Decentralized finance, also referred to as “DeFi” or open finance, aims to recreate traditional financial systems (such as lending, borrowing, derivatives, and exchange) with automation in place of middlemen. Once fully automated, the financial building blocks of DeFi can be composed to produce more complex capabilities. Today, the primary venue for decentralized finance is Ethereum, but in principle these ideas can be implemented on any smart contract platform.
In this beginner’s guide to decentralized finance (“DeFi”) we review the following:
- • Stablecoins. A building block of DeFi, coins that are engineered to remain “stable” at exactly 1.00 units of fiat.
- • Decentralized lending. Programmatically take out a loan on the blockchain. No bank account required.
- • Decentralized exchanges. Buy and sell cryptocurrencies through a blockchain, rather than a exchange.
- • Collateralization. Provide digital assets to collateralize your decentralized loans,
- • Decentralized Identity. Identities used in the context of smart contracts
- • Risk management. High returns in DeFi are often accompanied by even higher risks.
If we try recreating traditional financial products on a blockchain, we are faced with an immediate problem: price volatility. Specifically, the native cryptocurrency of the Ethereum blockchain (namely ETH) experiences large intraday swings in the USD/ETH exchange rate, sometimes moving 10% or more in a single day.
An instrument with this degree of price volatility is less than ideal for a number of traditional financial products. For example, if you take out a loan, you don’t want loan payments to oscillate by 10% right before a payment. That degree of volatility would make it hard to plan for the future.
Stablecoins are one solution to this problem. These are cryptocurrencies specially engineered to remain “stable” at an exchange rate of approximately 1.00 units of fiat per coin. The Stablecoin Index and Stablecoin Stats provide a good list of the top stablecoins.
Given functional stablecoins like USDC and DAI, we can start rebuilding pieces of the traditional financial system as automated smart contracts. One of the most fundamental is the concept of borrowing and lending.
There are a number of DeFi platforms which enable borrowing and lending of Ethereum tokens directly through smart contracts, like Compound, dYdX, and Dharma. An impressive feature of these smart contracts is that a borrower need not find a lender or vice versa. Instead, the smart contract replaces the role of the middleman, and interest rates are calculated algorithmically according to supply and demand.
Decentralized crypto exchanges attempt to put services like Coinbase Pro on the blockchain. That is, they aim to facilitate trades of different cryptocurrencies between two parties. To understand the use case, start with centralized cryptocurrency exchanges. These exchanges act as an intermediary where two parties deposit their assets and are able to trade with each other. While they have worked at scale to facilitate billions of dollars in trades, centralized exchanges do present a single point of failure that can be hacked, censor transactions, or prevent certain people from trading.
Decentralized exchanges aim to address this by using smart contracts to reduce or eliminate middleman.The dream is fully peer-to-peer exchange of all digital assets.There are a number of projects pursuing decentralized exchange of Ethereum-based tokens in various forms, like Uniswap, 0x, and Kyber. For example, Uniswap utilizes a so-called automated market maker (AMM) to algorithmically provide liquidity. Buyers and sellers pull liquidity from the smart contract directly and receive a price quote based on the token quantity desired and the liquidity available. Uniswap will always quote a price regardless of the order size by asymptotically increasing the price as the size of the order increases.
One issue with the decentralized lending and borrowing services mentioned thus far is that they require quite a lot of collateral. This overcollateralization requirement can be a highly inefficient use of capital — and many people do not have the extra funds in the first place to provide as collateral. However, people are working on decentralized identity and reputation systems that will reduce the collateralization requirements. One of the first applications would be building blockchain analogs of fiat-based credit bureaus like Experian, TransUnion, and Equifax that institutions like banks rely on for credit scores.
Now, to anticipate an objection, it’s certainly true that credit bureaus can put certain groups such as international and young people at a disadvantage. But newer services like Lending Club have addressed the problem of overreliance on FICO scores by offering additional data points like home ownership, income, and length of employment.
Decentralized identity and reputation services could offer something similar by including attributes such as social media reputation, history of repayment of previous loans, vouching from other reputable users, and the like. Making this useful for actual financial decisions will require a lot of trial and error on the specific data points to use and the corresponding collateral requirements, and we are just at the beginning of that process.
While DeFi is fascinating, it is important to acknowledge the risks that come with it. Let’s enumerate some classes of risk:
- • Smart contract risk. Many of these systems are new and need more time to be battle tested. When protocols are interacting with each other, the smart contract risk compounds. There are also risks associated with specific collateral types used to back loans.
- • Overcollateralization reduces volatility risk, but if the price of the collateralized asset falls too quickly, a margin call isn’t guaranteed to cover the full amount that was borrowed. However this should be less of a risk with a reasonable collateralization ratio and vetted collateral types.
- • Regulatory risk. DeFi platforms have varying degrees of decentralization, and we have not yet seen court cases that test all the claims being made. We’ll have to see what happens here.
Decentralized insurance like Nexus Mutual and Convexity are an area within DeFi that provides the ability to hedge some of these risks. Prediction markets like Augur also address the hedging use case by allowing users to bet on the probability that there will be a smart contract issue with one of the protocols they are using.
With that said, these hedging methods themselves are in their infancy, and add smart contract risk of their own. We do think they will mature, however. And if the DeFi space gets large enough, then traditional insurance companies might offer products too.
Taken from Nakamotos Beginners Guide to DeFi