Decentralized Finance or DeFi is the movement that allows users to utilize financial services such as borrowing, lending, and trading without the need to rely on centralised entities.
As the world used to run on traditional financial systems, this new wave provides a range of services that are meant to replace the legacy systems via Decentralised Applications(Dapps).
DeFi is not a single product or company but is instead a set of products and services that acts as a replacement for institutions ranging from banking, insurance, bonds and money markets.The fundamental innovation of DeFi is similar to blockchains: reducing trust by replacing centralized platforms with a decentralised system.The resulting system is considered trustless, meaning that no single party must be trusted for storing funds and sending transactions.
In order for DeFi to work, tokenisation brings the possibility of executing business logic using smart contracts via languages like Solidity (ETH-based scripting language). This enables margins to be rewarded and distributed to rewards users in the system. The connectivity of DeFi is often called “Money LEGOS” and is one of the most promising features the DeFi ecosystem has to offer. This composability leads to users and developers to build different financial applications that allow for faster transactions and incentives to be distributed.
The DeFi Ecosystem
There are 3 degrees of decentralisation surrounding DeFi ecosystem and we are going to break them down into pieces.
Characteristics: Custodial, uses centralized price feeds, centrally-determined interest rates, centrally-provided liquidity for margin calls.
· Examples: Salt, BlockFi, Nexo and Celsius
2. Semi-Decentralized (has one or more of these characteristics but not all)
Characteristics: Non-custodial, decentralized price feeds, permissionless initiation of margin calls, permissionless margin liquidity, decentralized interest rate determination, decentralized platform development/updates
Examples: Compound, MakerDAO, dYdX, bZx
3. Completely Decentralised
Characteristics: Every component is decentralized
Examples: No DeFi protocol is completely decentralized yet.
Currently, most DeFi dapps are sitting in the semi-decentralized category. A further breakdown of the decentralization components can be read in Kyle Kistner’s article in the Recommended Readings
So what makes DeFi so disruptive.
Well, we could say that the main differences between the traditional finance sector and DeFi are as follow:
1. Monetary Policy can be easily managed and coded using smart contracts, which allows for a degree of modularity that financial institutions don’t have.
2. Providing Liquidity via trading with assets (tokens) without a counterparty order book is possible
3. Rebalancing portfolio using diff strategies based on exposure bias can be done automatically without the need of a portfolio manager.
4. Non-custodial nature: participants have full control of their funds at any point in time
5. Permissiononless nature: anyone can interact with financial services without being blocked or censored by a third party.
The possibilities are endless and as long as traditional finance has inefficiencies, the DeFi space will try to explore and resolve most of them. I guess in terms of economics, what makes DeFi special is the sovereignty that the user has and how this is less controlled by central governed entities.
DeFi can contribute to how value is being stored to users to incentivise its growth, via platforms such as Compound (COMP)and Uniswap(UNI). Yield farming on the other hand incentives liquidity provision. Token distribution and yield farming have managed to attract most talent and capital. Platforms can engineer economic policies straight into the smart contracts and provide value to the communities via a long-term sustainable protocol. Yield farming will be the topic in one of our future series. Whilst crypto-economics is a growing field and many issues such as scalability , security, KYC and slippage still exist, the pace of growth outnumbers the number of issues that happen within the industry and the potential is exponential here.
Some links towards some of the great resources in Defi that we found helpful:
How to DeFi
Buy How to DeFi by CoinGecko, Lau, Darren, Lau, Daryl, Teh, Sze Jin, Kho, Kristian, Azmi, Erina, Lee, TM, Ong, Bobby…
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