What is DeFi?

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Decentralized finance (DeFi) seems a lot more complicated than it actually is. DeFi is not a company or a cryptocurrency — it’s an attempt to recreate the existing financial system on the blockchain. This is done through smart contracts, which are programs that live on the blockchain. Just like how Bitcoin is immutable and trustless, so are smart contracts. This allows for functions like peer-to-peer lending markets, streaming services and decentralized exchanges to be built into smart contract applications.

The DeFi industry offers stablecoins, lending, exchanges and other products and services found in the traditional banking industry, but with a catch. The difference lies in DeFi’s distinct technological advantages that allow for superior products that were never before possible.

How Decentralized Finance Works

Recent advancements in blockchain technology have sparked a new wave of online financial services without a central authority for the 1st time. DeFi is an umbrella term for any decentralized financial product. The majority of DeFi products rely on Ethereum and its turing-complete programming language Solidity. However, new entrants into the industry are giving Ethereum a run for its money –– namely Solana, Avalanche and Binance Smart Chain.

Central banks employ thousands of people, incurring huge expenses to offer products and services. Banks also need to rely on the legal system to handle disputes. 

DeFi replaces employees and the legal system with Ethereum smart contracts on the blockchain, drastically reducing operating expenses in order to provide products many deem superior to their traditional bank counterparts. 

Smart contracts are legal or business agreements written in code (Ethereum’s Solidity programming language). 

Smart contracts typically replace the need for trust with the use of collateral. By requiring collateral, parties are incentivized to behave properly without anyone watching over them. Smart contracts hold collateral in escrow and can handle defaults and successes automatically for negligible cost. 

Smart contracts are stored and executed on a blockchain for safekeeping. Since these blockchains are decentralized, no one entity can control the financial functions that are executed on-chain.

DeFi Applications

New decentralized financial applications are being developed every day as venture capitalists are eager to hop on the new wave of open finance. 

Currently, stablecoins, lending, exchanges and non-fungible tokens (NFTs) are the largest markets in the DeFi space. Here’s Benzinga’s breakdown of these DeFi markets. 

Decentralized Exchanges

Decentralized exchanges (DEX) allow the permissionless exchange of cryptocurrencies. DEXs use 1 of 2 methods to make a market: order books or liquidity pools.

Moreover, DeFi users can take advantage of a relatively new type of blockchain-based service referred to as DEX aggregators. Interestingly, these services are similar to travel booking websites. In the same way that these sites aggregate prices from hundreds of hotel, airlines and travel provider websites, DEX aggregators compare cryptocurrency prices and trading fees across several DEXs. A prime example of a DEX aggregator is 1inch - a protocol that provides traders with the lowest fees and best prices on their transaction.

Order Books

The order book method of exchange has been used by centralized finance (CeFi) for a long time. An order book provides the exchange of assets so long there is supply and demand at the same price point. This type of structure pairs buyers and sellers of each asset, and an investor can buy or sell an asset at the highest bid or lowest asking price.

Loopring and IDEX are the current largest Decentralized order book exchanges.

Liquidity Pools

Liquidity pools are the new way to make a market through what's known as an Automated Market Maker (AMM). DeFi projects Uniswap, Kyber and Balancer are competing to become the leading liquidity pool DEX. Let’s take a look at Uniswap to see how a liquidity pool works. 

Uniswap runs on the Ethereum blockchain and facilitates the exchange of Ethereum-based tokens for a small fee (0.3%). However, users must also pay Ethereum gas fees, which is a major roadblock to the adoption of DeFi on Ethereum. Uniswap offers users the ability to exchange Ethereum-based cryptocurrencies instantly by tapping into its smart contract liquidity pools. 

These liquidity pools are funded by other users who earn the exchange fees for providing this liquidity. 

Lending

Decentralized lending offers higher interest rates than centralized lending with better security and anonymity. DeFi projects Aave and Compound are the leading lending protocols today.

On both platforms, borrowers must offer collateral greater than the amount they borrow into the loan smart contract. The smart contract safely holds collateral in escrow throughout the term of the loan, replacing the need for a trusted middle-man. 

Should the borrower default, the lender is automatically repaid the borrower's collateral by the smart contract.

With this level of overcollaterization, Aave is able to offer 10% APY for certain stablecoin loans with no know-your-customer (KYC) required, a product truly unheard of in traditional finance. 

Stablecoins

A stablecoin is a cryptocurrency whose value is tied to another asset, most commonly the U.S. dollar. On January 4, 2021, the Office of the Comptroller of the Currency (OCC) officially allowed U.S. banks to conduct business using stablecoins. This marks a historic milestone for cryptocurrency acceptance, and an influx of cash is likely on the horizon. 

Tether, USD Coin and DAI are the biggest stablecoins to date. But, DAI is the only decentralized stablecoin of the 3, and the only 1 that is truly a DeFi product. Tether and USD Coin are both centralized and run by private companies. 

• Tether. Tether was launched in 2014 and is the biggest stablecoin by market cap. Tether issues 1 of its USDT tokens for each dollar staked. USDT is not issued by smart contracts, but the central Tether is in charge of making sure each Tether is properly backed. It’s important to note that the Tether team is currently under investigation by the New York Attorney General for issuing more Tether than there is USD backing it. 
• USD Coin. USD Coin (USDC) was created by Coinbase in response to the issues arising within Tether. Unlike Tether, USDC is voluntarily regulated by U.S. financial institutions. Coinbase has never supported Tether exchange on their platform, and now it aims to capitalize on Tether’s legal issues.  
• Maker DAI. MakerDAO is a DeFi platform with its own stablecoin, DAI. DAI is different from USDT and USDC because it is not centralized. DAI is run entirely on Ethereum smart contracts, that issue 1 DAI for each dollar it holds in escrow. The DAI stablecoin is the favorite of the crypto community because it’s decentralized – meaning better security and no risk of inside fraud.

Cryptocurrency has grown faster than regulators have been able to keep up. New OCC guidelines allowing banks to use stablecoins signify wider acceptance to come in the near future. 

This leaves a lot of questions on the table. Which stablecoin will the banks adopt, and what happens if Tether gets shut down? 

Make sure to subscribe to the Benzinga Crypto newsletter to stay informed.

Non-Fungible Tokens

In 2017, a game called CryptoKitties clogged the Ethereum network for several days. 

A CryptoKitty is a virtual cat that has more in common with a bitcoin than a real cat. A crypto kitty is a token on a blockchain – just like Bitcoin, Ether or UNI – these tokens are attached to wallets, are liquid and store value. 

CryptoKitties' explosion in popularity drove demand (and prices) for these virtual cats through the roof. CryptoKitties are expensive collectibles like limited edition baseball cards. Similar to baseball cards, each kitty is non-fungible, or unique.

CryptoKitties proved to the community that the concept of non-fungible tokens (NFTs) could really work to verify collectible digital assets. 

NFTs aren’t limited to digital cats. NFTs are currently taking over the billion-dollar art industry, and a new game called Decentraland aims to show how NFTs might even be used for virtual real estate.

By tokenizing non-fungible assets, they immediately become more liquid, and can even be used as collateral for loans. NFTs can store meta-data providing detailed information about the asset it represents. NFTs are typically Ethereum-based and exchanged on the Ethereum blockchain where their ownership history is securely stored forever. 

DeFi Investment Opportunities

DeFi products use smart contracts and blockchain technologies to offer special advantages over the traditional traditional banking industry.

The DeFi industry is still in its infancy, but already boasts some promising startups. Most DeFi projects use a proprietary cryptocurrency token to power their system. Should one of these DeFi startups create a hit product, demand for their token will increase, and so will its value.

The 2017 crypto bull run sparked a wave of new altcoins that typically were nothing more than elaborate pump-and-dump schemes with aesthetic webpages and plagiarized whitepapers. 

Now the majority of popular, high market cap altcoins are actually the tokens of the biggest and most promising DeFi projects. These tokens are volatile – even for crypto – so be careful, and don't invest more than you’re willing to lose. 

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