The economic value present in DeFi platforms has almost tripled since the beginning of the year, reaching 42 billion dollars. Currently it’s around 36 billion, following the downsizing of the market on February 23rd. The Index DeFi Pulse , which tracks ten of the largest tokens by market capitalization, has risen more than 260% year to date.
Crypto fund manager Bitwise recently launched a DeFi fund, which tracks the weighted value of a basket of DeFi tokens. More listed trusts may arrive from the USA: in recent weeks, Grayscale Investments, the largest fund manager in the crypto industry, has filed for authorization to token-based investment trusts for DeFi services, including Yearn Finance, Aave and Chainlink.
The arrival of institutional investors into the DeFi ecosystem, in the form of investment or venture capital, will increase the liquidity and legitimacy of the sector. Institutional support will be essential to guide the ecosystem through regulatory changes and the gradual adaptation of current market infrastructures.
The challenges that DeFi applications pose are related to the impossibility of stemming unfavorable market events. As in the recent case where DeFi lending platforms liquidated around $25 million in assets as the price of Ethereum quickly plummeted by 15%. This was the highest amount paid in the last 3 months.
What is Decentralized Finance? (DeFi)
DeFi is an ecosystem of decentralized financial applications built on top of blockchain infrastructure. A set of connected and related applications that offer new models of value creation and distribution in user communities.
DeFi allows financial services with some fundamental characteristics: being transparent in transactions, open to everyone without the need to request permission from a central party, open source as regards the software code on which they are based. Users maintain control of their assets by interacting in the ecosystem through decentralized applications (dApps).
Main advantages of DeFi
The main advantage of DeFi is the easy access to financial services, especially for people who are excluded from the current financial system. Since the traditional financial system relies on the generation of profits by its intermediaries, its services are generally not easily accessible to the low-income population. DeFi promises to cut costs significantly, and even low-income individuals will therefore benefit from a wider range of financial services.
If traditional finance relies on intermediaries, DeFi applications do without them. The software code of each DeFi application specifies its execution rules, without users having to delegate control of their funds. This reduces the costs associated with brokerage and potentially allows for the development of a frictionless financial system. This promise has yet to materialize, given that currently the most used blockchain for DeFi, Ethereum, is overloaded with requests and its costs are not yet accessible to the masses.
Another advantage is the modular framework, meaning DeFi applications are interoperable and potentially create new financial markets, products and services.
Financial data is recorded on a specific blockchain (Ethereum, Cardano, Polkadot, Algorand, etc.) and disseminated in the network of nodes, making censorship or the potential suspension of the service really difficult.
Main Use Cases of DeFi
Lending services represent one of the most popular applications within the DeFi ecosystem. Lending and borrowing has many advantages over the traditional credit system. These include instant settlement of the transaction, the ability to collateralise digital assets, and no credit checks.
Since lending services are developed on public blockchains, the required trust is based on the mathematical functioning of the underlying blockchain. DeFi lending platforms reduce counterparty risk, make granting and borrowing potentially cheaper, faster and more accessible.
Decentralized Exchanges (DEX)
DEX platforms allow users to trade digital assets without the need for an intermediary – the company representing the exchange – to manage the funds on their behalf. Decentralized exchanges will come to have lower trading fees than their centralized counterparts, although this is currently not true of Ethereum, at least until its scalability issues are resolved.
These services can include issuance of stablecoins and tokenized insurance.
In particular, decentralized stablecoins can be used for everyday use as digital money not issued or controlled by a central authority. Blockchain insurance could eliminate the need for intermediaries and allow risk to be distributed among many participants. In the future this could lead to lower insurance premiums with the same quality of service.
Challenges for DeFi
- Scalability: Blockchain technology develops slower than centralized technology services for the complexity of it, which is also reflected in the applications built on top. DeFi application developers need to be aware of these limitations and optimize their products accordingly.
- Risks of software bugs and user errors: These applications are still in an early stage of maturation, so they are not free from bugs and potential exploits. An example of this is when funds are withdrawn incorrectly or lost because of programming errors. Furthermore, DeFi applications transfer management responsibility from intermediaries to the users. This can be a critical aspect for many. Designing services that minimize the risk of a user error is a complex challenge because the services are implemented on immutable blockchains.
- User Experience: Currently, using DeFi applications requires a learning commitment from the user. In order for DeFi applications to become a central element of the global financial system, they will have to simplify their interfaces and make them user friendly even for non-technologically advanced users, in the same way as what happened with the consumer applications that we all use today in our smartphones.
Ethereum is currently the blockchain software where the largest number of DeFi dapps are developed. This is because Ethereum has an advantage due to its composability, which is the fact that the different DeFi products can be hooked to each other to build a more complex structure. Developers in DeFi services can leverage any combination of open finance without the need for authorization, as it is open source code.
The real transformation happens when those involved in the process gain value. Most of the applications and protocols are owned by their respective communities, some even started by anonymous groups. If the traditional world of capital formation predicts an increase in value for investors and employees, with DeFi the same users of the projects create value. Users form communities around a specific DeFi token, which they own and use that property to vote on the future of the token.
Investors and market players are starting to realize just now, how further this new decentralized finance infrastructure can go. Many experts believe that once the lens through which the market looks at DeFi becomes increasingly refined, adoption and investment will grow exponentially, similarly to what happened with major cryptocurrencies. As services and applications mature, and best practices on how to assess risk develop, DeFi has a promising future on the horizon.