31 October 2023
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1 min read
understanding DeFi > the future of finance
DeFi, short for 'decentralized finance,' is an umbrella term encompassing various financial services on public blockchains such as ethereum. within DeFi, users can engage in the same activities offered by traditional banks, such as lending, borrowing, obtaining insurance, and earning interest, all without the need for intermediaries, which significantly accelerates the speed of financial transactions. DeFi is built utilzing smart contracts, which run on blockchains that are ultimately distributed ledger technologies enabled in simple terms by multiple, distributed participants, eliminating the need for a single centralized authority.
the importance of DeFi lies in its power to overcome centralization, intermediaries and custody. the pitfalls of centralized finance have been made obvious through multiple cycles of financial crisis caused by mis-aligned incentives and the custody-structure of traditional finance (tradfi) markets.
think of DeFi as tradfi, but without middlemen. instead, decentralised applications (dapps) and smart contracts handle everything automatically based on transparent sets of rules. in banking, transactions are logged in private ledgers, controlled by centralized institutions. in contrast, a blockchain is a public ledger shared by all market participants, recording transactions in encrypted code, providing security, and preventing fraud. moreover, in DeFi, no intermediary entity like a bank actually takes custody of client assets. the deposited quantums are always on-chain, or on smart contracts, and clients have direct custody of the investments in their wallets, and could redeem their positions directly and in a permissionless manner without needing anyone's approval.
this is made possible as smart contracts execute code automatically based on specific conditions, making them execute complex transactions once covenants are met or when depositors of capital directly initiate and authorise transactions from their wallets. DeFi therefore executes complex transactions once covenants are met or when depositors of capital directly initiate and authorize transactions from their wallets. DeFi is therefore a highly adaptable solution for building the next generation of finance on a decentralised infrastructure.
the importance of DeFi
traditional financial markets rely on complex chains of intermediaries containing different actors like banks, clearing houses, advisors, brokers, lenders and more, which result in added complexity, information asymmetry and higher fees for participants. blockchain technology and smart contracts allow market participants to directly access global financial markets and services in a transparent manner while being the sole custodian of their own assets. while transaction costs are not completely removed in the world of DeFi, they are negligible in comparison to the associated costs of traditional financial institutions. with an increasingly digitized world, self custody of digital assets is growing in importance in order to reduce counterparty risk.
the emergence of DeFi has the potential to disrupt financial markets as we know them. broadly speaking, DeFi is reshaping the following areas in financial markets:
accessibility
DeFi streamlines access to financial markets through the permissionless principles of blockchain technology and smart contracts. to interact with DeFi protocols all you need is an internet connection, a wallet and some digital assets.
principal-agent problem
DeFi effectively addresses the principal-agent problem, as self-enforcing smart contracts reduce the need for intermediaries, creating less principal-agent relationships. the transparent nature and decentralization of DeFi protocols also significantly reduce the risk for agency costs.
flexibility
DeFi is built on permissionless protocols DeFi lowers switching costs for users, it boostings user flexibility. by eliminating intermediaries, while offering a wider array of financial services more efficiently.
transaction costs
DeFi offers the prospect of very low fees compared to the traditional centralized finance framework. this cost efficiency arises from the smart contracts, eliminating the need for intermediaries and their associated fees.
DeFi applications
unlike traditional apps you would find on your phone or computer, decentralised applications (dapps) are digital programs operating on blockchains. a dapp is programmed using smart contracts, resulting in a transparent, secure and automatic functionality. dapps serve as the execution layer for building a functioning DeFi ecosystem on top of a blockchain such as ethereum. like the blockchains distributed ledger itself, dapps are also secured by the blockchains decentralized system. when you are interacting with DeFi outside of simply transferring funds, you are interacting with a dapp.
to understand how DeFi dapps work, let’s consider prominent DeFi lending protocols to understand how DeFi dapps work, let’s consider prominent DeFi lending protocols compound finance and aave as examples. these protocols have created a completely trustless and permissionless lending market. here’s how they work:
- lenders deposit crypto assets into liquidity pools governed by smart contracts.
- borrowers borrow against collateral from the liquidity pools, without direct lender interaction.
- in return for lending, compound finance provides tokens known as ctokens, while aave provides atokens, denoting the amount of crypto assets supplied and the yield earned on those assets. this is a mechanism in place for the smart contract to keep track of the loan book.
- lenders earn interest, also received in the form of these tokens, calculated by algorithms based on market dynamics.
- when the loan is repaid, the ctokens and atokens are redeemed for the cryptocurrency provided.
- if a loan would not be repaid, the collateral provided by the borrower would be sent to the lender. the smart contract governed loans described here are always over-collateralized to ensure there is no incentive to not repay the loan.
simply put, the DeFi dapp described above enables trustless lending and borrowing against collateral in a fully automated and transparent manner. let’s take a look at another example involving real world assets (rwas).
centrifuge is a dapp that enables DeFi participants to invest in rwas like real estate, invoices and royalties through the use of non-fungbile tokens (nfts). nfts are blockchain-based tokens with a unique identifier, meaning it is possible to distinguish each nft from another. let’s dive in to the centrifuge tokenization and investment process:
- owners of rwas (originators), let’s say a commercial real estate property yielding rent every month, connect their crypto wallet and perform kyc or kyb required.
- the originator then proceeds to upload all relevant documents concerning the rwa onto the centrifuge protocol dapp.
- in the dapp, the asset documents are verified and the asset can then be tokenized to nfts.
- when the documents are tokenized, the originator enters into a legal contract with centrifuge.
- as an investor, you can then invest into real estate using cryptocurrency like $eth or $usdc fully on-chain.
while rwa protocols like centrifuge are a great way of providing additional liquidity to owners or rwas and allowing DeFi investors to diversify their holdings from crypto markets on-chain, kyc requirements and legal contracts are tradfi features that have been merged into operations to ensure reliability and regulatory compliance.
now that we have covered lending platforms and rwas, let’s take a look at some other practical use cases for DeFi dapps:
decentralized exchanges (dexs)
dexs are online platforms that enable the exchange of cryptocurrencies, allowing users to trade directly with each other without the need for a trusted intermediary. similarly to the lending platform described above, dexs are based on smart contract governed liquidity pools.
stablecoins
sstablecoins are a category of cryptocurrencies intricately pegged to external assets, typically conventional fiat currencies like the u.s. dollar or euro. this pegging mechanism serves as a stabilizing force in DeFi to counteract crypto volatility.
prediction markets
in DeFi, prediction markets allow betting on various future events, including sports outcomes, without intermediaries. they replicate traditional markets while benefiting from blockchain's transparency and security, increasing accessibility and trust.
DeFi adoption
the adoption of DeFi and its rapid increase in market size shows its transformational trajectory. grand view research predicts that the size of the DeFi market will grow at a compounded annual growth rate (cagr) of 42.5% from 2022 to 2030. historically, unique users in DeFi increased by 40% in 2022 despite market conditions, going from 4.7 million at the beginning of the year to more than 6.5 million at the end of the year. this momentum becomes even more impressive given the fact that DeFi had around 940,000 users at the beginning of 2021, marking an increase of almost 700% in two years.
interestingly, in the context of grassroots cryptocurrency adoption, india has emerged as the top-ranked country in a comprehensive analysis conducted by the blockchain data analytics company chainalysis. this ranking surpasses notable contenders such as nigeria, vietnam, and the united states, among a total of 154 countries included in the assessment. this data underscores india's significant role in fostering organic cryptocurrency adoption, marking it as a pivotal player in the global cryptocurrency landscape.
on- and off-ramping in DeFi
to enter the world of DeFi, you need cryptocurrency assets and a crypto wallet. but how do you turn cash into crypto assets? this is where crypto on-ramps come in.. on-ramps are the gateways that allow users to convert fiat currency into cryptocurrencies.
typically, regulated cryptocurrency exchanges serve as on-ramps. users kickstart the process by depositing fiat onto an exchange and submitting a purchase order to acquire the cryptocurrency they desire at the current market price. next, users send their acquired crypto assets to a crypto wallet, such as metamask. these wallets are where you custody your crypto assets and private keys, aka the cryptographic signature you use to authorize transactions. after depositing crypto assets to a wallet users can then explore DeFi freely.
when users decide to move assets out of the DeFi landscape or convert their cryptocurrency assets back into cash, they engage in a process known as off-ramping. crypto off-ramping refers to the exchange process that facilitates the conversion of crypto assets into fiat.
DeFi's operation hinges largely on crypto ramps, acting as bridges between traditional finance and blockchain-based DeFi. while these ramps can simplify access and exit, broadening DeFi's reach, they also serve as single points of failure should governments step in and fully regulate the on- and off-ramping market.
risks and challenges in DeFi
as with every emerging market, the opportunities crowding DeFi are followed by a significant amount of challenges. in this chapter we will review some of the biggest obstacles for DeFi gaining mainstream adoption.
security
to this day, there have been over 148 successful cyberattacks targeting DeFi platforms. these cyberattacks, or exploits as they are called, have caused over $4.28 billion dollars worth of crypto assets to be lost.
complexity
inherently DeFi is a highly complex technology and can be difficult for users to understand. while the technology is fundamentally trustless, it is hard for users to trust something they do not fully understand, creating major educational challenges in onboarding new users to DeFi.
regulation
up until present day, DeFi has been highly unregulated. during 2023 and 2024 we will see regulators ramp up significantly with the mica directive coming into force in the eu and the sec currently pursuing several lawsuits of digital asset companies in the us. at the end of the day, regulators will have the final say in what centralized entities such as on- and off-ramps are allowed to do and not do.
scalability
we are currently seeing above 6 million unique users in DeFi and a daily trading volume of around $6 billion dollars for the major DeFi tokens. in contrast, the swift network processes over $5 trillion dollars on a daily basis, so the DeFi infrastructure still has some scalability tests to pass before major global adoption can occur.
custodial requirements
in the realm of DeFi, your cryptocurrency assets rely entirely on safeguarding your wallet's private key. misplacing a private key results in forfeiting access to your funds, as there exists no recourse for recovering a lost private key. this is something the ethereum foundation is currently addressing with account abstraction, but we are yet to see a practical solution for this dilemma.
customer service
in the absence of a central authority, customer support in the DeFi sphere is almost non existent. of course developers of specific dapps can assist users with understanding the applications by designing better products and taking user feedback into account. however, given the custodial and immutable nature of DeFi, if you happen to send a mislabeled transaction, there’s no one to call to get it undone.
the future of DeFi
as DeFi has maintained good activity and active users continue to grow, it becomes evident that this is only the beginning. the rapid pace of innovation within this space promises an exciting future, shaping the way we interact with financial markets. in this final chapter we will take a look at what lies ahead for DeFi.
tokenization – bridging the material and digital realms in DeFi
tokenization refers to minting assets, either digital or physical, onto a blockchain using a smart contract. this can be done either using fungible or non-fungible tokens. the tokenization of assets paves the way for putting on chain a wide range of assets like traditional financial market products, to real estate, to expensive art, and to complex digital asset structured products. which will lead to increased liquidity, and democratized access to complex financial products easily, and fractionally. as various assets are tokenized, DeFi platforms can develop new financial products with the potential to build truly permissionless financial markets.
ux improvements and complexity abstraction
while DeFi has made remarkable strides, its true potential lies in reaching individuals and institutions alike across the globe. given the complex user journeys, the current state of DeFi remains gated for technically proficient individuals. the ongoing efforts to enhance user interfaces and abstract away the complex processes DeFi is built on will contribute to making DeFi more accessible to a broader audience. as the technology becomes more user-friendly, we can anticipate a surge in adoption, bringing decentralized finance into the lives of individuals around the globe. account abstraction has the potential to improve accessibility, reducing entry barriers for a wider audience. it streamlines decision-making by allowing users to focus on financial choices rather than grappling with protocol specifics.
regulatory developments
as regulators around the world grapple with the implications of DeFi, the industry is at a crossroads. the recent introduction of the mica directive in the eu and the sec's scrutiny in the us underscore the growing need for regulatory clarity. how DeFi navigates these regulatory waters will undoubtedly shape its future. the community's proactive response and collaboration with regulators will be pivotal in fostering a regulatory environment that allows DeFi to thrive responsibly.
scalability, interoperability & liquidity
scalability remains a critical challenge for DeFi as it strives to handle larger transaction volumes. however, ongoing projects and innovations aimed at improving scalability hold the key to DeFi's ability to compete on a global scale. addressing these challenges head-on will pave the way for a more robust and efficient decentralized financial infrastructure.
the future of DeFi may also see increased interoperability between different networks. the ability to seamlessly communicate and transact across various chains has the potential to unlock new possibilities and enhance the overall efficiency of decentralized finance. liquidity in any new asset class is a hurdle, especially for long tail assets. cross-chain compatibility and cross-chain liquidity will help scale DeFi significantly.
the collaborative efforts of innovators, regulators, and the global community will shape the destiny of DeFi, ushering in an era where financial systems are open, transparent, and accessible to all. the journey continues, and the future of DeFi holds the promise of not just a more inclusive financial landscape, but a new & open financial system where the financially buoyant can access opportunities which were reserved for the 1% earlier. .
we hope you have enjoyed this article on DeFi and that we have sparked your curiosity to learn more about the world of crypto assets. crypto is evolving fast to reach its rightful position as a foundational technology, and a transformative asset class.
about aarnâ
aarnâ is an advanced DeFi asset management platform, designed at the intersection of AI and DeFi, to help users manage their digital assets lifecycle.