Decentralized finance

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Decentralized finance (often stylized as DeFi) offers financial instruments without relying on intermediaries such as brokerages, exchanges, or banks by using smart contracts on a blockchain, mainly Ethereum. DeFi platforms allow people to lend or borrow funds from others, speculate on price movements on assets using derivatives, trade cryptocurrencies, insure against risks, and earn interest in savings-like accounts. [1] DeFi uses a layered architecture and highly composable building blocks. [2] Some applications promote high-interest rates [1] but are subject to high risk. [3] Coding errors and hacks have been common in DeFi. [4] [1]

Contents

History

Multi-layered Architecture of the DeFi Stack The DeFi Stack Figure.jpg
Multi-layered Architecture of the DeFi Stack

Decentralized exchanges (abbreviated DEXs) are alternative payment ecosystems with new protocols for financial transactions that emerged within the framework of decentralized finance, [2] which is part of blockchain technology and fintech. [5]

CEXs (centralized exchanges), DEXs and DEX aggregators are all built on the multi-layered DeFi architecture or components, where each layer serves a well-defined purpose. [2] (See Figure: Multi-layered Architecture of the DeFi Stack).

While they share common components of the first four layers, such as the Settlement layer, Asset layer, Protocol layer and Application layer, DEX aggregators have an additional component or Aggregator layer, which allows them to connect and interact with other DEXs via smart contracts.

The Ethereum blockchain popularized smart contracts, which are the basis of DeFi, in 2017. Other blockchains have since implemented smart contracts.

MakerDAO is a prominent lending DeFi platform based on a stablecoin that was established in 2017. [6] [7] It allows users to borrow DAI, a token pegged to the US dollar. Through a set of smart contracts that govern the loan, repayment, and liquidation processes, MakerDAO aims to maintain the stable value of DAI in a decentralized and autonomous manner. [8] [9]

In June 2020, Compound Finance, a decentralized finance protocol enabling users to lend or borrow cryptocurrency assets and which provides typical interest payments to lenders, started rewarding lenders and borrowers with a cryptocurrency called Comp. This token, which is used for running Compound, can also be traded on cryptocurrency exchanges. Other platforms followed suit, leading to stacked investment opportunities known as "yield farming" or "liquidity mining", where speculators shift cryptocurrency assets between pools in a platform and between platforms to maximize their total yield, which includes not only interest and fees but also the value of additional tokens received as rewards. [10]

In July 2020, The Washington Post described decentralized finance techniques and the risks involved. [10] In September 2020, Bloomberg said that DeFi made up two-thirds of the cryptocurrency market in terms of price changes and that DeFi collateral levels had reached $9 billion. [11] Ethereum saw a rise in developers during 2020 due to the increased interest in DeFi. [12]

DeFi has attracted venture capitalists such as Andreessen Horowitz [3] and Michael Novogratz. [13]

The Economist regarded the future of digital finance in 2022 as a "three-way fight" between: Big Tech, such as Facebook with its digital wallet; "big rich countries" that have been testing their own digital currencies; and software developers "building all sorts of applications" to decentralize finance. Handling the risks presented by crypto-assets already valued at $2.5 trillion was a particular challenge for US regulators. [14]

Key characteristics

DeFi revolves around decentralized applications, also known as DApps, that perform financial functions on distributed ledgers called blockchains, a technology that was made popular by Bitcoin and has since been adapted more broadly. [15] [1] Rather than transactions being made through a centralized intermediary such as a cryptocurrency exchange or a traditional securities exchange, transactions are directly made between participants, mediated by smart contract programs. [3] These smart contracts, or DeFi protocols, typically run using open-source software that is built and maintained by a community of developers. [16]

DApps are typically accessed through a browser extension or application. For example, MetaMask allows users to directly interact with Ethereum through a digital wallet. [17] [18] Many of these DApps can be linked to create complex financial services. [1] For example, stablecoin holders can lend assets like USD Coin or DAI to a liquidity pool in a borrow/lending protocol like Aave, and allow others to borrow those digital assets by depositing their own collateral. [19] The protocol automatically adjusts interest rates based on the demand for the asset. [3] Some DApps source external (off-chain) data, such as the price of an asset, through blockchain oracles. [20]

Additionally, Aave introduced "flash loans", which are uncollateralized loans of an arbitrary amount that are taken out and paid back within a single blockchain transaction. [21] Many exploits of DeFi platforms have used flash loans to manipulate cryptocurrency spot prices. [22]

Another DeFi protocol is Uniswap, which is a decentralized exchange (DEX) set up to trade tokens issued on Ethereum. Rather than using a centralized exchange to fill orders, Uniswap pays users to form liquidity pools in exchange for a percentage of the fees collected from traders swapping tokens in and out of the liquidity pools. Because no centralized party runs Uniswap (the platform is governed by its users), and any development team can use the open-source software, there is no entity to check the identities of the people using the platform and meet KYC/AML regulations. As of 2020, it is not clear what position regulators will take on the legality of such platforms. [23]

Decentralized exchanges

Decentralized exchanges (DEX) are a type of cryptocurrency exchange, which allow for either direct peer-to-peer, or Automated Market Maker (AMM) liquidity pool cryptocurrency transactions to take place without the need for an intermediary. The lack of an intermediary differentiates them from centralized exchanges (CEX).[ citation needed ]

In transactions made through decentralized exchanges, the typical third party entities which would normally oversee the security and transfer of assets (e.g. banks, stockbrokers, online payment gateways, government institutions, etc.) are substituted by a blockchain or distributed ledger. Some common methods of operation include the use of smart contracts or order book relaying – although many other variations are possible, with differing degrees of decentralization. [24] [25]

Because traders on a decentralized exchange often do not need to transfer their assets to the exchange before executing a trade, decentralized exchanges reduce the risk of theft from hacking of exchanges, [26] but liquidity providers do need to transfer tokens to the decentralized exchange. Decentralized exchanges are also more anonymous than exchanges that implement know your customer (KYC) requirements. [27] [28]

There are some signs that decentralized exchanges have been suffering from low trading volumes and reduced market liquidity. [29] The 0x project, a protocol for building decentralized exchanges with interchangeable liquidity, attempts to solve this issue. [30]

Disadvantages

Due to a lack of KYC processes, and no way to revert a transaction, users are at a loss if they are ever hacked for their passwords or private keys. [31] Additionally, liquidity providers staking in DeFi protocols can suffer what is called an impermanent loss if, when withdrawn, the token pairs they have invested have altered in value ratio significantly. [32] [33] [34]

Although liquidity pool DEX are the most widely used, they may have some drawbacks. The most common problems of liquidity pool DEXes are market price impact, slippage, and front running.

Price impact occurs because of the AMM (Automated Market Makers) nature itself — the larger the deal, the stronger impact it has on the price. For example, if the constant product AMM is in use, every deal must keep the product xy = k constant, where x and y are quantities of two cryptocurrencies (or tokens) in the pool. Price impact is non-linear, so the larger is the input amount Δx, the lower is the final ratio y / x that gives an exchange price. The problem is mostly significant for relatively large deals versus the liquidity pool size. [35] [ better source needed ]

Front running is a special type of attack in public blockchains when some participant (usually a miner) seeing an upcoming trading transaction puts his own transaction ahead (playing with a transaction fee for example), making the initial transaction less profitable or even reverted. To provide some protection against front running attacks, many DeFi exchanges offer a slippage tolerance option for end-users. This option serves as a safeguard, allowing users to set a limit on the worst acceptable price they are willing to accept from the time of transaction signing.[ citation needed ]

Degrees of decentralization

A decentralized exchange can still have centralized components, whereby some control of the exchange is still in the hands of a central authority. The governance of a DeFi platform, typically as part of a Decentralized Autonomous Organization, is done through tokens that grant voting rights and are distributed amongst participants. However, the majority of these tokens are often held by few individuals and are rarely used to vote. [36]

In July 2018, the decentralized exchange Bancor was reportedly hacked and suffered a loss of $13.5M in assets before freezing funds. [37] In a Tweet, Charlie Lee, the creator of Litecoin spoke out and claimed an exchange cannot be decentralized if it can lose or freeze customer funds. [38]

Operators of decentralized exchanges can face legal consequences from government regulators. One example is the founder of EtherDelta, who in November 2018 settled charges with the U.S. Securities and Exchange Commission over operating an unregistered securities exchange. [39]

Errors and hacking

Coding errors and hacks are common in DeFi. [4] [1] Blockchain transactions are irreversible, which means that an incorrect or fraudulent DeFi transaction cannot be corrected easily.

The person or entity behind a DeFi protocol may be unknown and may disappear with investors' money. [16] Investor Michael Novogratz has described some DeFi protocols as "Ponzi-like". [13]

DeFi has been compared to the initial coin offering craze of 2017, part of a cryptocurrency bubble. Inexperienced investors are at particular risk of losing money because of the sophistication required to interact with DeFi platforms and the lack of any intermediary with customer support. [4] [40] On the other hand, as the code for DeFi smart contracts is generally open-source software that can be copied to set up competing platforms, experienced users and user-created bots might create instabilities as funds shift between platforms which share the same code. [16] In addition, DeFi platforms might inadvertently provide incentives for cryptocurrency miners to destabilize the system. [41]

In 2021, half of cryptocurrency crime was related to DeFi. This rise has been attributed to a combination of developer incompetence and non-existent or poorly enforced regulations. [42] [43] [44] Theft from DeFi can come from either external hackers stealing from vulnerable projects, or "rug pulls", [45] where the developers and influencers promote a project and then take the money, as a form of pump-and-dump. [44]

Regulation

In October 2021, the FATF included DeFi in the guidance for crypto service providers, making the authority's aim to regulate this type of asset. [46] [47] They are expecting each individual country to determine if individuals involved in DeFi can be considered a virtual asset provider and be subjected to the FATF's guidelines. [48]

See also

Related Research Articles

A smart contract is a computer program or a transaction protocol that is intended to automatically execute, control or document events and actions according to the terms of a contract or an agreement. The objectives of smart contracts are the reduction of need for trusted intermediators, arbitration costs, and fraud losses, as well as the reduction of malicious and accidental exceptions. Smart contracts are commonly associated with cryptocurrencies, and the smart contracts introduced by Ethereum are generally considered a fundamental building block for decentralized finance (DeFi) and NFT applications.

<span class="mw-page-title-main">Cryptocurrency</span> Digital currency not reliant on a central authority

A cryptocurrency, crypto-currency, or crypto is a digital currency designed to work as a medium of exchange through a computer network that is not reliant on any central authority, such as a government or bank, to uphold or maintain it.

<span class="mw-page-title-main">Ethereum</span> Open-source blockchain computing platform

Ethereum is a decentralized blockchain with smart contract functionality. Ether is the native cryptocurrency of the platform. Among cryptocurrencies, ether is second only to bitcoin in market capitalization. It is open-source software.

A decentralized autonomous organization (DAO), sometimes called a decentralized autonomous corporation (DAC), is an organization managed in whole or in part by decentralized computer program, with voting and finances handled through a blockchain. In general terms, DAOs are member-owned communities without centralized leadership. The precise legal status of this type of business organization is unclear.

A decentralised application is an application that can operate autonomously, typically through the use of smart contracts, that run on a decentralized computing, blockchain or other distributed ledger system. Like traditional applications, DApps provide some function or utility to its users. However, unlike traditional applications, DApps operate without human intervention and are not owned by any one entity, rather DApps distribute tokens that represent ownership. These tokens are distributed according to a programmed algorithm to the users of the system, diluting ownership and control of the DApp. Without any one entity controlling the system, the application is therefore decentralised.

<span class="mw-page-title-main">Ethereum Classic</span> Blockchain computing platform

Ethereum Classic is a blockchain-based distributed computing platform that offers smart contract (scripting) functionality. It is open source and supports a modified version of Nakamoto consensus via transaction-based state transitions executed on a public Ethereum Virtual Machine (EVM).

<span class="mw-page-title-main">Cardano (blockchain platform)</span> Public blockchain platform

Cardano is a public blockchain platform. It is open-source and decentralized, with consensus achieved using proof of stake. It can facilitate peer-to-peer transactions with its internal cryptocurrency, ADA.

<span class="mw-page-title-main">Polkadot (cryptocurrency)</span> Cryptocurrency

Polkadot is a blockchain platform and cryptocurrency. The native cryptocurrency for the Polkadot blockchain is the DOT. It is designed to allow blockchains to exchange messages and perform transactions with each other without a trusted third-party. This allows for cross-chain transfers of data or assets, between different blockchains, and for decentralized applications (DApps) to be built using the Polkadot Network.

<span class="mw-page-title-main">Tron (cryptocurrency)</span> Blockchain computing platform

TRON is a decentralized, blockchain-based operating system with smart contract functionality, proof-of-stake principles as its consensus algorithm and a cryptocurrency native to the system, known as Tronix (TRX). It was established in March 2014 by Justin Sun and since 2017 has been overseen and supervised by the TRON Foundation, a non-profit organization in Singapore, established in the same year. It is open-source software.

<span class="mw-page-title-main">MetaMask</span> Software cryptocurrency wallet

MetaMask is a software cryptocurrency wallet used to interact with the Ethereum blockchain. It allows users to access their Ethereum wallet through a browser extension or mobile app, which can then be used to interact with decentralized applications. MetaMask is developed by ConsenSys Software Inc., a blockchain software company focusing on Ethereum-based tools and infrastructure.

<span class="mw-page-title-main">Dai (cryptocurrency)</span> Stablecoin cryptocurrency

Dai is a stablecoin token on the Ethereum blockchain whose value is kept as close to one United States dollar as possible by decentralized parties incentivized by smart contracts to perform actions that affect the token's supply and therefore its price. Dai is maintained and regulated by MakerDAO, a decentralized autonomous organization composed of the owners of its governance token, MKR, who may propose and vote on changes to certain parameters in its smart contracts.

<span class="mw-page-title-main">Uniswap</span> Decentralized cryptocurrency exchange

Uniswap is a decentralized cryptocurrency exchange that uses a set of smart contracts to execute trades. It is an open source project and falls into the category of a DeFi product because it uses smart contracts to facilitate trades. The protocol facilitates automated transactions between cryptocurrency tokens on the Ethereum blockchain through the use of smart contracts. As of October 2020, Uniswap was estimated to be the largest decentralized exchange and the fourth-largest cryptocurrency exchange overall by daily trading volume.

<span class="mw-page-title-main">0x (decentralized exchange infrastructure)</span> Cryptocurrency

0x is an open-source, decentralized exchange infrastructure that enables the exchange of tokenized assets on multiple blockchains. Developers can use 0x to incorporate exchange functionality into their applications, and market makers can use 0x to create markets for cryptocurrencies and tokens. ZRX, an Ethereum ERC-20 token, is the native governance and staking token of 0x. Individuals who own ZRX can vote on protocol changes and stake their tokens to earn liquidity rewards in Ether (ETH). The project's creator and core developer is 0x Labs.

Stacks, formerly Blockstack, is a blockchain platform for smart contracts, decentralized finance ("DeFi"), non-fungible tokens (NFTs), and decentralized apps ("DApps"). Stacks blockchain is a layer for bitcoin similar to the Lightning Network.

<span class="mw-page-title-main">Solana (blockchain platform)</span> Public blockchain platform

Solana is a blockchain platform which uses a proof-of-stake mechanism to provide smart contract functionality. Its native cryptocurrency is SOL.

<span class="mw-page-title-main">Celsius Network</span> American cryptocurrency company

Celsius Network LLC was a cryptocurrency company. Headquartered in Hoboken, New Jersey, Celsius maintained offices in four countries and operated globally. Users could deposit a range of cryptocurrency digital assets, including Bitcoin and Ethereum, into a Celsius wallet to earn a percentage yield, and could take out loans by pledging their cryptocurrencies as security. As of May 2022, the company had lent out $8 billion to clients and had almost $12 billion in assets under management.

ICON is a decentralized, open-source blockchain with smart contract functionality. ICX is the native cryptocurrency of the platform.

Tokenomics is a term that refers to the study and analysis of the economic aspects of a cryptocurrency or blockchain project, with a particular focus on the design and distribution of its native digital tokens. The term is a portmanteau of words token and economics.

GATE.io is a global cryptocurrency exchange and blockchain platform established in 2013. According to Bloomberg and Reuters it is ranked among the top most worldwide for the trading volume.

The Aave Protocol is an open-source, decentralized finance (DeFi) protocol built on the Ethereum blockchain and released in 2020. It is one of the largest cryptocurrency liquidity protocols. The Aave Protocol uses smart contracts to automate processes, including distributing funds and handling collateral.

References

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