Decentralized finance is one of the hottest topics in the crypto space, and many believe it will be much larger than the well-known ICO bubble of 2017.
So what on earth is DeFi? And what could it mean for the crypto space?
In this article, I will answer that question. I will also take a look at
- the popularity of DeFi;
- explain what a collateralized debt position, or CDP, is;
- explain why DeFi is useful and what you can do in the current DeFi ecosystem;
- explore the future of DeFi, and
- highlight some of the current problems with decentralized finance.
The goal is to help answer the question: Should we pay more attention to DeFi-related projects?
Before I jump into the content, I need to say a few quick things. My writings are here to help you with your research and are certainly not investment advice. I am no one’s financial advisor. However, if you read to the end, I’ll also share my take on decentralized finance and let you know which DeFi-related projects I have my eye on. Okay, let’s rock and roll into DeFi.
What are digital smart contracts?
To explain decentralized finance, I must explain what smart contracts are. In short, digital smart contracts let you trade anything valuable without going through an intermediary. Let’s use this as an example: businessman A wants to sell a commodity to buyer B. However, seller A doesn’t trust that buyer B will send the money, and buyer B doesn’t trust that seller A will send the product after making payment.
This brings up the age-old problem of who sends first. To solve this problem, a middleman could be used to act as an escrow agent. This could be expensive, though, and neither seller A nor buyer B wants to waste money on an unnecessary intermediary. This is where smart contracts prove helpful. The contract could be set up so that the assets will only change hands if the seller sends the smart contract a digitalized product deed. Buyer B sends the payment in Bitcoin to the smart contract. If both criteria are fulfilled, the smart contract will execute the trade automatically.
The key thing to know here is that digital assets can be received through programmable smart contracts. They can also be set up to follow custom rules, and each transaction is recorded on a public blockchain. This means that the ownership of the assets cannot be disputed.
In short, decentralized finance takes parts of traditional finance and makes them less centralized by getting rid of intermediaries and replacing them with smart contracts. A straightforward example of this is decentralizing loans and earning interest.
What exactly is decentralized finance, and how does it work?
I’m uncomfortable giving you the impression that the current DeFi products and services are decentralized. Elements of the current DeFi ecosystem are heavily centralized. This is because a big company that makes smart contracts backs many DeFi services and products. Instead, in DeFi you don’t need to trust a third party like a bank since it’s non-custodial finance. That’s a more accurate term to describe what DeFi is.
However, I do not doubt that the marketing departments at DeFi projects would take issue with having to throw around the term “non-custodial finance.” It’s simply not a very sexy buzzword to use. So l will be rude by saying “non-custodial” and not explaining that. Put differently, non-custodial means that you still hold the keys to your crypto and do not trust them with a middleman like a banker.
DeFi loans – over-collateralized loans
Now that you know what DeFi is, let’s consider why you might consider using DeFi products or services. Decentralized finance is all about building more complex financial systems on top of the blockchain and enabling them to work with that store of value, that currency, and that payment system. The cool thing is that you can participate in financial services like loans, collateralized debt, and fundraising, thanks to blockchains that support smart contracts.
So this begs the question, “What are most people doing in the decentralized finance ecosystem?” The most common use cases are borrowing money and supplying money to earn interest. The critical thing to note about taking out a loan or borrowing money in DeFi is that it’s not the same as getting a loan from your bank, where you essentially bring future cash flows forward to today. Loans within decentralized finance are more like getting a loan from your local pawnbroker.
In case you need to know who a pawnbroker is, a pawnbroker is a person or a business that offers loans to individuals in exchange for collateral in the form of personal property. Pawnbrokers typically lend money to individuals who need short-term financial assistance and are willing to pledge their personal property as collateral. The pawnshop owner keeps the borrower’s personal property until the loan is paid. At that point, the borrower gets the property back.
Pawnshops can buy items from people outright or sell items left as collateral that has yet to be picked up. The pawnbroker might lend you 50% of the item’s value and still charge you interest. And if you miss your repayments, they might sell your item to recoup the loan’s value. Pawnbrokers will always lend you less than the value of the item you’re putting up as collateral. And this is known as an “over-collateralized loan.”
Borrowing in DeFi is similar to this. To get a loan, you need to provide collateral, in this case, cryptocurrency. Your asset is locked up in a smart contract called a collateralized debt position or CDP. The thing to know is that if you’re borrowing money in DeFi, it will be over-collateralized. And if the value of your collateral falls too much, you can have your crypto liquidated by the CDP to cover the loan. It’s like a pawnbroker selling an item to cover a loan that’s defaulted.
The fantastic thing about DeFi is that it enables you to access many financial products or services without having to perform KYC or get approval from anyone. It doesn’t use credit scores or discriminate based on your location. In short, DeFi makes financial products available to people worldwide and eliminates the annoying barriers that make traditional finance hard to use.
Earning interest on the crypto you hold on DeFi Platforms
If you’re dipping your toes into DeFi, you’re considering earning interest on the crypto you hold. The thing to note is that there isn’t just a single DeFi interest rate, and you’ll need to shop around to get the best deal. That’s where websites like LoanScan come in. Here you can easily compare the different interest rates on the different DeFi platforms and choose the right deal.
If you’re interested in earning interest on your crypto, then a place to start is Compound. With $634,980,887 of borrowing backed by $2,091,627,777 of collateral across 2 networks at the time of this writing, it’s one of the most popular lending platforms. And after using it myself, I can give it two thumbs up.
For DeFi trading platforms, you have the DYDX exchange, which offers non-custodial margin trading. You can trade pairs like ETH/DAI, ETH/USDC, and DAI/USDC, etc. With a Metamask wallet and the platform, you can send or receive small or large amounts of Ethereum. That means you can trade while having complete control over the keys to your crypto, doing away with the need to trust a centralized exchange that could run off your funds.
TokenSets.com is a pretty interesting DeFi platform that automates your crypto portfolio management and lets you select the trading strategy of your choice. Let’s say that we’re bullish on DeFi, and we think ETH will do well; seeing that the vast majority of DeFi projects are built on Ethereum, we might want 75% of our portfolio in ETH 25% in Bitcoin. The problem, of course, is that it takes a lot of work to constantly rebalance your portfolio. This is where TokenSets.com comes in. Set up the ETH/Bitcoin weight at 75%/25% once, and TokenSets would automatically rebalance it monthly for you—an excellent solution to save crypto holders time and effort.
What is the future of decentralized finance?
Now that I’ve talked about a range of products and services that make up the DeFi ecosystem, I’d like to explore the future of decentralized finance. DeFi is still very young, and that’s why so many people believe in its explosive growth potential. What I find most interesting about the decentralized finance movement is that it could open access to financial services to everyone. World Bank statistics have it that an incredible 1.7 billion adults worldwide don’t have access to a bank account. In other words, the World Bank has excluded 1.7 billion adults from access to essential financial services like loans.
Currently, DeFi loans are overcollateralized. However, as the industry matures some under-collateralized loan alternatives will emerge. I do foresee a loan reputation system coming about shortly, one that’s recorded on the blockchain and enables people to access under-collateralized loans, a bit like how a bank lends you money for a mortgage after you’ve put down a deposit for a house. However, the important thing here is that a bank account would not be needed, the unbanked population could access financial services with just a smartphone.
Another major setback to Defi is the friction to transfer value into and out of the crypto space. How on earth is a non-banked person going to trade their local currency for crypto to participate in the DeFi ecosystem? One way is to use a service like LocalBitcoins and do a real-world peer-to-peer exchange. I’m sure that new methods may be defined in the future.
The potential role people in developing countries could play in the growing popularity of DeFi
I’m also fascinated by the potential role people in developing countries could play in the growing popularity of DeFi. In developing countries, DeFi has the potential to play a significant role in increasing financial inclusion. Many people in these countries don’t have access to traditional financial services due to various factors, including a lack of access to bank branches, documentation, and high fees. DeFi applications can provide an alternative way for these individuals to access financial services. You can get to decentralized financial services from anywhere with an internet connection, and you don’t have to complete a lot of paperwork to use them.
In addition, DeFi has the potential to offer more favorable terms and conditions to people in developing countries, as it can potentially reduce the need for intermediaries, which can lower costs and increase transparency.
Overall, the growing popularity of DeFi could help people in developing countries by making it easier for them to get financial services and giving them access to a broader range of services.
There are many countries in the world that are experiencing rampant inflation. People in developing countries with high inflation need a stable asset they can use to keep their buying power and earn interest simultaneously. They can do that with a platform like Compound, by lending out their DAI stablecoins and earning USD interest. The good news is that these people can now protect themselves and their loved ones if they embrace decentralized finance. This is a massive use case for DeFi that people can use today. And how big can this get once word gets out?
What is the future of decentralized finance?
So now that I’ve shared my thoughts about DeFies future, it would be remiss of me not to highlight some of DeFi’s current problems. A significant issue with DeFi is that it’s complicated for your typical person to understand. To participate in the decentralized finance ecosystem, you’ll need to use Metamask. And that is more difficult for the average person.
Another primary concern is that smart contracts can have bugs in them. There are numerous occasions where bugs have occurred, and users have lost their funds by having them stuck in the smart contract. Now, that’s a scary risk people could take by participating in the DeFi ecosystem.
However, these risks can be managed with decentralized insurance projects like Nexus Mutual, ETHERISC, and CDx. As the industry matures, DeFi insurance will be a big thing and play a key role in giving users the confidence to use DeFi products and services.
DeFi services are mostly speculation-based and let people use their crypto assets differently. There’s no issue with this. However, for DeFi to truly succeed, I’d like to see more meaningful DeFi solutions being created.
Finally, I’ve been unable to find a DeFi platform with a non-custodial solution. All the current DeFi platforms appeared to be crypto to crypto. While the ability to save and earn interest on my money on a platform like Compound, and get fiat funds in my bank account quickly in case I suddenly need the money to pay an unexpected bill, is a wonderful thing, it would be much easier for crypto newbies to get into DeFi if there was a quick and easy way to get Ethereum on some of these DeFi platforms using their bank account.
DeFi remains the preserve of crypto veterans, which could potentially hamper future growth. However, a non-custodial way to get in and out of crypto or Fiat on The horizon could solve this problem. A little-known project I’m following is called Nimiq. And one of the products they offer is known as NimIQ Oasis, allowing non-custodial crypto-fiat trades.
I know there is a lot to take in. However, I’d like to share my closing thoughts on decentralized finance with you. I’m optimistic about the future of DeFi and believe it will go from strength to strength as more people dip their toes into the DeFi waters and even more products and services are built.
One of the critical things set to supercharge DeFi’s growth is the terrible returns banks try to give you on your savings. In the past few years, many traditional banks have given low returns on savings accounts, usually well below the inflation rate. This has led some people to look for alternatives, such as DeFi platforms, which may offer higher returns.
Another attractive solution to consider is where retail bank interest rates will go. With all this funny money flying around, interest rates on cash deposits are sinking lower and lower. It wouldn’t surprise me if DeFi started attracting a more mainstream audience looking to earn a bit of interest on their cash. I’m especially interested in seeing if DeFi will be widely used in developing countries to protect against inflation and if it can give the 1.7 billion people in the world who don’t have bank accounts access to financial products.
Now, in terms of favorite DeFi projects, given that the vast majority of DeFi projects are built on Ethereum, if DeFi takes off, it could trigger a big move for ETH. And more and more people are learning about and wanting to get involved in decentralized finance, which is why Ethereum is my biggest DeFi play.
