April 26, 2022 - 11 min read
Decentralized finance, or DeFi, is a modern financial phenomenon enabled by the composability of blockchains, smart contracts, and oracles. That is, the combination of these three technologies make DeFi a functionally secure and practical way to conduct financial transactions online. Since its inception, the concept of DeFi has evolved beyond facilitating financial transactions, but has been incorporated into business models ranging from supply chains and insurance companies to video gaming and the creator community.
Within a DeFi ecosystem, users need only register for a wallet. ‘Know Your Customer’ screening processes, if they are done at all, are carried out at the time of wallet creation, meaning users can then interact freely with decentralized applications (dApps) which have been deployed on the given blockchain. Once a user takes possession of a wallet and deposits crypto assets, the network of dApps to interact with is wide open for exploration.
Take the Ethereum blockchain, for instance, where users register for a wallet and add crypto assets before interacting with various dApps built upon the network. The dApps themselves do not require users to create new accounts, but recognize the wallet address and other relevant compatible assets and permit interactions with less friction in the user experience.
Without centralized intermediaries creating friction for users, transactions become cheaper and require far fewer ‘accounts’ for which to sign up and to surrender one’s sensitive data. Of course, early blockchains ran into scaling problems, with Ethereum’s gas fees having been notoriously high in recent years due to network congestion. Decentralization inherently enjoys reduced counterparty risks, protects the privacy of users, and guards against censorship or other acts of collusion which tend to plague systems containing single points of failure.
DeFi distributes a network’s power dynamics via properties of decentralization, and makes it secure yet transparent through cryptography and verifiable proof. DeFi is a phenomenon of interoperable, global, permissionless finance run on cryptographic software rails.
The status quo of our global financial system of payments and final settlements places inordinate amounts of power in the hands of very few individuals heading up heavily centralized institutions. While centralization has gotten a bad reputation in recent years, it is difficult to argue that the collective efforts of human civilization focused on concentrated efforts haven’t achieved truly remarkable results. Centralization hasn’t been all bad, but there may be better ways forward.
However, it also lays the foundation for a system to eventually reach stagnation, which inevitably incentivizes legacy stakeholders to invest increasing amounts of time and effort towards preserving their own status and power instead of providing superior and efficient services honoring equitable, fair-market conditions. That is, the power dynamics shift away from fair competition and instead trend towards corruption. High barriers to entry pose little threat to those in power, but stifle competition and consequently, innovation.
Employing open-source software, DeFi protocols run on public blockchain infrastructure, and can be equally accessed and used frictionlessly in a peer-to-peer manner. Not only do users take and keep possession of their crypto assets, but they can also benefit from the transparency that blockchain ledgers provide. Coupled with on-chain analysis, audits, and forensic accounting techniques, a fairer and more open system results.
Since dApps often run on a unified blockchain infrastructure, like Ethereum dApps for instance, the assets and smart contracts facilitating transactions benefit from the same transparency and security advantages in addition to interoperating with one another permissionlessly. Since much of the underlying network development is open-source and public, developer costs and other barriers to entry are greatly reduced.
Rather than having to generate an entirely bespoke ecosystem and competing for a growing user base, blockchain dApps benefit from exponential network growth since their dApps simply plug into compatible blockchains, freeing up resources for more productive endeavors. This has fostered such rapid development that technological advancements have far outpaced any legal jurisdiction’s ability to keep up. Fortunately, with so many use cases and unparalleled, 24/7 global market liquidity, regulatory sandboxes have sprung up all over the world in order to attract and foster technological innovation.
Some of DeFi’s most profound use cases can be found in stablecoins and other tokenized assets. Stablecoins, of course, are mirrored blockchain versions of traditional assets, typically pegged 1:1 to an aggregate spot market price of a given asset. For instance, the US dollar is represented by several stablecoins which are used to trade the dollar using blockchain technology rails.
USD Coin and Gemini USD are two examples of fiat-backed stablecoins pegged to the US dollar through direct collateralization. Another example of a collateralized stablecoin is Pax Gold (PAXG), which is the blockchain representation of one ounce of gold held in the Paxos Trust’s treasury reserves allocated to tokenization. These collateralized stablecoin models are only the start of what DeFi has to offer, however.
Algorithmic, decentralized stablecoins, in contrast, are not issued to users via direct fiat deposits. Instead, algorithmic stablecoins are both minted and burned by the issuer via a decentralized protocol which tracks supply, demand, and various money market conditions for their stablecoin in order to maintain the pegged exchange rate.
To be more specific, users may deposit cryptocurrency as collateral to a protocol in exchange for borrowing an algorithmic stablecoin. When market conditions change, interest rates adjust to encourage users to repay borrowed funds by burning the tokens out of existence, thus returning the circulating supply to the desired price peg. Of course, tracking the spot price in real time relies on external data sources and therefore the use of oracles, which will be covered in more detail below.
NFTs are perhaps the most recent and exciting of the emerging technologies made possible by DeFi’s composability. Non-fungible is a term commonly used in economics, referring to something which is not easily interchangeable for something else due to its uniqueness. In essence, NFTs make it possible to create assets which mirror those of the real world in that they cannot be duplicated a thousand times as can be done with JPEG images.
An NFT is a digital token, minted on a specific blockchain. Each NFT represents a unique asset which is maintained on a blockchain’s ledger, so that ownership can be tracked and verified regardless of how many times it is resold on secondary markets. Currently, the most common examples of NFTs include digital art, collectibles, real estate, and even land in the metaverse.
By connecting NFTs to external data with oracles, developers can create dynamic NFTs that can evolve over time, adding new functionality to NFTs and enabling novel game mechanics. For instance, a tokenized digital trading card (NFT) of a soccer player could be upgraded based on the player’s performance in real life, like tracking the number of goals scored in a season. Not only would the dynamic NFT track statistics and keep them updated in real time, but new features or rarity characteristics could unlock once players reach certain performance thresholds.
The usefulness of dynamic NFTs extends beyond digital collectibles and gaming. With oracle networks, governments may begin issuing blockchain-derived digital passports as dynamic NFTs. Oracles would facilitate the querying and verification of identity or educational credentials when called upon by smart contracts. Land deeds could also be represented on-chain as dynamic NFTs that have their appraisals and tax collection automated by smart contracts. Disaster insurance claims could also be handled automatically via IoT sensors which track weather conditions and storm damage in relation to dynamic real estate NFTs.
Decentralized exchanges, or DEXs, make it possible for users to trade blockchain-native assets frictionlessly and permissionlessly. Using Ethereum again as an easy reference, dApp developers may launch a protocol, along with an Ethereum-compatible (ERC-20) token, and immediately gain access to the liquidity of the entire Ethereum network. For instance, The Graph indexing protocol offers their GRT token, which can be traded for any other ERC-20 token on a DEX application like Uniswap.
Money markets are another example of a powerful DeFi use case. Borrowers and lenders can connect in a peer-to-peer manner, giving lenders the ability to generate interest yields much greater than what is currently available at traditional banks. Likewise, borrowers benefit from instant and permissionless access to on-chain liquidity. The increased liquidity and lack of friction from the democratization of borrowing and lending effectively results in increasing levels of economic dynamism.
Money markets in the cryptoverse do not use the fractional reserve lending mechanisms or check credit scores of borrowers. Such measures would either pose critical risks to the system’s properties of decentralization or else make counterparty risks so great as to make them untouchable by investors. Who would want to loan money to strangers online, without knowing their credit scores? This logic has been used by banks and financial institutions until the advent of DeFi.
Instead, DeFi money markets offer borrowers various tiers of overcollateralized borrowing options, meaning in order to borrow, users must first deposit another asset as collateral. Interest rates for borrowers vary, depending on how much collateral the borrower posts in relation to the desired amount to be borrowed. For example, interest rates increase as the overcollateralization levels of the borrowers decrease.
Depositing ETH and borrowing 25% of the collateral amount would have the lowest rates, while attempting to borrow the maximum 50% of the collateral’s value would have a higher interest rate to reflect the increased risk. Of course, if the value of the ETH collateral were to fall, the borrower would be required to add more ETH or else be moved to a higher interest rate. If already at the highest rate, an extended failure to increase the collateral deposit would result in partial liquidation to bring the borrower’s LTV ratio back to the appropriate numbers.
Automated Market Makers, or AMMs, are software protocols which use on-chain liquidity pools to fund trading pairs for instant liquidity on a DEX. That is, the DEX does not take custody of user funds in order to fill the limit orders on their books. Instead, users deposit pairs of crypto assets into decentralized liquidity pools which can be withdrawn at will, like ETH-USDC, for example.
By making use of these paired-asset liquidity pools, AMMs can fill orders automatically while simultaneously leaving users in control of their assets throughout the process. Users providing liquidity to the AMM earn crypto rewards from trading fees, generated by activity on the DEX between the paired assets. The strategy of looking for ways to earn passive crypto income is often referred to as Yield Farming.
The ownership of on-chain assets, historical record of transactions, and other protocol governance measures are upheld via consensus of the network’s nodes. That is, blockchains have highly sophisticated and secure mechanisms for monitoring assets within their own ecosystems. However, some of the most important use cases for DeFi involve interactions with external data sources, like APIs or other blockchains, for example.
Users might want to create smart contracts which involve knowledge of things like commodity or equity spot prices, local weather conditions, the results of a sports game, fluctuating interest rates, and more. These are often called hybrid smart contracts since they make use of both on-chain and off-chain data via the help of oracles.
Oracles fetch and validate external data for use by hybrid smart contracts on blockchains, but their usage poses an increased security risk to blockchains if the oracles are not decentralized and secured just as robustly as the blockchains themselves. Smart contracts use deterministic mechanisms which rely on accurate inputs in order to execute properly, and are unable to identify faulty off-chain data since blockchain nodes only maintain copies of their own ledgers. That is, they need to “trust” oracles. The dilemma of having to ‘trust’ oracles for data has come to be known as The Oracle Problem.
Due to the composability of Web3 technologies like blockchains, smart contracts, and oracles, any systemic risk of erroneous or stale data making its way into the system could be disastrous. Since oracles shoulder the burden of ensuring that the sourced data is absolutely pristine at all times, the development and use of secure, decentralized oracles must be a top priority in order for more widespread adoption of the technology to take place.
Though blockchains offer secure environments for the deployment of smart contracts, they remain limited in their use cases without the use of oracles for external data communications and interoperability amongst various networks. Scaling the use of hybrid smart contracts to encompass the entirety of global financial transactions may still be far off into the future, but the day will not come until all stakeholders can rely on the robustness of the data coming in from oracles, as well as the network’s ability to handle the transaction throughput and remain always online.
DeFi is but the first manifestation of humanity’s shift towards decentralization efforts in as much as a century. Prior to blockchain technology, it could be argued that power has been consolidated in virtually every sector of global societies. We have the World Economic Forum, the United Nations, and the Bank of International Settlements, just to name a few examples. Now, banking, gaming, marketing, governance, insurance, and even the creation of art has all begun trending away from centralized entities in favor of decentralized organizational structures.
It should be expected that this conflict between centralization and decentralization will create chaos in a number of ways. Centralized authorities are not familiar with being challenged, and often use physical force or their political influences to diminish any competition and create barriers to entry which disincentivizes competitors from entering the market. Decentralized entities, on the other hand, are nimble and adaptable, giving rise to the hope that their efforts will ultimately succeed by sheer virtue of offering better and more equitable services to the people of the world. Alas, it’s doubtful that many great achievements in this world ever came easily.
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