What is DeFi Crypto/Tokens? (DeFi Pulse?)

In this article we’ll discuss what DeFi cryptos are, and how they could be used.

Over the last year or so, “DeFi” has caused a bit of a stir in the crypto community. Many in the community believe that DeFi, or decentralized finance, can completely turn the global economy on its head by making the finance sector transparent and more easily accessible. The DeFi movement leverages decentralized networks to transform old financial products into trustless and transparent protocols that run without intermediaries:

• The pitfalls of traditional finance.
• What is DeFi, and why do we need it?
• DeFi use-cases and applications.

DeFi has a unique opportunity to craft a unique niche for itself in the space. There are currently 1.7 billion people around the world who don’t have access to essential financial services. However, with a simple internet connection, they will be able to access smart contracts and experience immense financial growth and security with DeFi. So before we look into the nitty-gritty of this revolutionary system, let’s understand what’s going on currently in traditional finance systems.

The various products involved in DeFi are also collectively referred to as open finance since it’s an ecosystem where blockchains, digital assets, open protocols are integrated with conventional financial structures.

What are DeFi apps?

DeFi or “decentralized finance” is an all-encompassing term that refers to the digital assets, decentralized applications (DApps), financial smart contracts, and protocols that run on top of public blockchains like Ethereum. Public blockchains have several highly disruptive properties.

• Decentralization: Every node in the network maintains a copy of all the data stored inside the blockchain, negating the need for a centralized authority. Imagine a decentralized bank or a finance system that’s not dependent on the whims on a central regulator. That’s one of the most exciting promises of DeFi.
• Transparency: Since everyone in the network maintains a copy of the blockchain, all the data stored inside is open for them to see.
• Permissionless: A public blockchain, as opposed to a permissioned/private one, is open for everyone. By utilizing this property, DeFis will be able to create an open system where people from around the world — who don’t have access to sophisticated financial services — can participate without going through extensive red-tape.
• Trustless: In a decentralized system, individual nodes have an economic incentive to work in the interest of the system. This is in stark contrast to the traditional financial system where you need to trust a centralized governing body to do their job well.
• Censorship Resistance: Blockchains leverage sophisticated cryptographic hash functions to be completely immutable. In other words, once you enter some data into the blockchain, no one can tamper with it.
• Programmable: Public blockchains like Ethereum and EOS are open-source systems and they welcome developers from all around the world to create their own unique applications on top of them. This openness to innovation has led to the creation of some fantastic DeFi applications.

Why do we need DeFi when we already have cryptos?

Since cryptocurrencies like Bitcoin are already decentralized and borderless, in nature, why do we need DeFi?

• Comparing pure cryptocurrencies with DeFi is like comparing US Dollars to loans. DeFi is a financial service that can have multiple use cases.
• Old school cryptocurrencies have decentralized the act of issuing and storing money. However, they haven’t decentralized the core financial system in itself.
• Cryptocurrencies are still dependent on centralized exchanges for their use. DeFi brings in decentralized exchanges to make sure that there no centralized point-of-failures within the ecosystem.
• Centralized organizations manage the majority of the cryptocurrencies.

DeFi Use Case #1 — DeFi Lending

Transparent and open lending protocols have fast become the most popular use-case of DeFi. Let’s hop back to Defi.Pulse and check out the top five most popular DeFi applications on Ethereum:

As you can see, three out of the top five are lending protocols. The reasoning behind this is two-fold:

• The immense popularity of MakerDAO and its stablecoin DAI.
• DeFi Lending is a very convenient way of earning passive income.

What is DeFi Lending?

Similar to a traditional bank, a user deposits their money to the platform and earns interest when someone else borrows it. The core difference lies in how the platform handles the money in between.

In traditional credit structure, the loans are issued by financial institutions such as banks or third-party lending services. These institutions conduct a thorough background check of the borrower to judge if they will be capable of paying back the loan or not. This check includes but isn’t limited to:

• Annual salary
• Credit score
• Past defaults

As such, many people get excluded from the process even. Even if they do get in, they still have to pay exorbitant interest rates, making the whole system highly inefficient.

DeFi lending aims to democratize this entire process and connect borrowers to a wide pool of lenders. Instead of having institutes acting as intermediaries, smart contracts directly connect the borrower and the lender with each other. The smart contract is responsible for:

• Dictating the terms of the loan agreement based on predetermined conditions.
• Distributing the interest accordingly.

Both the borrower and the lender can benefit immensely from the open nature of DeFi lending.

Borrowers

• Zero credit checks which make loans available to a wide variety of investors.
• Gain access to different utilities. Eg. A borrower can temporarily loan some EOS tokens and stake them in the EOS ecosystem to take participate in network governance.
• Immediately short the asset they borrow in different exchanges to participate in margin trading.

Lenders

• It’s a solid long-term HODL plan.
• The opportunity to earn passive income via interests.
• Due to the transparency and lack of mediators, the lender earns higher returns and has a clearer understanding of the risks involved.

One example of DeFi lending DApps is “MakerDAO”. It’s by far the best DeFi lending DApp out there so far. It’s dominating this space with a whopping $484+ million locked up in it. A crazy huge sum for something like a decentralized finance space.

DeFi Use Case #2 — DeFi Derivatives

“Derivative” is a pretty well-known term in traditional finance. It refers to a contract that derives its value from the market performance of an underlying entity such as an asset, index, or interest rate. The terms of the contract are executed by a third-party called “broker.”

Decentralized derivatives are pretty similar, save for one crucial factor — instead of a centralized broker, they use a smart contract to. There are several advantages to this approach:

• Eliminates the need for a third-party.
• Automated, on-chain settlement.
• Users can create instruments on virtually any underlying asset.

So, why use derivatives in the first place? There are two main reasons:

• It protects you from future price fluctuations since you signed a contract to buy an asset for a fixed price.
• Gain by correctly predicting how the price of the entity is going to change in the future.

The four types of derivatives

• Swaps: Allows counterparties to exchange cash flows between each other. The swaps derivative contract defines the dates of the pay-outs and its calculation.
• Options: The buyer can purchase or sell the underlying asset governed by the contract if they want to.
• Futures: Buyer must purchase the underlying asset at the predetermined price on a fixed date in the future.
• Forwards: This is a more customizable version of the futures contract.

Importance of DeFi derivatives

Synthetic assets, like derivatives, form a huge and vital part of the global financial landscape. As per the Bank for International Settlements (BIS), for the first half of 2019, around $640 trillion in financial derivatives are currently outstanding. This easily makes the derivatives market the largest in the world.

With DeFi, it will be possible to bring these derivatives contracts in the decentralized space. Let’s look at just some of the derivatives use cases in the crypto world:

• Futures derivatives can allow investors to mitigate the risk of price fluctuations.
• Allow users in developing countries to invest in stocks in first-world countries.
• Bet on a coin’s future performance.

An example of a DeFi derivatives app is “Synthetix”. It’s a peer-to-contract trading platform which allows it’s users to mint various synthetic assets, including derivatives.

DeFi Use Case #3 — Decentralized Exchanges

Exchanges serve one of the most critical functions in the crypto ecosystem, serving as a bridge between the fiat and crypto worlds. Having said that, it’s hard to ignore its many problems and the way it has plagued the crypto space over the last several years.

• First, let’s address the elephant in the room. Time and again, centralized exchanges have proven themselves to be an obvious target for hackers. Such repeated attacks have damaged the public perception of cryptocurrencies.
• Since exchanges are centralized entities, they can be subject to mismanagement. The infamous Mt. Gox hack happened directly as a result of gross mismanagement.
• Finally, the operations of the exchange can be affected by the policies of the country it is registered in.

What are decentralized exchanges?

Decentralized exchanges or “DEX” enables trustless trading without being intermediary-dependent by running on top of a shared ledger. A DEX directly connects two parties with each other and allows them to share assets without having to go through an intermediary. Let’s look at how the process works:

• Suppose you want to convert your BTC to ETH.
• You send in a request to the DEX to convert your BTC to ETH.
• The DEX smart contract will first check if you have sent them the required amount of BTC or not.
• Now the DEX will go through its other requests to match you with an appropriate order.
• Once the transaction is complete, you’ll receive the appropriate amount of ETH in your wallet.

Advantages of DEX

• The lack of an intermediary ensures that there is no single point of failure.
• Not dependent on centralized management.

One example of a DEX is the ethereum based exchange “UniSwap”. It allowes the trading of ETH and ERC20 tokens.

Aren’t Cryptos Supposed To Tackle Decentralization?

Bitcoin, Ethereum, and other early crypto coins have offered a way of secure peer-to-peer trading without the need for intermediaries like a bank for trade settlement. This gives users complete control over their assets.

However, keep in mind that these cryptocurrencies have not really decentralized the financial system. They have just decentralized the issuing of money and its storage. There are a couple of problems exist which are hindering blockchain from making the financial system genuinely decentralized.

• While the cryptocurrencies are decentralized, they can mostly be accessed via centralized access points such as exchanges.
• Most of these crypto projects are managed through centralized companies that lack accountability or transparency.

Stablecoins

Unlike other crypto coins which have a volatile value, stablecoins are blockchain-issued tokens designed to hold on to a specific value. This is usually done by pegging it with fiat currencies like the US dollar, but oftentimes with other assets like gold. Stablecoin incorporates collateral to accommodate for the price variation.

Stablecoins can be primarily categorized into 3 types:

1. Fiat-Collateralized
2. Crypto-collateralized
3. Non-Collateralized

#1 Fiat-collateralized

These types of stablecoins are the most popular. These coins store their value in fiat currencies like the US dollar or Euro and are usually supposed to be redeemable at a 1:1 ratio with the pegged currency.

These regulatory-compliant and audited coins have great opportunities for mass adoption since active measures are taken to maintain the peg. A fiat currency reserve is kept in a bank to back the current circulating supply of the token. Tether, Gemini Dollars, and USDC are other such stablecoins.

However, this makes it centralized, thus posing the counterparty risk. These stablecoins need trust in a centralized entity and are therefore vulnerable to loss of peg and destabilization from external geopolitical factors. It also becomes risky when there is a lack of trust in the central party’s ability to cover the issued IOUs. This issue is solved by making these stablecoins auditable.

Note that firms behind these stablecoins get their revenue from the interest earned on the deposited funds (in fiat) from users that they store in a bank account. Research suggests that eventually, this rate margin would come down and benefit the customer more.

#2 Crypto-collateralized

These decentralized stablecoins are backed by crypto assets as collateral. They rely on trustless issuance and maintain their 1:1 peg against assets through various methods including over-collateralization and incentives.

The trustless issuance makes this type of coin wholly transparent and the reserve auditable. Maker’s Dai is such a stablecoin. ETH, The underlying asset here is over-collateralized against the loaned Dai based on the current collateralization ratio. For example, the DAI stablecoin is pegged to USD and backed by Ether. For every DAI, there are $1.50 worth of Ether (ETH) coins locked into the MakerDAO smart contract as collateral.

The collateral is held in a smart contract which is accessible only when stablecoin debt is cleared. If excess collateral falls below a certain predetermined level, the stablecoin system can close the smart contract and sold the collateral.

The volatility of the underlying collateral is the biggest threat to this model. If the collateral loses too much value, the system becomes under-collateralized and fallback procedures like stablecoin liquidation could be enabled.

Among these stablecoins, Maker’s Dai is an interesting stablecoin as it is only composed of borrowers, while the protocol itself is the lender. Thus it mints/burns the Dai based on the governance and CDP parameters. This stablecoin offers decentralized leverage and is censorship-resistant.

#3 Non-collateralized

These types of stablecoins are neither centralized nor over-collateralized with crypto assets. Based on an algorithm, the system supplies more tokens with increased demand while the price of each token is lowered and vice versa in order to maintain a stable peg.

“Basis” is such a stablecoin example but got shut down following regulatory concerns with its model late in 2018.

The risk here is that it is difficult to maintain stability while constantly contracting the money supply. Also, it requires that participants believe that the demand will increase in the future. In case demand stops growing, the stablecoin will not be able to maintain its peg.

What is DeFi Pulse?

If we take a look at the DeFi Pulse website here, we can see the following;

• First up, we have the all-important “Total value locked” or the TVL metric. This basically shows how much money investors have locked up in various DeFi contracts. Obviously, the higher the amount locked up, the more thriving the economy. If the quantity of TVL is on the higher side, it tends to have a positive effect on Ethereum price.
• On the side, you can see a simple graph that shows you the daily progression of TVL. As per the graph, the TLV jumped from $1.11 billion 16th June to $1.83 on 1st July. That’s a staggering 64.86% increase in just two weeks!
• Below the value locked up square, you have the market leader share metric. As of writing, Maker is the market leader and owns 21.05% of the market.
• Right at the bottom of the screenshot, you will see the different DeFi categories available on the website, mainly — Lending, DEX (Decentralized Exchange), Derivatives, Payments, and Assets.
• You also see the banner for “DeFi Pulse Farmer,” which happens to be their newsletter.

If we scroll down a bit — we see this:

Down here, you will see a list of the top DeFi projects in the space right now by TVL. As you can see, Lending projects dominate the top 3. Now, if you click on the individual tabs, you will see top projects in each of the categories. So, let’s click on “derivatives” and find out the top DeFi derivatives projects.