What is DeFi? • Decentralized finance • Benzinga Crypto
Cryptocurrency hacks are common in DeFi. We recommend securing your assets on Ledger’s DeFi-enabled hardware wallet for maximum security.
Decentralized finance (DeFi) sounds 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. This is done through smart contracts, which are programs that live on the blockchain. Just like how Bitcoin is immutable and trustless, so are smart contracts. This makes it possible to integrate functions such as peer-to-peer lending markets, streaming services and decentralized exchanges into smart contract applications.
The DeFi industry offers stablecoins, loans, exchanges, and other products and services found in traditional banking, but with a catch. The difference lies in the distinct technological advantages of DeFi that enable superior products that were never possible before.
How Decentralized Finance Works
Recent advances in blockchain technology have sparked a new wave of online financial services without a central authority for the first time. 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 deliver products and services. Banks must also rely on the legal system to manage disputes.
DeFi replaces employees and the legal system with Ethereum smart contracts on the blockchain, dramatically reducing operating expenses in order to deliver products that many consider 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 guarantees. By requiring guarantees, the parties are incentivized to behave properly without anyone watching them. Smart contracts hold collateral in escrow and can automatically handle faults and hits for negligible cost.
Smart contracts are stored and executed on a blockchain for safekeeping. Since these blockchains are decentralized, no single entity can control the financial functions performed on-chain.
Pro Tip:
Many traders will use MetaMask with DeFi applications, but software wallets are not as secure as hardware wallets. To best secure your investments, use a hardware wallet. Most hardware wallets are not DeFi-enabled, so some traders use MetaMask as their “leather wallet” and hardware wallet as their “bank account.” However, Ledger’s hardware wallet can connect directly to DeFi applications, making it the most secure and useful hardware wallet on the market.
DeFi Apps
New decentralized finance applications are being developed every day as venture capitalists are eager to jump on the new wave of open funding.
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 permissionless exchange of cryptocurrencies. DEXs use 1 of 2 methods to create a market: order books or liquidity pools.
Additionally, DeFi users can take advantage of a relatively new type of blockchain-based service called DEX aggregators. Interestingly, these services are similar to travel booking websites. In the same way that these sites aggregate prices from hundreds of hotel, airline, and travel supplier websites, DEX aggregators compare cryptocurrency prices and trading fees across multiple DEXs. A great example of a DEX aggregator is 1inch – a protocol that offers traders the lowest fees and best prices on their transaction.
Order books
The order book trading 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 buyers and sellers of each asset, and an investor can buy or sell an asset at the highest bid price or the lowest ask price.
Loopring and IDEX are currently the largest decentralized order book exchanges.
Liquidity pools
Liquidity pools are the new way to create a market through what is known as an automated market maker (AMM). DeFi projects Uniswap, Kyber and Balancer are competing to become the main pool of DEX liquidity. Let’s take a look at Uniswap to see how a liquidity pool works.
Uniswap runs on the Ethereum blockchain and facilitates the exchange of Ethereum-based tokens for a low fee (0.3%). However, users also have to pay Ethereum gas fees, which is a major barrier to DeFi adoption on Ethereum. Uniswap offers users the ability to instantly trade Ethereum-based cryptocurrencies by tapping into its smart contract liquidity pools.
These pools of liquidity are funded by other users who collect exchange fees to provide this liquidity.
Ready
Decentralized loans offer higher interest rates than centralized loans with better security and anonymity. The DeFi projects Aave and Compound are the main lending protocols today.
On both platforms, borrowers must offer collateral greater than the amount they are borrowing under 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.
If the borrower defaults, the lender is automatically reimbursed from the borrower’s collateral by the smart contract.
With this level of overcollateralisation, Aave is able to offer 10% APY for certain stablecoin loans with no knowledge of the customer (KYC) required, a truly unique product in traditional finance.
Stable Coins
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 allowed US banks to do business using stablecoins. This marks a historic milestone for cryptocurrency acceptance, and an influx of cash 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 staked. USDT is not issued by smart contracts, but the central Tether is responsible for ensuring that each Tether is properly backed. Importantly, the Tether team is currently under investigation by the New York Attorney General for issuing more Tether than there is USD backing it.
- Coin in USD. 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 the Tether exchange on its platform, and now it aims to capitalize on Tether’s legal issues.
- IAD manufacturer. MakerDAO is a DeFi platform with its own stablecoin, DAI. DAI is different from USDT and USDC because it is not centralized. DAI is run entirely on Ethereum smart contracts, which issue 1 DAI for every dollar held in escrow. The DAI stablecoin is a favorite of the crypto community because it is decentralized, which means better security and no risk of internal fraud.
The cryptocurrency has grown faster than regulators could keep up. New OCC guidelines allowing banks to use stablecoins mean wider acceptance to come in the near future.
That leaves a lot of questions on the table. Which stablecoin will banks adopt and what will happen if Tether is shut down?
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.
CryptoKitties’ explosion in popularity has skyrocketed demand (and prices) for these virtual cats. CryptoKitties are expensive collectibles like limited-edition baseball cards. Similar to baseball cards, each kitty 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 are not 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 tokenizing 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 Ethereum-based and traded on the Ethereum blockchain where their ownership history is stored securely forever.
DeFi investment opportunities
DeFi products use smart contracts and blockchain technologies to offer particular advantages over traditional traditional banking.
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, demand for their token will increase, and so will its value.
The 2017 crypto bull run sparked a wave of new altcoins that were usually nothing more than elaborate pump-and-dump schemes with aesthetically pleasing web pages and plagiarized white papers.
Now, the majority of popular high market cap altcoins are actually the tokens of the largest and most promising DeFi projects. These tokens are volatile – even for crypto – so be careful and don’t invest more than you are prepared to lose.
Recommended conference: 3 Digital Currency Challenges Facing Central Banks
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