Introduction to Defi

In many ways, the current surge in DeFi, or decentralized finance, can be seen as part of the natural progression for blockchain and for crypto, beginning with the introduction of Bitcoin which promised to disrupt traditional currencies and along with it financial markets as a whole. With the introduction of many new and increasingly complex DeFi protocols filling in for the roles of traditional financial services, the spotlight is on DeFi for its disruptive potential and the increasing likelihood for a holistic alternative to traditional finance. Unlike traditional centralized finance which is mediated by lawyers, banks, and financial institutions, DeFi uses smart contracts to create permissionless, open, and censorship resistant protocols.

Like Bitcoin, DeFi primarily makes use of cryptography, and blockchain technology. However, unlike Bitcoin, the use of smart contracts allows for the development of more complex transactions than the simple transfer of currency. Smart contracts are programmable transactions that are executed automatically by the established rules of the program, usually expressed as if/then statements. Smart contracts are often likened to digital vending machines, which are programmed to change state based on certain inputs and result in predictable outputs. Most DeFi projects are built upon Ethereum as it is currently the most supported smart contract platform and provides all of the necessary tools to build the automatically executable smart contracts which DeFi projects are based upon.

The use of smart contracts means that third party entities who are traditionally responsible for ensuring that financial transactions go through in their expected manner, such as lawyers and banks, may be cut out of the picture. For traditional financial transactions, control over the disclosure of the rules and structure of a given transaction are usually held by a minority in-group. On the other hand, smart contracts and their rules are openly visible to the public, meaning end users may verify the trustworthiness of contracts for themselves without having to trust a third party. Furthermore, records of all transactions are stored publicly and in multiple locations via the blockchain, further decreasing the need for trust. This decentralized model of finance is where DeFi gets its name.

The DEFI Ecosystem

The DeFi Ecosystem is a thriving space made up of many different applications built upon one another like lego blocks. The most important building blocks of the DeFi ecosystem are lending and borrowing, stable coins, decentralized exchanges, derivatives, margin trading, and insurance. This section of the article will go on to examine each of these in a bit more detail, and briefly introduce the more widely used projects within the DeFi space.

Lending and borrowing

Lending and borrowing are the pillars of any financial system. In DeFi, lending and borrowing happens in an open, permissionless way. There are several noteworthy projects currently operating in this space: MakerDao, Compound and Aave.

MakerDao

Established in 2015 and the very first of these projects, MakerDao allows users to lock in collateral, such as Ether, to generate Dai, a stable algorithmic coin whose value is connected to USD.

Compound

Compound is an algorithmic and autonomous interest rate protocol which allows its users to supply assets such as Ether, Tether, BAT and 0x, and make interest. These assets can also be used as collateral for borrowing other assets.

Aave

Another popular project, Aave, formerly known as Lend, offers a decentralized market for users to borrow and lend their cryptocurrencies. What makes Aave unique is the ability for users to choose from both stable and variable interest rates.

Stablecoins

Stablecoins are cryptocurrencies which are designed to minimize volatility and attempt to maintain a stable price relative to some other asset. This is done by pegging the price of the cryptocurrency to another asset, such as another cryptocurrency, a fiat currency, or to a precious metal. Currently, the price of most popular stablecoins are pegged to the US dollar. Stablecoins may derive their price stability from a number of ways which may be broadly distinguished between centralized and algorithmic.

1. Centralized

USDt, USDC, and PAX are examples of centralized stablecoins which are pegged to the US dollar. In the case of centralized coins, the company is responsible for holding the equivalent of the value of the stable coin in USD or other assets within a bank account. The value of these coins derives directly from the value of the assets held by the company. The risk of these centralized stablecoins is that if the company goes under, or somehow loses its assets, the value of the coin will be lost along with it. Although being centralized is seen as a drawback, these coins have nonetheless become increasingly popular, and are frequently used in DeFi apps such as Compound or Aave.

2. Algorithmic

Algorithmic stablecoins are designed to maintain price stability through some alternate means rather than by a centralized company. For example, Dai is an algorithmic, decentralized stable coin that aims to follow the price of the US dollar. Dai is generated when users deposit ETH on the MakerDao platform. Thus, the value of Dai is backed by collateral on the lending platform. The price of Dai is maintained by the increase or decrease of stabilization fees which are voted on by MakerDao users in order to control the supply and demand of the Dai coin. Another well known algorithmic stablecoin is Ampleforth. Ampleforth is designed to either increase or decrease in total supply in order to reach a stable equilibrium where supply meets demand at a price of around one US dollar per Ampleforth coin.

Dexes (Decentralized Exchanges)

Decentralized exchanges allow for the exchange of crypto assets in a completely decentralized and permissionless way, without giving up custody of the coins. There are two main types of dexes: liquidity pool based dexes, and order book based dexes. A few examples of liquidity pool based dexes are Uniswap, Kyber, Balancer, and Bancor, and some examples of order book based dexes include Loopring and Idex.