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How Decentralized Finance Works and Use Cases: Updated March 2020

Illustrations by A. Gnetova and G. Phan

In This Article

Bitcoin (BTC)
   
Ethereum (ETH)
   
EOS (EOS)
   
Maker (MKR)
   
Melon (MLN)
   

Decentralized Finance (DeFi) are financial services built on blockchain technology. It seeks to empower the populace by creating an open, efficient, and all-inclusive financial system. Using smart contracts, DeFi platforms provide permissionless finance, thus enabling financial inclusion for all. DeFi has taken off to include many meaningful use cases. These include decentralized exchanges, lending platforms, prediction markets, and others.

It takes out the middleman and replaces it with smart contracts—which creates trustless protocols. Smart contracts are self-executing contracts that act out a programmed agreement between a buyer and a seller. With the removal of intermediaries, DeFi offers access to financial services, particularly to those unbanked by the current systems.

In this guide we will cover the following:

 

Bitcoin

The Difference between DeFi and Fintech

It’s easy to confuse DeFi with Fintech. Both work via the Internet, and they provide financial services without the need to deal with banks or traditional financial institutions. However, they differ on some fundamental levels.

One of the prominent differences is that while Fintech puts the traditional financial infrastructure on the Internet, DeFi is built solely on the blockchain technology into the mix.

FinTech juggernaut Square, is a payment processor that offers faster and cheaper cross-border payments than traditional banks. However, Square’s platform still involves a central authority – Square itself. The company completes transactions on behalf of its customers, and they also require the provision of a valid identification before opening accounts.

DeFi, on the other hand, differs. Dai is an Ethereum-based stablecoin with a value pegged to the dollar. Anyone transacting with this currency doesn’t need to trust any organization to complete transactions. Instead, transactions are validated by Ethereum miners on the blockchain. This is done regardless of race or nationality.

Ethereum

Decentralized Finance Use Cases

 

Defi Lending and Borrowing

This is perhaps the most significant use case for DeFi. Lending and borrowing platforms provide loans to users without the need for intermediaries like BlockFi. There are also lending protocols in place that pays users interest in stablecoins and cryptocurrencies.

For now, the EOS and Ethereum blockchains are the most popular ones for DeFi lending and borrowing. Some of the most popular lending and borrowing platforms in this racket include Dharma, Compound., and BlockFi.

Compound

  • Money market protocol that supports BAT, DAI, ETH, USDC, REP, ZRX tokens.
  • Compound uses its native currency, the cToken (cBAT), for lenders and borrowers on its platforms.
  • Unlike some other DeFi platforms, the interest rates are not fixed -they are based on market dynamics.

 

Dharma

  • This is a semi-centralized p2p lending and borrowing platform.
  • Based on the Ethereum blockchain, the platform supports DAI, ETH, and USDC for collateralization.
  • Interest rates differ based on the coins.
  • Lending and borrowing rates are the same across the board, and the rate is determined by the team behind the asset.

 

Maker

  • Maker is the company behind stablecoin Dai.
  • The Ethereum-based lending and borrowing platform support both DAI and ETH tokens, and it allows users to borrow money in Dai. However, unlike p2p models, the protocol here issues coins from reserve pools.
  • The platform intends to allow borrowers to deposit several assets as collaterals to help offset the volatility of one asset.

DeFi Asset Management

DeFi asset management tools act as asset custodians, but aren’t engaged in any banking or commercial services. In DeFi, asset management tools provide wallets apps and other tools that help crypto holders to effectively manage their assets.

New investors might find it difficult to set up wallets or making their way around the space (including diversifying their investments, finding exchanges, etc.), but asset management tools help take out any complexity.

Melon

  • Melon is a DeFi platform that provides asset management solutions to users.
  • With ETH and ERC tokens, users can manage their wealth and those of others as well.
  • The platform is entirely decentralized, and protocols are also managed by the community – no central authority or a board of governors.

 

InstaDApp

  • This decentralized smart wallet works on the MakerDAO protocol.
  • It allows users to keep track of their blockchain assets in a decentralized manner, thus optimizing their holdings across several protocols.
  • The platform is still only limited to Ethereum web 3.0 wallets.

Derivatives

A derivative is a contract between two or more parties that depends on the performance of an underlying asset to get its value.

DeFi derivatives are very flexible, as their inherent smart contracts can issue tokenized derivatives contracts that are executed automatically. Generally, derivatives are used to safeguard investors from price fluctuations, and to speculate on the performance of an asset in the future. Some examples of DeFi derivatives platforms include:

UMA

  • UMA is a decentralized contract platform that allows Total Return Swaps on Ethereum to offer exposure to several assets.
  • The platform has an open-source protocol that allows two counterparties to customize and create a smart contract. However, the contracts themselves are secured with economic incentives.
  • UMA requires a price feed oracle that returns the current price of the underlying asset.

 

Synthetix

Synthetix operates as a multi-tier exchange and issuance platform that allows users to mint various assets – including cryptocurrencies, fiat currencies, and derivatives. With its Synths tokens, users are able to make investments in some top assets (including Bitcoin, gold, and the dollar) and stocks (including Apple, Tesla, etc.) within the Ethereum blockchain.

A user invests collateral in the form of the Synths token and creates a synthetic asset. From there, they can exchange or swap one asset for another. The process is independent of any counterparties too.

Insurance

Crypto insurance remains one of the most sought-after concepts in the cryptocurrency space. Investors will like to have platforms that can help them insure their private keys and digital assets, especially in the face of exchange hacks, security breaches, carelessness on their part, and fund mismanagement.

DeFi insurance protocols make it possible for users to take out insurance policies on smart contracts and digital assets by pooling funds to cover individual claims. Admittedly, the DeFi insurance market is small. However, as the market grows, players are set to grow as well.

A popular player in this space is Nexus Mutual – an Ethereum-based decentralized insurance protocol that allows anyone to buy insurance coverage or contribute capital to help cover a claim through a risk-sharing protocol. Members own the insurance pool, and participation is done by contributing Ether into the pool in exchange for its native NXM token. However, the fund will need to have at least 12,000 ETH before insurance claims can be processed.

Risks associated with DeFi

1. Smart Contract Risks

DeFi transactions aren’t dependent on human intermediaries. However, there’s still a risk to smart contracts themselves. Inherently, smart contracts are open-sourced. This means that others can review them. Reviews can give smart contract users some peace of mind; there’s still a risk that someone could have missed something important, thus resulting in a terrible operational error.

The DAO, one of the biggest crypto crowdfunding projects ever, was affected after hackers exploited a vulnerability in its open-source code. The vulnerability allowed them to steal about a third of the funds raised.

Bitcoin MACD

2. Centralization of the Data Feed

One of the most significant limits to a blockchain’s operation is its inability to access off-chain data. They help compensate for this with Oracles, which gives access to important external data. With Oracles, smart contracts can take information from the outside world and make changes based on that.

However, when the Oracle provides the wrong information, it could be catastrophic. Wrong information could arise intentionally or not, but they do happen. The Oracle used by Synthetix once submitted false data. A bot used by one of the platform’s owners caught this, and the lucky owner was able to make over $1 billion in profits in less than an hour.

Google Oracle

3. Capital Inefficiency in Loans

The permissionless nature of DeFi loans is laudable. However, when compared to traditional finance, they’re still markedly capital-inefficient, as the loans you can get relative to collateral isn’t as favorable as what you could get with traditional loans.

 

Conclusions

  • DeFi is growing to be one of the most important parts of crypto finance. By providing financial liberty and eliminating intermediaries from important financial transactions, the concept seems to be on the path to exponential growth in prominence.
  • Efficient and transparent financial services are important in the mission to provide inclusion for everyone, and while the traditional financial system has failed to get this done repeatedly, DeFi is on the right path to providing a much-needed paradigm shift.
  • It’s rapidly staking a claim to be the main driver for Ethereum. It was recently reported that the total funds locked in decentralized finance contracts had blasted through $900 million. While DeFi has always positioned itself as an alternative to traditional finance, it has a long way to go before it moves from a niche market to mainstream finance.

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