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June Katz 9 min read

What Is DeFi: Decentralized Finance Explained. Part 2

What Is DeFi: Decentralized Finance Explained. Part 2

In the first part of this article, we laid the groundwork for better understanding what DeFi fundamentally is and what it is made up of. Now it’s time we went further and examined the actual pearls that it offers at the most practical level, warts and all. So buckle up and enjoy this quest for DeFi’s treasures with us!

Decentralized exchanges

Decentralized exchanges, or DEXes, came before the notion of DeFi as such has emerged. More correctly, DEXes were the DeFi back in the day for the sole reason that there was nothing else that would truly qualify as DeFi beyond them. This is not to say that the field has been stagnating all these years. On the contrary, with the emergence of automated market makers, it has become one of the cornerstones of the entire space. That’s another reason (besides purely chronological) why we start off with decentralized exchanges here. Earlier implementations of DEXes followed the traditional design where buy and sell orders are matched against each other in the so-called order book. The order book database itself can be off-chain or on-chain. But what sets these exchanges apart from centralized trading places like Binance or Bitfinex is how the user’s assets are stored. With Ethereum-based exchanges, such as IDEX or EtherDelta, users maintain the sole custody of their private keys, and all trades must be authorized by them, while an exchange smart contract trustlessly stores the assets. That was a huge step forward from custodial exchanges fraught with way too many hacks, scams, and third party risks like funds arbitrarily blocked or confiscated. But in terms of popularity, which translates into trading volumes, order book-based decentralized exchanges failed to set the world on fire. What really ignited the fire of DeFi, though, and made this idea actually popular among the trading public and beyond was the invention of reserve-based trading aka automated market makers (AMMs) and the advent of DEXes featuring this model. Uniswap is the new king on the block, and as of this writing, according to Dune Analytics its market share surged to over 60% in the 7-day trading volume among all decentralized exchanges, irrespective of the order matching engine. But it is not the only fish in the sea as with anything popular the space quickly gets crowded. The top dogs like Curve, Balancer, 0x, dYdX, to name but just a few, can take over the packmaster any moment. But what’s even more important, they are now starting to compete with regular exchanges, and that’s a big deal.

Decentralized stablecoins

As we highlighted in the first part of this article, initially, the idea of stablecoins was to allow crypto traders and investors to store the value of their accumulated wealth in cryptocurrencies without falling victim to volatility, especially on exchanges that didn’t offer the so-called on-ramps and off-ramps (fiat gateways). Today, their usage has massively extended to DEXes where trading plain crypto-to-fiat pairs is still impossible due to the nature of these exchanges. Decentralized stablecoins pegged to fiat currencies easily solve this problem.The decentralized sector of this space is largely dominated by MakerDAO and its flagship product – the stablecoin DAI, the primary provider of the on-chain financial stability. To maintain its peg to the US dollar, it utilizes the so-called collateralized debt position. In layman terms, the currency peg is kept through the balance of the available supply of DAI and the market value of its collateral. The higher the value, the more DAI can be created, and vice versa. At the outset, it only used Ether as collateral, but today it uses a select crypto portfolio. There are several other projects relying on this model, for example, Augmint with its A-EUR token pegged to the euro, and EOSDT featuring an EOS blockchain-based USD stablecoin. However, most other projects in this realm go with different, more flexible approaches such as elastic supply aka dynamic peg (Ampleforth), where the supply expands and contracts algorithmically based on demand, and self-collateralized models used by, for example, BitShares, with its BitAssets like BitUSD, BitEUR, BitGold, and similar digital assets. 

Decentralized lending & borrowing

Lending & borrowing are like the two sides of the same coin – one is not poss4ible without the other. Decentralized variety of it is no particularly different: lenders provide loans to borrowers taking crypto assets as collateral, who, in turn, enable the lenders to earn interest on their digital assets. It’s very similar to a loan from a bank, with borrowers and depositors on both sides but without the bank as an intermediary in between. A pretty simple setup. So let’s now check what makes it actually work and which services are available to us in the wild. As with virtually everything in DeFi, decentralized lending & borrowing is done via smart contracts which make both parties stick to their ends of the bargain. But what’s in it for the lenders and borrowers, you may ask? Given that lending requires overcollateralization at the bare minimum of 150%, with an average ratio well over 300% across the market, lenders are more inclined to loan out their assets at an agreed interest rate instead of selling them. This is a winning strategy as long as the market is on the rise, which was the case recently.For borrowers, loans work as a hedge against sudden price drops like short squeezes. If their collateralization ratio is at 200%, the loan turns into an effective stop-loss order at 50% of the price of the provided collateral should it plunge dramatically, no matter how much below that mark. In the worst-case scenario, they can only lose their collateral and still have the borrowed cryptocurrency on hand, without suffering the negative consequences and ramifications like bad credit histories if they were to borrow from a commercial bank. Then rinse, repeat.This space is mostly taken by three major players, which is Aave, already mentioned MakerDAO, and Compound, with dozens of smaller players. In terms of DeFi, they all leverage the same smart contract tech applied through decentralized applications (dApps) that offer market participants dynamic interest rates based on supply and demand. Aave boasts most advanced lending services which include uncollateralized loans aka flash loans, immensely popular among arbitrageurs, along with an impressive list of possible collateral types.

DeFi in other domains

DeFi is making inroads into very diverse fields of application, and it is hard to keep track of all the dimensions along which it rapidly evolves, let alone being able to tell what avenues it is going to take in the future. In this part, we will briefly outline other uses which are worthy of mention. These include cryptocurrency staking, ecommerce marketplaces, insurance services, blockchain oracles. Cryptocurrency staking is as old as PoS cryptocurrencies are, where it is used for transaction confirmation similar to mining in Bitcoin. DeFi breathed new life into this space in the form of staking pools that set up cryptocurrency staking on your behalf, freeing you from the hassle of running the nodes yourself. There are many pools available for staking your coins offered by Staking-as-a-Service providers, but you should probably stick with Staked if you want the staking to be done in a non-custodial, DeFi way, that is to say, your way. With Amazon and its likes around the world stubbornly refusing to accept cryptocurrencies as a legit means of payment, DeFi also brought forth the idea of decentralized ecommerce marketplaces, and it didn’t take long to materialize as peer-to-peer platforms like OpenBazaar, district0x, and Particl. The latter is particularly noteworthy as it features its own privacy-oriented cryptocurrency, PART, and decentralized escrow in the form of the so-called MAD contracts, which fully deserve their name standing for Mutually Assured Destruction. In the first part, we referenced insurance as an example of a service that can be decentralized. Believe it or not, someone has already done just that, namely Nexus Mutual, a blockchain-based alternative to insurance built on risk-sharing pools. Right now it only provides cover against the theft of funds from smart contracts, for example, due to hacks, but in the future it hopes to come up with more mainstream products.In the end, we should also mention a unique decentralized service that has no parallel in traditional finance. Smart contracts that the entirety of DeFi is built around called for the rise and advance of blockchain oracles – services that bridge together off-chain data sources and on-chain smart contracts. Dedicated blockchain platforms like Chainlink and Provable which offer such services can thus be rightfully considered part of the DeFi world.

The DeFi problem

The truth about DeFi is that it actually lives up to its promise of a decentralized, trustless environment free from scores of intermediaries and levels of authority. Put shortly, decentralized application is your intermediary and smart contract is your authority. However, this environment has its downside too, which is in fact the evil twin of its upside. Lack of centralized governance to set apart the good and the bad makes this space a rich feeding ground for all kinds of fraudsters. In a sense, it is a Wild West where everyone is for himself, without trade-offs or compromises. In practice, it may mean losing money, so at all times everyone should do their own research before stepping into these deep waters. To sum it up, DeFi is far from being as simple as it might look to you after reading the piece.


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