Decentralized Finance (DeFi)

What is DeFi

DeFi (Decentralized Finance) refers to a set of diverse financial services executed on public blockchains, primarily the Ethereum blockchain.

Starting from the summer of 2020, known as the “DeFi Summer,” blockchain innovation has seen a tremendous increase in interest and development of these protocols, which are proposed as the “financial alternative” to traditional credit and intermediation systems.

In less than two years, these protocols have seen a huge influx of capital, reaching a total locked value (TVL) of $250 billion in their smart contracts, and the long-term trend seems to be in strong and decisive growth.

Thanks to DeFi, it is possible to perform the majority of operations supported by traditional banks, such as requesting and providing loans, purchasing insurance policies, and trading derivative instruments.

The guiding principle of DeFi is to make capital more efficient, more flexible, and unlock new value opportunities through the tokenization of traditional assets.

The difference between DeFi and the traditional credit system is measured in terms of efficiency, accessibility, and compositeness:

• Anyone can access these products without authentication and without barriers related to credit profiling and available capital amounts;
• intermediaries, which often act as entry barriers, require long document processes, cause enormous inefficiencies and costs, are eliminated.

As with all operations performed on public blockchains, DeFi is global, peer-to-peer (i.e., transactions occur directly between two people without the intermediation of a centralized system), pseudonymous, and open to everyone.

Current DeFi Landscape.

The world of DeFi is growing rapidly and is seeing rapid evolution thanks to the enormous profit opportunities allowed by the removal of intermediaries and the flexibility it allows.

Protocols such as Aave and Compound offer the possibility of obtaining loans with one click, simply by depositing cryptocurrencies (or stablecoins) as collateral, and with the same simplicity, loans can be repaid.

Other protocols, such as Synthetix or Mirror Protocol, allow trading of “tokenized” versions of traditional assets such as Apple or Google shares, or certificates related to commodity values such as gold or oil.

Another example of tokenization that is proving to be a “game-changer” is the Centrifuge Protocol, which allows the tokenization of real estate, allowing it to be used as collateral for instant decentralized loans.

Other protocols offer passive investment tools that “behind the scenes” exploit the financial primitives of various products, using complex strategies to optimize the returns of the protocols just mentioned.

One example is Yearn Finance, which has seen a peak of $8 billion in total locked value (TVL) accumulated in the protocol.

Many other examples are left out of this list, which makes us understand the vastness of the opportunities that lie in the DeFi landscape.

Lending & Borrowing.

Crypto lending & Borrowing is an alternative form of investment, where investors lend fiat money or cryptocurrencies to other borrowers in exchange for interest payments. This means that there are two main parties involved in this loan:

• The lender, who will receive interest from the borrower in exchange for the loan.
• The borrower, who will deposit crypto-assets as collateral to ensure the investor’s investment.

By depositing collateral, lenders can be sure that if something goes wrong, the collateral will be used to compensate them. All DeFi lending services are based on blockchain, which is usually Ethereum.

What are the advantages of Crypto Lending & Borrowing?

Traditional banks no longer offer interesting interest rates, and some even have a negative deposit rate. It’s no surprise that many investors are seeking more lucrative opportunities in search of passive income.

Cryptocurrency lending is still a debated topic, but more and more people are turning to it as an alternative source of income. Interest rates can even reach 30%!

Borrowers can take out loans backed by cryptocurrencies to ensure they have funds available, avoiding the loss of their exposure to specific crypto assets.

Lenders are the ones who help provide these loans to borrowers through DeFi platforms, and often through centralized financing platforms (CeFi).

What are the advantages of Crypto Lending & Borrowing?

• All loans are provided through smart contracts. Every detail of the loan is automated and verified.
• DeFi loans do not require custody to perform any operation.
• The interest on income is automatically adjusted to the market.
• The collateral put up by the borrower is automatically collected in the event of inability to repay the debt.

In short, DeFi loans have proven to be a safe and easy way for investors to make a profit from their crypto or stablecoins.

Tokenized Assets.

In today’s financial system, only the largest companies have direct access to liquid capital markets. Most rely on banks for their capital needs. The lack of an open and transparent market denies these small businesses access to competitive interest rates, especially due to market inefficiencies and transaction costs.

Projects like RealT allow real estate investments to be “tokenized” in a fractional manner, allowing anyone to own a % of a property and benefit from its appreciation.

Protocols like Centrifuge aim to bring crowdfunding benefits to those who have not had access to DeFi liquidity so far.

Centrifuge connects real-world assets to DeFi to reduce capital costs for SMEs and provide DeFi investors with a stable source of non-correlated returns to volatile cryptocurrencies.

Centrifuge allows anyone to launch an on-chain credit fund by creating pools of collateralized loans. Tinlake provides a simple way for any business to enter DeFi liquidity.

For DeFi investors, these assets will create a safe and stable return for their money that is not correlated to the attractive but volatile returns of cryptocurrency markets.

Risks of DeFi.

DeFi, being a nascent world, is not free from risks, in fact!

To use it consciously, it is first necessary to be aware of the risks involved, which are of two types:

• Risks of an IT nature
• Risks of a financial nature

IT Risks.

DeFi projects are often complex networks of smart contracts. Smart contracts are agreements (or parts of agreements) that are digitally coded and automatically executed on a blockchain network.

One advantage of smart contracts is to reduce (or completely mitigate) counterparty risk. It can be reasonably certain that certain exchanges (such as the exchange of one token for another token in a decentralized exchange) will be executed simultaneously.

But smart contracts raise other technological risks.

• If you make approximate decisions, such as transferring to the wrong address or through the wrong network, your funds may be irretrievable. There is no centralized third party, like a bank, that can reverse the smart contract and return your funds.
  
• Another technological risk for smart contracts is oracles. Oracles are necessary to collect external (off-chain) data, providing information such as asset price feeds. But when these oracles falter, or are compromised by malicious activity, there is a risk to the intended execution of a smart contract.
  
• Smart contracts themselves can also have bugs. As entrepreneurs push the boundaries of DeFi innovation, smart contracts are combined and distributed in new and unprecedented ways. They are mixed and matched together to provide new products and services. Some bugs are inevitable. While some bugs are inadvertently revealed, others are the result of deliberate attacks.

Financial Risks.

DeFi is introducing what is known as “money LEGOs,” meaning the high composability of financial primitives it offers. This great flexibility also poses systemic financial risks, for example:

• If the prices of crypto assets put up as collateral for loans drop very quickly, there can be a loan liquidation.
  
• Malicious actors can exploit the complex financial properties of protocols using “flash loans” to govern on-chain decisions on protocols and change the variables of smart contracts, for example, canceling a loan in an unforeseen way.

Can DeFi truly be an alternative to traditional finance?

It is too early to draw conclusions, but we are certainly seeing a huge growth of interest in the new primitives of decentralized finance.

Certainly, in the coming years, we will see a maturation of the sector, with many projects failing because they have unsustainable business cases, or because they will be supplanted by more efficient or secure competitors.

The great challenge for DeFi in the coming years is not to confront traditional finance in a direct clash, but to propose itself as a possible alternative, alongside institutional operators such as banks and insurance companies.

Lorenzo Smeraldi (Coinflow s.r.l.)