The financial services sector has always presented some of the strongest use cases for the nascent blockchain technology. From online payments and remittance to cryptocurrency storage and trading, blockchain has been coming up with ways to challenge traditional finance from day one. After the recent emergence of the decentralized finance (DeFi) movement, the case for blockchain in finance has become much stronger.
The term DeFi, short for decentralized finance, is used to describe a variety of blockchain-powered applications aimed at creating peer-to-peer alternatives to traditional financial services and institutions. Having generated a lot of excitement last year, decentralized finance has kept powering ahead, attracting impressive amounts of capital and meeting expectations that it would be among the leading trends of 2020.
According to DeFi Pulse, the go-to data aggregator for decentralized finance, the total value locked in DeFi protocols currently stands at just under $11.5 billion, up from less than $1 billion a year ago. While this certainly pales in comparison to traditional financial markets, the key takeaway here is that DeFi has grown more than tenfold over the past 12 months. This is a clear sign of decentralized finance’s surging popularity. What’s most encouraging is that rapid growth seems to reflect the strength of DeFi’s value proposition. Let’s examine what makes decentralized finance such an investment draw.
The benefits of decentralized finance
The DeFi movement promises to bring a lot of benefits to customers and investors, including eliminating intermediaries and central oversight, making financial markets more accessible to retail investors and creating new investment opportunities. To achieve their lofty ambitions, DeFi developers are making use of some fundamental properties of blockchain technology.
The term ‘decentralized finance’ is already a clear indication of what the DeFi movement considers to be its defining feature. That’s hardly surprising. Decentralization is at the heart of blockchain’s value proposition. The aim is to move away from relying on corporations and other institutions for oversight, server space, data storage and so on. Blockchain networks achieve this by ensuring that one transaction history is shared among all of their members.
The decentralized approach can help democratize banking and finance by ensuring easy access to financial services for everyone.
Most DeFi apps run on Ethereum, the second-largest blockchain protocol, after Bitcoin. As a permissionless (public) blockchain, Ethereum is highly decentralized and readily accessible to anyone interested in building or using a DeFi app. In addition, the permissionless nature of the blockchain, as well as the interoperability it enables, opens the door for all kinds of third-third party integrations.
It is important to note that these features are not exclusive to Ethereum. However, being the leading network for smart contract development has positioned Ethereum as the preferred platform for building not only DeFi applications but also other types of decentralized apps (dApps).
With decentralization also comes greater transparency. Since the distributed ledger containing information about all the activities that have taken place on a blockchain network is shared by everyone, the network’s data is publicly available for inspection. Furthermore, the cryptographic principles underpinning blockchain guarantee that information is recorded only after its authenticity has been verified.
For customers, the transparency afforded by DeFi applications can be a game-changer. It can improve due diligence and help people identify and avoid potential financial scams and harmful business practices.
Through the clever use of cryptography and consensus algorithms like proof-of-work, blockchain technology achieves true immutability. This guarantees that manipulating records stored on a blockchain network is practically impossible. In combination with the features we already discussed, this creates a level of security that’s difficult, if even possible, to achieve with traditional means.
DeFi apps bring the inherent advantages of blockchain to the financial sector, while also striving to create convenient interfaces to ensure a smooth user experience. In addition, employing smart contracts such as dApps provide extra protection against bad actors and fraudulent transactions.
How can DeFi help the financial services sector?
From what we’ve seen so far, DeFi certainly has the potential to benefit traditional finance. But as with any transformative technology, DeFi’s potential is not limited to just improving on the current status quo. Rather, its true strength lies in its ability to disrupt the space by enabling new types of financial products and services. Even at this early stage, the technology is showing great promise in that regard. It is already changing the way people manage their assets, borrow and lend money, and trade online. Here are just some of DeFi’s most prominent use cases:
Lending and borrowing
DeFi has enabled the development of peer-to-peer lending and borrowing solutions that bring significant benefits to the end-user. These services come with cryptographic verification mechanisms and smart contract integration that eliminate intermediaries such as banks that typically verify and process lending and borrowing transactions. This makes the process much cheaper and faster, while still making sure that the counterparties involved in a transaction are protected. Other benefits include instant settlement of transactions and greater accessibility.
Lending and borrowing dApps are among the most popular DeFi applications. One platform that has become particularly popular in this category is Compound. Lenders on the platform can supply crypto assets to a number of lending pools that are available for other people to borrow from. For these lenders are entitled to a share of the interest borrowers payback to the pool. The interest rate a lender earns is based on their contribution to the pool, as well as the liquidity of the crypto assets.
The growing popularity of DeFi lending platforms has opened up new ways for people to manage their savings. As mentioned above, by locking their crypto assets into lending protocols such as Compound, users start earning interest on those assets. This has led to the emergence of DeFi saving apps that can plug into different lending protocols to maximize their users ability to earn interest. The term ‘yield farming’ has been introduced to describe the increasingly popular practice of users moving their idle crypto assets around in different lending protocols to get higher returns.
The Ethereum boom from a few years ago led to the emergence of one of blockchain’s most important trends – tokenization. The protocol’s robust smart contract capabilities enabled the issuance of crypto tokens – digital assets that exist on a blockchain and can have various properties and uses. These range from utility tokens that are native to a specific dApp, security tokens that can be likened to digital shares, real estate tokens enabling fractional ownership over physical properties, and more.
Tokens can also provide exposure to other assets – physical and digital – such as oil, gold, fiat currencies, and cryptocurrencies. These so-called crypto synthetic assets are collateralized by tokens locked into Ethereum-based smart contracts. One of the most popular synthetic asset platforms, Synthetix, currently has almost $600 million locked in smart contracts.
Closely related to crypto synthetic assets, stablecoins are crypto tokens pegged to a stable asset or basket of assets. In most cases, stablecoins are pegged to fiat currencies like the US dollar, but there can also be commodity-pegged and cryptocurrency-pegged tokens. Stablecoins aim to reduce the price volatility of cryptocurrencies and strengthen the case for using blockchains as payment solutions.
We can identify three types of stablecoins based on the method used to maintain their value. Collateralized stablecoins require the coin issuer to hold the assets against which their coin is pegged (fiat currency, gold, silver, etc.). Other coins are pegged to cryptocurrencies and their value is maintained by over-collateralization and stability mechanisms. Finally, there are also non-collateralized tokens whose prices are kept at fixed levels algorithmically.
Stablecoins are in many ways what fuels the DeFi engine. They’re widely used across the space to enable remittance, lending and borrowing, and other DeFi services.
DeFi is also starting to impact the way we exchange goods and services online. An example of this is the recent emergence of decentralized exchanges (DEXes), which facilitate peer-to-peer trading of digital assets. Uniswap is one of the major players in this category.
The concept can be easily expanded to include traditional financial instruments and even physical goods, as well as services. One of Limechain’s clients, Idoneus, is utilizing smart contracts and other blockchain features to create a new way for people to buy, sell, rent, and trade luxury goods. Learn more about how LimeChain has been helping Idoneus reinvent the luxury asset market.
Given DeFi’s stellar growth in 2020, it’s hard not to feel optimistic about the future of the space. The new year will likely bring new challenges, but with interest in DeFi being on the rise, fresh opportunities will also arise.
At LimeChain, we are excited about DeFi’s future and we’re eager to contribute to the sector’s success. Do you have an idea for the next groundbreaking DeFi app? Let’s talk about how we may be able to help you build it at [email protected].