges (DEXs): these are exchanges that operate
without an intermediary. With a DEX, users can connect directly with one
another to buy and sell cryptocurrencies. Any assets traded under a DEX are not
held in escrow or in a third party wallet the way a centralized exchange would
do. Some top DEXs include Uniswap, SushiSwap, and Curve. These exchanges are
not as popular as centralized exchanges, which are operated by a central
authority. DeFi Explained: Special Report 11
Coinbase and Binance are examples
of centralized exchanges and are custodial in nature because the buyers and
sellers trust the central authority to keep their assets safe. Lending
Platforms: these use smart contracts in place of third parties like banks or
stockbrokers. This allows lenders and borrowers to participate in an open
system. Proponents of DeFi claim that these platforms are democratizing the
entire financial landscape. In decentralized lending platforms, lenders can
earn interest on cryptocurrency assets by loaning them out, while borrowers can
assess liquidity without actually selling off those assets. With our
traditional financial situation, you must offer collateral before you can get a
loan from the bank. DeFi is similar, but borrowers have to offer assets which
add up to more than the total loan in order to obtain that loan. Some of the
top DeFi lending platforms include Aave, Maker, and Compound. DeFi Explained:
Special Report 12 Prediction Markets: these allow you to bet on the outcome of
a future event, such as a presidential election. In fact, they flourished
during the 2020 elections, with Augur recording a milestone volume of over $8
million. Prediction market platforms act like traditional prediction markets,
but with blockchain functionality, which means no intermediaries. Some examples
include Gnosis, Augur, and FTX. Yield Farming: this is the hottest new term in
DeFi. It’s the process of locking up cryptocurrencies in exchange for some sort
of reward. Yield farmers stake popular coins like ether, tether, dai, etc. Aave
and Compound are two of the major platforms to farm DeFi yields. DeFi
Explained: Special Report 13 The True Power of DeFi Traditional banks are
bureaucratic. They’re expensive to run, too. They take too long to process
transactions—sometimes days—and have excluded many people from the financial
system due to their stringent requirements. Here are some of the benefits of
decentralized finance. It is permissionless. DeFi opens the financial system to
everyone regardless of race, income, culture, or geographic location. All
anyone needs is a connection to the internet via a smartphone or computer. In
2018, the World Bank estimated that some 20% of the world’s population has no
access to banking services. Mostly, this is because they lack required
government-issued identification cards. DeFi Explained: Special Report 14 There
are several DeFi platforms that allow these people to access banking services.
For example, you can take out a Maker loan without identification or even a
credit score. It offers interest rates for investors. You can keep your assets
like a traditional savings account if you wish, but DeFi also offers the chance
to earn interest on your assets. Platforms like Compound and Aave will let you
deposit your cryptocurrency and then loan it out to borrowers. At some
agreed-upon time, you collect your interest on that cryptocurrency and can
return your capital to the system. Compound offers up to 4.3% interest on
deposits from some tokens and Aave is offering as much as 5.73%. Compared to
the pittance (0.06% or 0.07%) offered by traditional banking establishments for
savings accounts, this is an amazingly high DeFi Explained: Special Report 15
interest rate. You can see why people are switching from traditional banking to
DeFi. If offers control over your own finances. No one can ban you from a DeFi
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protocol. You have control over your own finances instead of depending on a
third party to approve your loan. While you do have to deposit your funds into
the platform, what happens to those funds is up to you. The underlying smart
contract takes the place of the traditional human intermediary. It offers
heightened transparency. DeFi allows a far greater degree of openness and
accessibility. Since most of the DeFi protocols are built on the public ledger
of a blockchain, every activity is available to the public. Anyone can view any
transaction, but these transactions are not tied to any individual the way they
are with a traditional bank. Instead, DeFi accounts list only numerical
addresses. DeFi Explained: Special Report 16 Also, users with programming
knowledge can access most of the source code to audit or build upon, since
these are open-source codes. This type of code is of a higher quality and far
more secure than proprietary software, thanks to community interaction. It
offers increased access. One of the biggest reasons people without bank
accounts can’t make financial transactions is that they lack documentation
proving their identity, such as government-issued identification cards, credit
cards, or passports. This also prevents them from enjoying social benefits like
owning property, which severly limits their opportunity for growth. That
barrier is lifted when you use DeFi. “Digital identities,” says Entrepreneur,
“serve one of the essential components of DeFi.” A digital identity may be a
profile that is linked to a device’s IP address, or a randomly generated unique
ID. It could also be tied to a user ID and password. DeFi Explained: Special
Report 17 With this identification, any user anywhere in the world could buy,
sell, loan, or borroy cryptocurrency. DeFi Explained: Special Report 18 The
Downsides to DeFi Nothing is perfect and decentralized finance is no exception.
Here are some of the negative aspects of0 the platform. Security issues: The
smart contracts which form the backbone of the DeFi platform are susceptible to
manipulation. By default, these contracts are open-source. This design allows
you to inspect and review them before making your decision to invest in the
DeFi protocol. Most DeFi protocols hand their contracts over to security firms
for auditing—and that’s where they may run into trouble. Human beings can miss
flaws in these contracts that might be exploited at some future date. DeFi
Explained: Special Report 19 As an example, take a look at the DAO or
Decentralized Autonomous Organization. This investor-directed venture capital
fund was launched in April of 2016. It quickly grew to become one of the
world’s biggest crowdfunding platform, managing around $120 million. By June of
that same year, hackers had located and exploited a vulnerability in the smart
contract. They stole about a third of the funds, relocating them into a “child
DAO” with the same structure as the parent protocol. It took weeks for some
users to be able to access their funds, making this the largest hack in
crowdfunding history. This incident alerted the DeFi community and now,
developers who build protocols ensure that their smart contracts undergo
multiple rounds of auditing. Data feed centralization: Blockchain protocols
can’t access data that is off-chain. In order to remedy this shortcoming, many
use third-party DeFi Explained: Special Report 20 services called oracles.
These allow access to needed external information. As Forkast puts it, “Oracles
serve as bridges between blockchains and the external world, relaying information
to smart contracts for them to utilize.” The major issue with all this is how
to create a central trust point in a trustless and decentralized setup. This
can provide a vulnerability for the entire smart contract. If an oracle should
broadcast the wrong information, it could wreak havoc with the entire system.
Let’s look at the case of Synthetix, for example. This is a DeFi asset issuance
platform. In June, 2019, an oracle transmitted false price feed information to
the platform’s smart contract. One user’s trading bot took advantage of this
error and bought big, inflating the user’s balance, allowing that user to
convert around 37 DeFi Explained: Special Report 21 million Synthetic ETH
(sETH) tokens—worth around $70 million! The company later reached out to the
user, who agreed to reverse the transaction in return for an undisclosed “bug
bounty.” Hackers: In September 2020,
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top crypto exchange KuCoin confirmed that
hackers had transferred about $150 million in Bitcoun and ERC-20 tokens from
its hot wallets. Days after the actual event, blockchain intelligence software
Elliptic did the math and discovered that the exchange had actually lost about
$281 million. The hackers laundered the funds through DeFi protocols Kyber
Network, Uniswap, and others. Elliptic explained that many centralized
exchanges had frozen the hackers’ accounts so they couldn’t move the funds, but
that they had utilized decentralized exchanges which had no central authorities
to freeze their illegally obtained funds. DeFi Explained: Special Report 22 The
Future of DeFi “DeFi’s performance in 2020,” says Forkast, “has put the entire
crypto market on notice.” With assets increasing in value, even some of the
traditional crypto companies are wanting in on the action. According to DeFi
Pulse, the total value locked in DeFi is more than $16 billion (US Dollars). As
of December 2020, this is an increase of more than 2300% since January of that
year. Unfortunately, this boom has attracted a lot of criminal activity. Crypto
analytics firm CipherTrace recently reported that total losses from DeFi thefts
in 2020 exceeds $100 million. In the second half of the year, half of all
cryptocurrency thefts were from DeFi protocols. DeFi Explained: Special Report
23 And centralized exchange KuCoin had about $19 million liquidated by thieves
using decentralized exchanges. The DeFi industry is still in its beginning
phases. There’s plenty of room to grow but it’s suffering “the same growing
pains as the crypto space as a whole.” Despite the benefits and returns, DeFi
may still be a risky endeavor for investors.
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What We Can Do: Here are three of
the biggest bottlenecks to DeFi’s growth, as Entrepreneur sees it, and some
ways we can resolve them. Volatility: “It may seem strange,” says Entrepreneur,
“to imply that there are issues with an industry that’s worth over $50 billion
at the time of writing—but keep in mind that it was worth $80 billion just a
week earlier, according to data gathered by DeFi Pulse.” DeFi Explained:
Special Report 24 For many, this extreme volatility is what’s exciting. It
offers exponential short-term returns on their investments. For others, that
volatility is terrifying. They’re afraid to risk anything. The so-called “DeFi
Summer” of 2020 saw projects like Uniswap and Compound “pull gargantuan market
caps” as they introduced millions in liquidity to this new financial community.
However, months afterwards, many of these fell sharply in value “after the
initial wave of hype died down.” “Even worse,” Entrepreneur reports, “many
over-leveraged users of these platforms saw their holdings disappear the next
February and May, having billions of dollars worth of coins liquidated as a
result of a tempestuous market.” One solution to this volatility is
stablecoins. These are cryptocurrencies tied to the value of traditional
currencies such as the US dollar. DeFi Explained: Special Report 25 Tokens like
USDC, Tether, or DAI allow less reckless investors to try DeFi without worrying
about such wild price swings. China’s latest venture into Central Bank Digital
Currencies might have the potential to replace bank notes as the new standard
for currency exchange. This would allow people all over the world to utilize
DeFi protocols. Canada and the United States are also looking into creating
cryptocurrency exchange-traded funds (ETFs). While they are not decentralized,
these funds are a way “for investors in traditional exchanges to gain exposure
to potential profits from DeFi projects while limiting the risk.” Decentralized
ETFs are also being explored. Entrepreneur reports that the DeFi Pulse Index
looks good. This might be a good way to create a less volatile asset.
Accountability: One of DeFi’s strongest selling points is that
decentralization. DeFi Explained: Special Report 26 “The optimistic point of
view,” says Entrepreneur writer Bryce Welker, is that replacing laws and
institutions with smart contracts and blockchains will prevent the corruption,
fraud, and inequity that has plagued our existing financial systems.” It sounds
like some sort of science fiction utopia—an impartial system backed by
automation. But the reality is that “the darker elements of human nature” can
still interfere with the development of this utopia. For example, although
Bitcoin’s technology is designed to be almost impregnable, it still might be
vulnerable to an attack. And the cryptocurrency platforms don’t always live up
to their utopian promises. “In that context,” says Welker, “it’s hard to be
optimistic about the Ethereum Foundation’s ability to address the pervasive
scaling issues that are causing ludicrously high gas fees on every
transaction.” To fix this, we need to put accountability in the hands of the
people who deserve it most—those invested in making the best decisions for the
project. DeFi Explained: Special Report 27 People who utilize DeFi are often
issued governance tokens for their participation. The intended use of these
tokens is to cast votes on any decisions the project will face in the future.
Another way to promote accountability is to create competition. Alternate
blockchains like Cardano are currently trying this approach with Ethereum,
promising similar benefits like faster transaction speeds, lower fees and
greater energy efficiency. Perception: If you asked someone whose only exposure
to DeFi was breaking news, Welker says “he or she would probably describe it as
a mix of tulip speculation, money laundering, and a casino.” Perception is
probably DeFi’s worst enemy, and a leading cause of the first two problems.
“It’s tough to justify,” adds Welker, “getting involved in a financial
ecosystem that can seemingly collapse from a single tweet made by a known
market manipulator,” as when Elon Musk tweeted about maybe taking Tesla
private. DeFi Explained: Special Report 28 The worst-case scenario is that
users will simply return to a centralized institutions like banks and
stockbrokers for solutions to this problem. World governments and financial
magnates would love to get their hands on this technology because it poses a
threat to their existing power structures. Welker feels that the only way the
financial movement can attain its full potential is to “reinvent itself as a
separate entity from traditional economics and a fiat currency. If you stop
thinking about Bitcoin, Ethereum, and altcoins in terms of their dollar value,
you can escape the hegemony of the dollar and the ticking time bomb of
hyperinflation.” DeFi Explained: Special Report 29 Final Words Most people are
only familiar with DeFi on a surface level: they know it has the potential to
widen financial inclusion, for example, or to encourage permissionless
innovation. Entrepreneur feels that many skeptics just don’t fully grasp the
opportunities it presents. ‘Many entrepreneurs,” they say, “have chosen to get
on board because DeFi, by nature, removes many of the barriers to entry that
prevented small-/mid-size enterprises and start
[1]ups
from entering the market.” “DeFi today is still very much the Wild West,” says
Worth. “Thieves, federal investigations, cyberattacks, and a new class of brash
capitalists chasing a gold rush: it’s the American love story with capitalism,
exported on a global level.” “DeFi is the new lemonade stand,” Entrepreneur
quips. “The time has come to address the most significant issue in centralized
finance: too few people are in control.” DeFi Explained: Special Report 30 The
concept of the lemonade stand is an apt one: you’re providing goods or services
your fellow humans want or need, and they pay you for them. There’s no need for
an intermediary like a bank or financial manager. It’s also appropriate in that
it takes very little real money to set up such a “lemonade stand.” Creating a
lemonade stand isn’t just about starting a business, either. It’s about
contacting other people, forming networks that can work to everyone’s favor in
the future. “Anyone in the world,” says Entrepreneur Magazine, “should be able
to create a marketing strategy for their project or product without facing
multiple insurmountable roadblocks along the way.” DeFi offers such a chance
for the entrepreneur. More importantly, this concept can benefit any type of
business model, concept, or idea. All you need is a good idea, an internet
connection, and a few minutes to set it all up. Spend some more time
researching and getting to better understand the power of DeFi. DeFi Explained:
Special Report 31 Then you can set up your own lemonade stand. ;) To your
success, DeFi Explained: Special Report 32 Resources Here are links to a few
resources that I believe will help you: Defining DeFi: >>
https://www.fool.com/investing/stock-market/market
[1]sectors/financials/blockchain-stocks/decentralized-finance/
How Decentralized Finance Will Transform Business: >>
https://www.weforum.org/agenda/2021/07/decentralized-finance
[1]transaction-banking-smes/
Small Business Crypto Lending (DeFi) Platforms: >>
https://sourceforge.net/software/crypto-lending-defi/for-small
[1]business/ Enterprise
DeFi Explained: >>
https://medium.com/unidocore/what-is-enterprise-defi-why-are
[1]big-businesses-entering-the-defi-space-35aa97a1d21