Cryptocurrency may have found a killer DApp, in DeFi (Decentralized Finance). It has opened up the cryptocurrency space with a total valuation locked at $8.11B in early September 2020, with a high of $9.605B (source: DeFi Pulse). DeFi is providing an alternative financing instrument for loans, funding and exchanges that do not require the usual documents and papers in traditional finance. Banks would require new accounts to provide their KYC (Know Your Customer) information, along with personal data about employment, salary and assets. DeFi does not have such requirements. It is an open protocol for decentralized finance, and this is the main benefit of using it.
Popular DeFi DApps include Uniswap, Yearn.Finance, Bancor, Maker, Aave and Curve Finance. The DApps are now more user friendly, compared to the early days of decentralized applications. It can be accessed from a web browser with a connected digital wallet. Users do not need to sign up for an account or register their personal information. The user also has complete control of their funds with a digital wallet using public key cryptography.
The Beauty Of DeFi
When you can get a loan without requiring any documents, why would lenders trust you? In DeFi it is about collateralized digital assets. The platform (e.g Maker, Kava, etc.), which in theory is decentralized, requires a deposit of your digital assets as collateral. This can be cryptocurrency like ETH(ether) and wBTC(Wrapped Bitcoin), with created token pairs. It is deposited to a smart contract and executed on the Ethereum blockchain network (in most cases). Users pay the gas cost and transaction fee, and their collateral is deposited by a protocol in exchange for a token. That token is usually in the form of a stablecoin, and is immediately available for whatever purpose a user wants.
Decentralized platforms are not controlled by anyone. It is supposed to be a facilitator of exchanges i.e. DEX (Decentralized Exchange). There are different types, that include AMM (Automated Market Makers) which lock tokens for liquidity in Liquidity Pools for various markets that provide the best yields to users called Liquidity Providers. These platforms are like banks, but without the centralized governance and authority. They are trustless and permissionless, so any user can participate as long as they have a digital wallet that allows access to their tokens on the blockchain.
The user did not even have to pass a background check or perform all the usual steps in applying for a loan. As long as you have digital assets to collateralize, you provide it to the platform and you get the amount based on an over-collateralized ratio (x/y). That may not sound right if you think that you are giving your assets in exchange for less than its value. You don’t lose your digital asset at all. Instead you are allowed to borrow money, based on a borrowing ratio (it varies from platform to platform) of you the digital asset. You get your funds and a token from the platform.
You are free to do whatever you want with the funds you receive from your collateral. To reclaim your digital assets, you must pay back the amount that was borrowed along with a fee. This also burns a platform token, increasing the value for token holders. The collateral is then released back to the user. This method of financing allows users to keep their digital assets while borrowing from it. If the user is not able to pay back the borrowed money, the platform will liquidate the deposited collateral.
DeFi platforms can be thought of as a form of DeBank (Decentralized Bank). They are just like any bank, whether brick-and-mortar or digital. The main difference is that these platforms do not require any sign-up or personal information. All you need is a digital wallet. The good thing this has to offer are financial services for the unbanked, which is estimated at 1.7 Billion adults according to the World Bank. It just so happens that the unbanked do have access to the Internet, mostly via their smartphone. The Internet is all you need to access DeFi services i.e. DeBanks.
The difficulties in getting financial services is apparent to those who don’t have the proper documents. Many people do not have requirements like driver license, passport and full time employment. The typical bank requires personal information from their customers along with those documents. This creates more financial exclusion rather than inclusion when it comes to providing service. Many of these people are not able to apply for bank accounts because they do not fit the mold. Minimum deposits are required along with proof of income, like billing statements and payslips. It is unfortunate that lack of those document can be an obstacle to getting a bank account and availing of financial services.
When compared to some banks, crypto-collateralized loans might actually be cheaper. Since DeFi has just started, there is no track record over time that proves it is much better to take a loan out from a platform rather than going to a local bank or cooperative. For non-collateralized loans, user would have to pay back the amount through installments with an interest rate. It can be much more expensive over time when paying by installments.
Theory Differs From Reality
Pundits draw a pretty picture of DeFi. However, it is not perfect by any means and there are still things that need improvement. The decentralized, open access and no barrier entry are all on the positive. An automated financial system is what DeFi is offering, taking away the privilege of banks and other financial institutions for providing money. While it works well in theory, there has to be a reality check. Those who admit that there are still issues are correct and should not be dismissed for their viewpoints.
- Smart Contract Vulnerabilities — Security is one of the most serious issue in DeFi. Back in the early days of Ethereum, a smart contract hack led to the fall of the first DAO. That event led to the hard fork that created Ethereum and Ethereum Classic. Certain DeFi projects have been exposed, like YAM. It is bugs in the code that developers missed which can have disastrous consequences. What DeFi developers have to consider are smart contract auditing and serious cybersecurity testing to give users more confidence in their platform.
- Slippage — Stablecoin slippage was a problem that became apparent with Maker DAO and their DAI token. Slippage occurs when the peg changes value in a digital asset, affecting the value of stablecoins. This can lead to impermanent loss to users affecting liquidity provider’s earnings. Projects like Curve Finance attempt to address this issue with low risk stablecoin trading.
- Governance — As much as users in the crypto space hate the word centralization, if you look further into some of the projects it is not as decentralized as we think. When digital assets are pegged to fiat, it is not exactly determined by the market, but by a Central Bank. Some DeFi projects may also offer more influence to those who hold more tokens, thus allowing for certain users to have more say than others when it comes to digital governance. While governance is necessary, it must be in agreement with the community and not just favor a few token holders. Otherwise it would be more like a digital oligopoly. The problem with this system is going to be like what is happening in traditional finance, rife with abuse and manipulation. Those at the top will savor the benefits while those at the bottom suffer.
- Bubble — Careful observation by analysts show that DeFi is a big bubble. When it bursts, many will get rekt’d if the motivation is only short term and not long term. If things don’t come crashing down, and DeFi finds more adoption to sustain liquidity, then it can prove the critics wrong. The problem is how unpredictable the market is when it comes to cryptocurrency. News and rumors can quickly change things. Some in the industry, like Messari CEO Ryan Selkis believe that when the bubble bursts it will crush crypto traders. This is like playing the “Greater Fool Theory”. The DeFi space will benefit those who came early, since they can dump on those who came late. It seems DeFi is just one place where money is being pumped waiting for more users until those who had come early can dump and collect their earnings. This is why users have to look deep at the DeFi liquidity pools they are putting their assets into and make sure they have a mitigation plan in case things take a bad turn.
- High Risk — When you put your money into a high risk investment, you should probably have insurance. DeFi for the most part, is like swimming in a sea full of sharks, hoping to survive. There are no insurance policies when depositing digital assets. If your assets lose value over time, that is a problem and the smart contract could liquidate your assets. One of the highest risks when putting funds in DeFi are exit schemes by their developers, like what happened with SushiSwap. Another type of risk are Black Swan Events, which are unpredictable market disrupters with a severe impact. These events can severely tank a token’s prices. Users have to consider these risks, and look for a platform that can mitigate against them.
- Compliance — When you are a platform making money and not sharing it with any government and jurisdiction (e.g. taxes), it will surely lead to scrutiny from regulators. DeFi is not compliant with financial regulations like KYC, AML and ATF (Anti-Terrorist Funding) since it does not require users to register or provide any personal information. That in itself can become a problem if the platform is not truly decentralized. This is the reason digital exchanges like Coinbase and Binance cannot be considered true DeFi platforms since they collect user information for compliance purposes. For the most part users who get into crypto often do so from an on-ramp like digital exchanges (e.g. Coinbase), which are regulated and require user account registration and KYC data. It would be catastrophic if DeFi platforms were closed because of compliance violations. As long as they are decentralized they can circumvent regulations since there are no entity who can claim ownership of the platform.
DeFi is both an innovative idea for DApp developers and a high risk venture into unregulated financing. Some say it is the new crypto hype like ICO’s were in 2017. Many are just like science experiments being tested to see if it works. There has to be a balance to address the common problems like slippage and impermanent losses. More support for collateral types and a community-driven consensus mechanism for digital governance can help manage protocols as part of the improvement process. The need for more automated decentralized protocols in the platform’s code can help bring more efficiency in the DeFi space.
DeFi has been good for Ethereum, since the tokens used for pairing in Liquidity Pools are ERC20 tokens with ETH. The price of ETH increased between the months of July and September 2020 in relation to the increase in market cap of the DeFi projects (source Coinmarketcap). ETH began its surge on July 23 at a value of $262.39 opening ($30,733,019,165 marketcap) until a peak of $440.24 on September 3 ($43,370,721,326 marketcap) before its descent. DeFi may very well be the type of killer DApp the Ethereum blockchain needs to bring more use cases for ETH and ERC20 tokens.
In order to sustain these liquidity ecosystems, there has to be a consistent flow of tokens and assets. A suggested way to bring more liquidity into the DeFi space is through CeFi (Centralized Finance)/DeFi collaborations (CeDeFi). It is already happening with a centralized exchange like Binance funding or supporting DeFi projects. CeFi can also help with regulatory compliance as the bridge to DeFi services. This can lead to more innovative DeFi services with seed funding, but it can also be a bubble about to burst if these new financial instruments don’t gain any support. CeDeFi is just one way to bring improvements in the DeFi space, and is not the absolute solution to the problems. For the average user it is time to be more rational in the DeFi space and not fall for the “get-rich-quick liquidity traps” that can lead to huge losses.
Note: This is not financial advice. Please do your own research always to verify facts before making investment decisions.