A major topic in cryptocurrency is decentralized finance, or DeFi. The goal is to create a completely new financial system, completely independent of traditional financial institutions (TradFi). In addition to the investments being made, there are thousands of developers working on this goal around the world.This is part one of our series on DeFi. It is the aim of this series to provide financial advisors with a deep dive into this space in order to provide a bridge that will allow us to integrate the traditional financial world with the innovative and new DeFi space that is emerging.
This article originally appeared in CoinDesk’s weekly newsletter, Crypto for Advisors, that defines crypto, digital assets, and the future of finance.
Vitalik Buterin’s Ethereum Project: The Most Important Development For Blockchain Technology?
After working on Bitcoin, Vitalik Buterin founded Ethereum as a second cryptocurrency project in 2013. In contrast to Bitcoin, Ethereum was designed to function as a blockchain with multiple different purposes: as a digital currency, as a global payment system and as a platform for blockchain applications. On top of Ethereum currently runs an entire digital economy, including the DeFi ecosystem.
DeFi is a crypto movement built on cryptocurrency like Ether that is open to everyone (with access to the internet). Unlike traditional banking and government applications, DeFi is a trustless application, which means it is not controlled or hosted by a central authority. In order for this system of decentralized finance to exist, cryptography, smart contracts, and blockchain technology must be used.
In Ethereum, a robust smart contract programming language called Solidity is used, which allows the application code to include all of the necessary logic for financial contracts. The current state of the market is dominated by many other cryptocurrencies, including Avalanche, Terra, Fantom and others, but it is still important to remember that Ethereum is the first and largest network that was used to create DeFi.
On top of the Ethereum blockchain, MakerDAO was created in 2015. MakerDAO enables any user to lock ether, or ETH, via smart contracts and generate dai, a stablecoin pegged to the U.S. dollar. Using Dai in the Oasis decentralized savings platform, MakerDAO is effectively creating a decentralized bank. Oasis created a lending and borrowing platform for its users through the use of stablecoins and smart contracts.
DeFi: How Lending And Borrowing Can Speed Up The Crypto Market
As a result of DeFi’s lending and borrowing platforms, users are now able to lock their crypto positions into smart contracts and borrow against them. By allowing their coins to be lent out to borrowers, users can lock their cryptocurrency positions into smart contracts and generate yield.
Interestingly, lenders in the DeFi ecosystem generate substantially higher yields than traditional lenders. As smart contracts are much more cost-effective than traditional banks, nearly all of the yield generated from lending money is transferred directly to the lender. In an era of ultra-low interest rates, the cost-effective smart contracts are providing a technological solution to this issue. People place their trust in these transparent smart contracts and can generate an income from them.
It’s not possible to persuade central bankers to change their policies by political persuasion, so a solution is found through technology, which has created an opportunity for borrowers and savers alike. A strong DeFi portfolio would be a good way to hedge against the traditional banking system.
COMPOUND: A Decentralized Autonomous Protocol for Cryptoborrowing and Lending
Another large application in the lending and borrowing category of DeFi is Compound, an autonomous algorithmic protocol that allows users to supply various crypto assets and generate interest.
Compound’s native cryptocurrency is COMP. According to DeFi Pulse, Compound contracts contain $8.9 billion. Its users can borrow against crypto positions such as ETH and borrow stablecoins (with interest) to use for spending.
Anyone can lock assets into the Compound protocol and earn continuously compounding interest on their positions immediately. It is very similar to borrowing dollars against appreciated securities.
A user who supplies tokens to the Compound protocol is credited with cTokens, representations of underlying assets that are generating interest and acting as collateral. In contrast to traditional banks, Compound interest rates adjust automatically based on supply and demand. A compound user can borrow up to 50% of their cToken value. As in traditional financial systems, there is a liquidation point on the borrowed position. Users have immediate liquidity and the ability to withdraw their assets at any time.
Is It Too Late To Invest In Aave?
Aave is another large lending and borrowing platform in the DeFi ecosystem. Similar to Compound, Aave runs on Ethereum and is a decentralized, open-source protocol. The native cryptocurrency of the platform is AAVE, which has a current market cap of $11.8 billion. Users may borrow or lend AAVE. By supplying assets to the protocol, lenders can earn a yield on their assets. Like compound, the earned yield varies based on supply and demand.
As part of Ave’s unique offerings, the company offers “flash loans.” Flash loans are “one block borrow transactions,” in which a user borrows and repays a loan at the same time. In a smart contract, the loan is only permitted if the borrower and lender are in the same block (transaction). This technology is used in arbitrage and quick trading.
There is no such thing as a traditional loan, however this type of loan is seen as a major improvement to the TradFi system.Flash loans provide the possibility of cross-exchange arbitrage in the crypto ecosystem, as seen in this CoinDesk explainer: “Traders can make money by finding price differences across a number of different exchanges. Say two markets are pricing pizzacoin differently. It’s priced at $1 on Exchange A and $2 on Exchange B. A user can use a flash loan and call a separate smart contract to buy 100 pizzacoins for $100 at Exchange A, then sell them for $200 at Exchange B.”
The borrower then repays the loan and pockets the difference. Flash loans help to stabilize cryptocurrency exchange prices and ultimately strengthen cryptocurrency economy.
What is a Decentralized Exchange (DEX)?
As smart contracts, stablecoins, and lending and borrowing platforms became available, another crucial part of decentralized finance was created: decentralized exchanges (DEX). The trading volume of DEXs reached over $1 trillion in 2021. In my next article in this series, we’ll look at how DEXs came to be, their importance to the crypto economy, how they interact with lending and borrowing platforms, and how users benefit from them.
DeFi: The Future of Financial Services
The purpose of DeFi is to create an open financial market that’s trustless and permissionless. Significant investment and development have gone into the advancement of DeFi, so financial advisors need to understand it.Much of the technology in the DeFi space builds upon, and improves, the TradFi system, possibly resulting in an improved user experience. To keep up with the evolution of decentralized finance and to be prepared to interact with and rely on these applications, it’s vital to have a comprehensive understanding and knowledge of the space.