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What is DeFi? • Decentralized finance • Benzinga Crypto


Decentralized Finance (DeFi) seems a lot more complicated than it actually is. DeFi is not a business or a cryptocurrency – it is an attempt to recreate the existing financial system on the blockchain.

Using cryptography, blockchain technology and smart contracts, the decentralized financial system is without trust and without borders.

The DeFi industry offers stablecoins, loans, exchanges, and other products and services found in the traditional banking industry, but with a catch. The difference is in DeFi’s distinct technological advantages that enable superior products that were never possible before.

How decentralized finance works

Recent advances in blockchain technology have for the first time triggered a new wave of online financial services without a central authority. DeFi is an umbrella term for any decentralized financial product. The majority of DeFi products are based on Ethereum and its full programming language Solidity. However, new entrants to the industry are giving Ethereum a run for its money – namely Solana, Avalanche, and Binance Smart Chain.

Central banks employ thousands of people, incurring huge expenses to provide products and services. Banks must also rely on the legal system to manage disputes.

DeFi is replacing employees and the legal system with Ethereum smart contracts on the blockchain, drastically reducing operating expenses in order to deliver products that many deem superior to their traditional banking counterparts.

Smart contracts are legal or business agreements written in code (Ethereum’s Solidity programming language).

Smart contracts generally replace the need for trust with the use of collateral. By demanding guarantees, parties are encouraged to behave properly without anyone watching them. Smart contracts hold collateral in escrow and can automatically handle defaults and successes at negligible cost.

Smart contracts are stored and executed on a blockchain for custody. Since these blockchains are decentralized, no single entity can control the financial functions performed on a chain.

DeFi Applications

New decentralized financial applications are being developed every day as venture capitalists are eager to jump on the new wave of open finance.

Currently, stablecoins, loans, exchanges, and non-fungible tokens (NFTs) are the biggest markets in the DeFi space. Here is Benzinga’s breakdown of these DeFi markets.

Decentralized exchanges

Decentralized Exchanges (DEX) allow the unauthorized exchange of cryptocurrencies. DEXs use 1 of 2 methods to create a market: order books or liquidity pools.

Order books

The order book exchange method has long been used by centralized finance (CeFi). An order book allows the exchange of assets as long as there is supply and demand at the same price. This type of structure combines the buyers and sellers of each asset, and an investor can buy or sell an asset at the highest bid price or the lowest asking price.

Loopring and IDEX are the largest decentralized order book exchanges today.

Liquidity pools

Liquidity pools are the new way to create a market through something called an Automated Market Maker (AMM). The DeFi Uniswap, Kyber and Balancer projects compete to become the first DEX liquidity pool. Let’s take a look at Uniswap to see how a cash pool works.

Uniswap works on the Ethereum blockchain and facilitates the exchange of Ethereum-based tokens for a small fee (0.3%). However, users also have to pay Ethereum gas fees, which is a major obstacle to adopting DeFi over Ethereum. Uniswap offers users the ability to instantly trade Ethereum-based cryptocurrencies by tapping into its smart contract liquidity pools.

These liquidity pools are funded by other users who collect foreign exchange fees to provide that liquidity.

Ready

Decentralized loans offer higher interest rates than centralized loans with better security and anonymity. DeFi Aave and Compound projects are the main lending protocols today.

On both platforms, borrowers must offer more collateral than the amount they borrow in the smart loan contract. The smart contract securely holds collateral in escrow for the life of the loan, replacing the need for a trusted intermediary.

In the event of borrower default, the lender is automatically repaid the borrower’s collateral by the smart contract.

With this level of over-collateralization, Aave is able to offer 10% APY for certain No-Know-Your-Customer (KYC) Stable Loans, a truly unprecedented product in traditional finance.

Stablecoins

A stablecoin is a cryptocurrency whose value is tied to another asset, most often the US dollar. On January 4, 2021, the Office of the Comptroller of the Currency (OCC) officially authorized U.S. banks to do business using stablecoins. This marks a historic milestone for the acceptance of cryptocurrency, and an influx of money is likely on the horizon.

Tether, USD Coin and DAI are the biggest stablecoins to date. But, DAI is the only decentralized stablecoin of the 3, and the only one that is truly a DeFi product. Tether and USD Coin are both centralized and managed by private companies.

  • Attached. Tether was launched in 2014 and is the largest stablecoin by market cap. Tether issues 1 of its USDT tokens for every dollar put into play. USDT is not issued by smart contracts, but the central Tether is responsible for ensuring that each Tether is properly backed. Importantly, Team Tether is currently under investigation by the New York Attorney General for issuing more Tether than there are USD to back it up.
  • American dollar coin. USD Coin (USDC) was created by Coinbase in response to issues within Tether. Unlike Tether, USDC is voluntarily regulated by US financial institutions. Coinbase has never supported Tether trading on its platform and now aims to capitalize on Tether’s legal issues.
  • Manufacturer DAI. MakerDAO is a DeFi platform with its own stablecoin, DAI. DAI is different from USDT and USDC because it is not centralized. DAI is executed entirely on Ethereum smart contracts, which issue 1 DAI for every dollar it holds in escrow. The DAI stablecoin is the favorite of the crypto community because it is decentralized which means better security and no risk of internal fraud.

Cryptocurrency has grown faster than regulators have been able to keep up. New OCC guidelines for banks to use stablecoins mean wider acceptance to come in the near future.

This leaves a lot of questions on the table. Which stablecoin will banks adopt and what if Tether is closed?

Be sure to subscribe to the Benzinga Crypto newsletter to stay informed.

Non-fungible tokens

In 2017, a game called CryptoKitties clogged the Ethereum network for several days.

A CryptoKitty is a virtual cat that has more in common with a bitcoin than a real cat. A crypto kitty is a token on a blockchain – just like Bitcoin, Ether, or UNI – these tokens are attached to wallets, are liquid, and store value.

The explosion in popularity of CryptoKitties has exploded the demand (and prices) for these virtual cats. CryptoKitties are expensive collectibles like limited edition baseball cards. Similar to baseball cards, each kitten is non-fungible or unique.

CryptoKitties has proven to the community that the concept of non-fungible tokens (NFTs) can really work for verifying collectible digital assets.

NFTs aren’t just limited to digital chats. NFTs are currently taking over the billion dollar art industry, and a new game called Decentraland aims to show how NFTs could even be used for virtual real estate.

By symbolizing non-fungible assets, they immediately become more liquid and can even be used as collateral for loans. NFTs can store metadata providing detailed information about the asset they represent. NFTs are typically based on Ethereum and traded on the Ethereum blockchain where their ownership history is securely stored forever.

DeFi investment opportunities

DeFi products use smart contracts and blockchain technologies to offer particular advantages over the traditional traditional banking industry.

The DeFi industry is still in its infancy, but already has a few promising startups. Most DeFi projects use a proprietary cryptocurrency token to power their system. If one of these DeFi startups creates a successful product, the demand for their token will increase, as will its value.

The 2017 crypto bull run sparked a wave of new altcoins that were typically nothing more than pumping and dumping schemes elaborate with aesthetic web pages and plagiarized white papers.

Now, the majority of popular large-cap altcoins are actually the biggest and most promising DeFi project tokens. These tokens are volatile – even for crypto – so be careful and don’t invest more than what you’re willing to lose.

Recommended conference: 3 digital currency challenges facing central banks

Benzinga has developed a specific methodology for classifying cryptocurrency exchanges and tools. We prioritized platforms based on offers, prices and promotions, customer service, mobile app, user experience and benefits, and security. To see a full breakdown of our methodology, please visit our Cryptocurrency Methodology page.


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