The mystic of DeFi

Bit of theory

After the global economic crisis of 2008, the question of trust in the modern international financial system arose globally. The answer to this request was the emergence of the first decentralized Internet system - Bitcoin, which from "decentralized" money turned into a valuable financial asset by 2020. After that, other financial technologies on the blockchain began to appear and actively develop. Most of which are competing with traditional financial organizations and institutions.

DeFi (Decentralized Finance) is a decentralized finance industry, also called “affordable finance”. It has become one of the main drivers for using the Ethereum network. It became the basis of its capitalization and popularity. According to the DeFi principles, they are based on the creation of an innovative ecosystem of financial services, which is accessible to everyone without exception. However, it does not need permission from any central authority to access financial services and is not regulated from a single monitoring center. In addition, the main difference between the DeFi systems is that the user of decentralized financial services acts as the custodian of his money and completely controls his assets. You can also find this kind of definition:

“DeFi is all services in one form or another transferred from the ordinary financial world, but with fewer intermediaries, regulation, and also without the consensus that is used in traditional financial services. They are no different from other fintech applications on the blockchain. It’s just that the developers have introduced a new abstraction for classification and singled out as a separate area of their activity”

But despite this, according to the crypto-community of decentralized finance, developers in this area professes a number of principles:

?        Products must be open source and compatible. Since this allows products to interact within the ecosystem from a technological point of view, which increases their practicality and popularity.

?        DeFi-projects adhere to financial inclusion, that is, decentralized financial services can be available to absolutely everyone who has the Internet.

?        Financial transparency is important: at the user level, all information must remain confidential, while within the market, all data must be transparent.

Therefore, in order for a project to become part of the DeFi community, it is necessary that the product be related to fintech, be developed on the blockchain, and adhere to common standards along with interoperability, that is, compatibility with other projects from the DeFi ecosystem. The beauty of the crypto industry is that there is no standardization. And we see a real market where financial services in an absolutely wild market must win absolutely market competition with each other. Which gives rise to opportunities for other businesses where a variety of tools is needed. In general, decentralized finance includes;

?        DEX (decentralized exchanges)

?        credit and insurance protocols

?        derivatives

?        payment channels

?        stablecoins like Dai or USDC

?        asset management funds based on smart contracts

?        decentralized forecast markets

?        other financial services based on the blockchain

But in order to realize the idea of a financial system, all these products need to interact with each other, scale and independently exchange messages with each other. Since all the developments are based on Ethereum, the blockchain of which records the transactions of the entire crypto world, including operations from CryptoKitties and the casino, the issue of transfer processing speed and network scalability is still relevant. Moreover, one of the solutions to this problem is a number of products based on the Substrate blockchain and a number of others, which allows you to quickly conduct transactions and process them within one specific application, and not the entire decentralized universe.

In turn, the DeFi stablecoin in the Maker ecosystem, which allows anyone to issue Ethereum-based crypto-dollars, has become the cornerstone of DeFi. Stablecoin Maker DAO has become one of the key components of any financial protocol, contributing to an increase in the number of users, as it has reduced users' concerns about the volatility of cryptocurrencies. Also, the DFi ecosystem includes the Dharma deposit and lending protocol, which is essentially one of the most important structures for the traditional capital market. In addition, there are more and more such practical examples, which emphasizes the relevance of the development of decentralized finance as a separate fintech industry and its prospects.

DeFi position today

According to The Block's analytics (https://www.theblockcrypto.com), approximately 49% of leading decentralized finance (DeFi) startups are located in the United States. This is not surprising, since the USA is an empire for centralized finance, so no one wants to lose ground in the decentralized version of services. Of the 73 industry firms tracked by experts, 12% are based in the UK, another 10% are based in Singapore. If you take into account the registration of these startups, then the ratio changes somewhat. 21% of them have different legal and actual addresses. Many prefer to register more friendly regulatory jurisdictions, such as Singapore, Switzerland, the Cayman Islands or the British Virgin Islands, notes The Block. Taking into account the legal registration, the share of the USA is reduced to 44%, in the UK and Singapore it is 10% each. In Switzerland, 8% of DeFi startups are registered, although only 3% work in the country. The largest number of industry companies is engaged in the asset management sector (27%), the second most popular area is liquidity providers and exchange providers (23%). Confidently developing in recent months, landing services are engaged in 14% of monitored startups. The largest number of companies (41) of the industry were registered in 2017. This is more than in other years combined (57%). One of the startups, the Forecast Foundation (Augur), appeared before the official launch of the Ethereum network, which became the basis of the DeFi industry. Statistics say that in February 2020, the cost of blocked funds on smart contracts of DeFi applications exceeded $ 1 billion. The startup platform dYdX reported that the total volume of loans issued for the year exceeded this figure, decentralized exchanges also noted an increase in trading volumes. All these data indicates development and claims to stability.

However, not everything is clear. Cryptocurrency lending could become the Achilles heel of DeFi. The innovative cryptocurrency market suddenly appeared against the backdrop of last year's collapse in bitcoin prices and most other assets. Trying to avoid fixing losses, some hodlers in the midst of cryptowinter borrowed funds secured by digital assets, or deposited coins to get a small but passive income with minimal risk. Undoubtedly, the very young market is still tiny compared to the traditional counterpart. Statistics say that the volume of issued crypto loans compared to last year increased by 3.5 times. And DeFi here is at the epicenter of hype. Cryptocurrency loans include loans secured by digital assets. For centralized services like BlockFi and Crypto.com, bitcoin often plays the role of collateral, while for non-custodian DeFi applications it is Ethereum. The main range of products can be classified as follows:

?        Cryptocurrency loans in fiat dollar to individual participants and companies with the transfer of funds directly to bank accounts

?        Decentralized platforms for trading derivatives

?        Cryptocurrency lending secured by other digital assets

?        Non-custodial landing protocols (DeFi), using smart contracts on Ethereum to reduce counterparty risks and transaction costs

?        Loan platforms with native token

?        Continuous Securities Offering (CSO), where the essence of the model is to invest in the assumption that startups will consistently generate cash flows. Seeking to raise funds through CSO, the company undertakes to place part of its future income in escrow for a certain period. Investors through the platform can acquire claim rights to these funds.

It is not strange, but all of the above-decentralized services are growing in popularity in countries with expensive bank interest (like Argentina). Decentralized landing protocols not only minimize counterparty risk, but also provide transparent access to borrowed funds 24/7. It is likely that the development of cryptocredit and DeFi will trigger an increase in demand for coins used as collateral. Most likely, those who urgently need money, but have no desire to sell digital assets at a low price, will be most actively borrowing through such services. These are, first, residents and companies from countries with high bank interest rates, cryptocurrency traders, as well as those who are trying to hide their financial activity from the ubiquitous state eye. Almost a five-billion-dollar industry came out of nowhere just two years ago and the number of lending platforms continued to grow until the end of 2019. But the beginning of 2020 shows a different dynamics. As expected, the coronavirus pandemic, which hit traditional finance, has also affected DeFi. A sharp drop in the market triggered a wave of liquidations secured by a pledge of debt positions (CDP). According to experts, during the period of volatility, DeFi users were motivated to pay higher commissions in order to carry out the necessary actions in time, for example, to increase collateral to avoid the elimination of CDP. This has led to an increase in fees on the Ethereum network. This, in turn, in March 2020 led to the collapse of the market at the largest Ethereum landing services MakerDAO and Compound, where there were many liquidations of debt positions. In April, the same trend is going on - a decrease in activity in DeFi. Nevertheless, this segment is still underdeveloped and not so large. Its advantages over the traditional banking system with expensive loans and low-yield deposits are undeniable. This means that there is a potential for market growth, and considerable hype.

Prospects

Today, finance plays a major role in the global economy, but it is not an open system. After all, even if you have a bank account, you can be refused in loan for a new business and be left without financing. DeFi has to change that. With it, to interact with the system, the main tool of our time is enough - a smartphone. In addition, anyone can become a part of it. This is the main point for DeFi. With decentralized finance, users will have two incredible advantages over a modern system:

?        The ability to fully control assets and access to them. You no longer need to trust intermediaries who charge interest for their services. Everyone can get access to the service, while the system does not have a single control body;

?        All protocols running DeFi operate on open source. Accordingly, anyone can create a financial product based on it and come up with a new form of added value. This will accelerate the development of innovations and enhance the network effect, because with each new product more and more users and developers will switch to such platforms. Although for this, you need to have programming knowledge. An ordinary person without such experience is unlikely to be able to expand the capabilities of DeFi. If he is not an investor, of course!

DeFi means that people retain ownership of their assets and have full autonomy over them, rather than transferring them to the central system, allowing them to make decisions on your behalf. Considering this, in the future, DeFi will solve the fundamental problem associated with the traditional financial industry, while increasing its efficiency. In addition, there are many advantages to using DeFi as:

?        Decentralization helps counter censorship,

?        Freedom of participation regardless of social status or income

?        Relatively fast and inexpensive transactions

?        Users remain in private key ownership

?        Enhanced ecosystem transparency to improve market efficiency

Undoubtedly, all these advantages will make DeFi the trend for decades and the center of attention for venture capital. To understand how the DeFi theme has a global future, it is worth paying attention to the expert opinion of venture capital. They wouldn’t have started financing DeFi projects so intensively if they hadn’t seen the point and sense. In its report, “Mapping Decentralized Finance (DeFi),” Outlier Ventures, a venture capital firm, outlines five characteristics of DeFi that are advantages over other financial ideas:

1.     Resistance to censorship. Storage, transfer and exchange of tokens cannot be limited to a narrow group of players responsible for network maintenance.

2.     Software assets. The assets that make up a DeFi product must have the attributes of standard decentralized network tokens.

3.     The pseudonymity. DeFi applications must use Web 3.0 standards to validate operations and identification. This means that users use only a private access key, with which they sign their transactions and confirm the ownership of assets by analogy with Bitcoin. Additional user identity verification (KYC / AML) is not required.

4.     Transparency and reliability. The holder of a DeFi asset can be found and verified using the blockchain. A DeFi service should not store user funds on large centralized wallets of cryptocurrency exchanges. The operations involve independent electronic wallets like Trust Wallet, imToken and Coinbase Wallet, as well as smart contracts.

5.     No permission. Users can issue, trade and own DeFi assets without the approval of a bank regulator.

6.     DeFi-applications do not need intermediaries and courts. The code determines the resolution of each possible dispute, and users, in turn, control all their means. This reduces the cost of providing and using products, and allows you to create a more trouble-free financial system.

7.     Since the deployment of software of a new type of financial services is carried out over blockchain networks, the existence of a single point of failure in the operation of the system is excluded. Data is recorded on the blockchain and distributed among thousands of nodes, which virtually eliminates censorship or shutdown. Due to the fact that the framework allows you to create DeFi-applications in advance, their development and deployment becomes less complicated and more secure.

Decentralized finance takes familiar banking products and makes them freer. DeFi develops the advantages of cryptocurrencies and offer new tools for self-regulation of the financial market. This model increases the risks of fraud, but erases the boundaries between financial market participants. The issuer and seller of a decentralized financial asset is a technology entrepreneur, not a bank. Under these conditions, the host country of the parties to the transaction and local regulation no longer matter.

Threats

What problems do DeFi face?

?        Low productivity. Blockchains are slower in nature than their centralized counterparts, which leads to the creation of additional applications. DeFi application developers must consider these limitations and optimize their products accordingly.

?        High risk of user error. DeFi applications transfer responsibility from intermediaries to the user. This can be a negative aspect for many. Developing products that minimize the risk of user error is a particularly difficult task when products are deployed over immutable blockchain networks.

?        Poor user experience. Currently, the use of DeFi applications requires additional efforts on the part of the user. For these applications to be a key element of the global financial system, they must provide tangible benefits that will affect users' desire to abandon the traditional system.

?        The erosion of the ecosystem. Finding the most suitable application can be quite a challenge, along with this; users must have a certain skill in order to choose the best option. Also, the problem consists not only in creating applications, but also in thinking about how ideally they can approach a large ecosystem of decentralized finance.

Additionally, in its current state, DeFi is vulnerable to attacks and crashes, as can be seen from the attacks on bZx flash loans in February 2020. Moreover, most of the DeFi projects on the Ethereum platform are not very suitable for high-frequency trading, since they are limited in terms of computing speed. In addition, there is a problem of user acceptance. The lack of awareness and knowledge among the public, compounded by the fact that most DeFi applications have complex and confusing user interfaces, means that adoption can drag on for years. The concept of decentralized finance is amazing, but there are a number of risks that are hindering its global rapid advancement. Here are some of them:

?        The risk of a smart contract. These systems are new; it takes time to test them in practice. When protocols interact with each other, the risks of smart contracts are multiplied. If a critical error is present in one protocol, this can lead to a general system vulnerability. Therefore, do not rush to place large funds in such systems.

?        Collateral risk and volatility risk. Some forms of collateral for securing loans involve certain risks. Excessive collateral reduces the risk of volatility, but if the price of an asset falls too quickly, this requirement does not guarantee full coverage of the loan amount. A controversial point is the volatility of interest rates on many DeFi platforms, which casts doubt on the meaning of participating in them. Most likely, there will be agreements on replacing the floating interest rate with a fixed one, or other methods of fixing rates for an additional fee, but this introduces difficulties in the process

?        Regulatory risk. DeFi platforms have varying degrees of decentralization, and we have not yet come up with lawsuits for claims. It is worth seeing if they will be, and how they will be decided.

There is a decentralized insurance area within DeFi that provides the ability to manage some of the above risks (Nexus Mutual, Convexity). There are also prediction markets like Augur, which allow users to bet on the likelihood of errors in the smart contracts of the protocols used. It is clear that the above risk management methods are just beginning to develop and introduce the risks of their own smart contracts into the process. But the logic of development confirms that they will justify themselves. And if decentralized finance systems become popular, traditional insurance companies will probably offer their services.

Additionally, at the end of 2019, one began to talk more and more often that DeFi itself would threaten the security and stability of the Ethereum network. DeFi, one of the most promising uses of the Ethereum, will become a serious threat to network security after the transition to the Proof-of-Stake (PoS) consensus algorithm. It is argued that the work of the DeFi protocols runs counter to the PoS algorithm for securing the network. The PoS consensus mechanism assumes that the owners of crypto assets participate in the net management through staking, while receiving a reward. The more users doing this, the more decentralized and secure the network. The problem is that funds blocked in DeFi lending do not participate in staking and security. Further development of DeFi and asset transfers will make the Ethereum 2.0 PoS Consensus Protocol weak and vulnerable to attack. In order to attack a blockchain network with  PoS consensus algorithm, it is enough to own 1/3 of the assets participating in the stake. To prevent potential security issues, Ethereum 2.0 should offer competitive remuneration rates that are not yet available.

Summary

The concept of decentralized finance aims to build financial services that are separate from traditional financial and political systems. This will create a more open financial system and possibly eliminate censorship and discrimination around the world. This idea looks quite tempting and mystical, but not in all cases, decentralization can be useful. The search for use cases that are most suitable for the characteristics of blockchains is crucial for creating a useful stack of open financial products. If successful, DeFi will take power from large centralized organizations and transfer it to the free software community. However, at the moment it is not known exactly how effective this financial system will be, and even more so when decentralized finances become mainstream and are accepted globally by the society. So far, the concept for the world of global DeFi looks mystical and unstable.

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Sergey Golubev (Сергей Голубев)

EU structural funds, ICO/STO/IEO projects, NGO & investment projects, project management, comprehensive support for business.