Demystifying DeFi – Introduction to DeFi (1/6)

DeFi has been the buzzword in the crypto industry for months now. In the aftermath of the black Thursday crash in March, which saw Bitcoin crashing below 4000 USD, many DeFi applications successfully launched their main nets, which drew a lot of attention to the emerging space. DeFi related tokens like Compound’s COMP, Aave’s LEND, Balancer’s BAL or Synthetix’s SNX have since yielded astronomic gains for investors. But what exactly is DeFi and how do DeFi protocols work? Learn about it in our new six-part blogpost series “Demystifying DeFi”. New articles coming daily! Today we will start with a high-level introduction to the DeFi ecosystem, before covering decentralized exchanges, lending & borrowing platforms and yield farming in our upcoming blog posts.

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The term DeFi stands for decentralized finance. The term is still pretty new, and definitions might vary. But in its core, DeFi is about making financial services more widely accessible. As the term suggests, it aims to achieve this goal in a decentralized way, which means that no centralized party is acting as a middleman like it’s the case with traditional financial institutions like banks as this centralized party is replaced by a blockchain protocol serving as the trust layer.

According to this definition, one might argue that Bitcoin can also be classified as a decentralized finance. Because the vision outlined in Bitcoin’s whitepaper was for it to be a purely digital, peer-to-peer currency system not controlled by a central authority. The financial service covered by Bitcoin would therefore be payments. But due to the lack of smart contract functionality, the Bitcoin blockchain’s potential to cover a wider range of financial services is highly limited. Therefore, if people talk about DeFi today, they most likely refer to blockchain protocols which offer a much wider and more complex array of financial services, such as token swaps without the need for a centralized exchange or decentralized lending & borrowing facilities.

The most popular metric to measure the success of DeFi projects is total value locked (TVL). The metric measures how much crypto is locked in the smart contracts of a DeFi protocol. Currently, TVL of the entire DeFi sector amounts to approximately 8 billion USD. In terms of TVL by project, the leading protocol is Maker with a total of 8 billion USD in TVL. Its followed by Compound and Synthetix. While both Maker and Compound are lending/borrowing platforms, Synthetix focuses on on-chain derivative products.

But the DeFi ecosystem in its entirety offers much more than derivative platforms and lending/borrowing protocols. While projects like WBTC or REN focus on interoperability by providing possibilities to mint Ethereum-based ERC-20 tokens mirroring Bitcoin and therefore making Bitcoin usable for DeFi applications on the Ethereum blockchain, other projects include decentralized exchanges like Uniswap, which allow for trustless token swaps or decentralized derivative exchanges like Serum.

As you might know, the vast majority of DeFi projects is built upon the Ethereum blockchain. But why is that the case? The answer is actually quite simple. As Bitcoin has no smart contracts its not a feasible base-technology for DeFi projects. Ethereum on the other hand provides smart contract functionalities and is the most advanced project offering this feature. Moreover, Ethereum’s token standard ERC20 allows for Ethereum-based DeFi protocols to easily interact with each other. The composability of Ethereum dApps and the increasing network effects within Ethereum’s ecosystem seal the deal.

The fastest growing part of the DeFi sector in the past months has been lending & borrowing (like e.g. above-mentioned Compound). These protocols really embrace the idea of decentralized financial services by moving away from just using crypto assets as a mean of payments and rather deploying the underlying blockchain technology to create more advanced financial products without any intermediary in a fully trustless way and open source, allowing everyone to use their crypto to lend it out and earn a return or borrow funds by using crypto as collateral. The potential DeFi bears with regards to financial inclusion is incredible, especially for the unbanked and underbanked people in Africa and parts of Asia and South America.

Check back tomorrow for part two of our DeFi series!

Posted Using LeoFinance