DeFi stands for decentralized finance, and it’s a brand new financial system that’s being built on top of the Ethereum blockchain. The term decentralized refers to the fact that there is no centralized authority controlling transactions, the way a bank or PayPal does in the traditional financial system.
2020 has been the year of DeFi, and there are a number of reasons for that.
- DeFi is an open-source financial system for anyone in the world who wants to use it — all you need is an Ethereum wallet. Anyone in the world can access DeFi. There is no credit check and no banker who can say yes or no.
- Traditional bank accounts yield almost no interest on deposits. For instance, the interest rate on a Fidelity bank account is 0.01%. By allocating digital assets to DeFi, the smart investor can earn anywhere from 5 to 10% on their deposits.
- Sending money around the world is expensive and slow. $100 sent from Norway to the United States will take five days to get there and cost 10% in fees. Compare that to sending a stablecoin: ten minutes and the transaction costs a dollar or two.
These are just a few of the reasons why DeFi is popular. Other factors driving DeFi use include decentralized exchanges, tokenized Bitcoin on Ethereum, governance tokens, etc.
Although DeFi is an improvement over the existing financial system, there are still a couple of drawbacks. However, these downsides are outweighed by the benefits.
- There is less accountability. Anyone can create a DeFi dApp and take deposits. If the dApp is buggy and loses money (which happens) there is nothing investors can do. That’s different from a bank account with FDIC insurance or money held with a company like PayPal, which would be liable for losses.
- Scams can proliferate since they can’t be stopped. Even when a project is a known scam it can’t be shut down, which is bad in that unwitting investors can continue to lose money, but good in that it shows how DeFi is unstoppable.
DeFi is Hot: Here’s Why
The value locked in DeFi hit $3 billion near the end of July 2020. Before the ink was even dry on the headlines celebrating this fact, the value locked had reached $4 billion. To be sure, a lot of this growth was the result of ETH’s skyrocketing valuation. However, ETH prices aside the numbers show that DeFi is becoming increasingly popular and $10 billion in value locked seems like an inevitability at this point.
Another interesting fact is that there is now more BTC locked up in Ethereum than there is on Bitcoin’s lightning network. Most of this is in Wrapped Bitcoin — WBTC token, although there are other BTC tokens on Ethereum as well. Investors like to put their BTC on Ethereum since they can use it to collateralize loans or deposit it with a crypto lending platform to earn interest.
The total amount of BTC on the Ethereum blockchain
One of the most discussed DeFi solutions recently has been yield farming, the practice of allocating capital in the DeFi ecosystem in order to accumulate a reward token like Compound (COMP).
How does DeFi work?
DeFi replaces the centralized organization (like a bank or PayPal) with a smart contract. These smart contracts are very versatile and can be programmed to do all sorts of things, from originating loans to trading assets. Anyone can create a DeFi dApp, but the best dApps are coded by professional teams and thoroughly audited before release.
Sometimes DeFi projects with bad code are exploited and funds are stolen from investors. In other cases, the team might discover a bug and shut the project down. This was the case for tBTC which was shut down just 48 hours after its launch.
What are the main DeFi projects?
Judging by value locked, MakerDAO is the most popular DeFi dApp. It was the first one of its kind to accrue $1 billion in assets and Maker is rapidly moving toward the $2 billion mark. In many ways, MakerDAO is the beating heart of the DeFi system, and it’s valuable for two main reasons.
- Traders can deposit ETH into Maker and then take out a loan in DAI. In this way, MakerDAO provides decentralized leverage. It’s also one of the first times in history that someone can take out a loan without even having to provide their name.
- MakerDAO mints (creates) DAI which is the most popular decentralized stablecoin in the DeFi ecosystem. Many DeFi applications use DAI, and MakerDAO is the only platform that can create it.
Value locked in MakerDAO has been growing consistently since 2018
Uniswap is one of DeFi’s largest decentralized exchanges (DEX). Because it’s a DEX the Uniswap platform cannot freeze accounts or block trades, the way an exchange like Binance or Coinbase can. Liquidity on Uniswap comes from investors who deposit their coins. Investors choose to do this because Uniswap rewards them with a percentage of the trading fees that the platform collects.
Uniswap has been in the news recently for its massive spike in trading volume. Many of the comments referenced the fact that there was more trading volume on the decentralized Uniswap than there was on stalwart centralized exchanges like Gemini and Poloniex. This was, without exaggeration, a momentous achievement for a decentralized financial services platform.
Record volume on the Uniswap decentralized exchange
Compound is the platform that’s mostly responsible for starting the yield farming craze. By distributing their COMP token to investors and borrowers, Compound incentivized people to use their platform and their value locked has grown tremendously in just the last few months.
Compound exponentially increased its assets under management in June and July of 2020
Is DeFi a bubble?
While some parts of the DeFi ecosystem are “bubbly,” it’s important not to apply the label too broadly. Yes, tokens like COMP and YFI have grown too fast and become overvalued, there’s no doubt about it. However, in a larger sense, DeFi is anything but a bubble.
Earning interest on stablecoin deposits, quickly sending money around the world, taking out collateralized loans, decentralized exchange trading, futures contracts, etc. These are awesome financial products that serve a real purpose and they work.
The ICO boom of 2017 saw a lot of money coming into crypto with the promise of a big payoff from a future product. With DeFi, we’re starting to see a lot of money come in, but the big difference is that this money is flowing to working products, many of which are already generating a profit.
The Promise of Ethereum
If DeFi looks popular now, just wait until Ethereum 2.0, which will bring staking to the Ethereum network. This is going to be a massive event and will likely drive the price of Ethereum significantly higher. There is a historical precedent for this, as both Tezos and Cardano have seen significant price gains when they implemented their own staking consensus mechanisms.
The total value locked in DeFi is only going to grow as investors look to put their fiat currency to better use. DeFi’s fintech solutions are exciting and revolutionary. The use case is there, adoption is on the rise, and all the signs point toward continued growth in the ecosystem.