Decoding DeFi: An Insight into Decentralized Finance

Introduction

Decentralized Finance, abbreviated as DeFi, is one of the most popular subjects among crypto investors. This revolutionary approach to financial transactions is not just a fad; it’s already showing its potential to redefine our financial interactions. While the journey of DeFi has just begun, its innovative features have compelled investors to take a keen interest.

DeFi's inception came in the form of Bitcoin, a pioneer in financial innovation. Through the Bitcoin network, users can conduct secure transactions without involving a third party, thanks to the power of blockchain technology.

Now, let's delve into the DeFi world, understand its workings, and explore its potential future impact.

What is DeFi?

DeFi has been creating ripples in the financial domain, but what is it exactly?

Simply put, DeFi is a groundbreaking financial sector that enables users to avail financial services without an intermediary controlling the operations. This became possible with the advent of Smart Contracts.

Owing to its decentralized nature, DeFi offers several benefits over traditional services, such as:

• Swift transactions
• Lower costs
• No need to share private information

As the inaugural DeFi product, Bitcoin has a simple model compared to today's complex DeFi protocols. The launch of Ethereum, which brought smart contracts to the blockchain, catalyzed the development of advanced DeFi products.

Other blockchains such as Avalanche, Near Protocol, Aptos, and Binance Smart Chain have followed Ethereum's footsteps, fostering numerous DeFi applications.

DeFi guarantees unrestricted access to payments and services, offering a market that operates round-the-clock, in stark contrast to traditional exchanges. This level of transparency (as any person can check the code behind a decentralized application) and accessibility empowers individuals to take control of their financial decisions.

Contrasting Traditional Finance and Decentralized Finance

Here's a brief comparison of Traditional Finance (TradFi) and Decentralized Finance (DeFi):

• Regulation and User Protection

DeFi, without a central regulatory entity, lacks a safety net to compensate customers for losses due to unexpected issues.

In contrast, TradFi institutions usually have mechanisms to compensate for losses resulting from scams, bankruptcy, or criminal activities.

• Restrictions

Traditional companies, bound by stringent regulations, can easily impose restrictions on clients to prevent illegal activities.

• Transparency

Blockchain technology, the bedrock of DeFi, offers unparalleled transparency as anyone can access and verify its data. This level of transparency is absent in traditional financial firms and banks.

• Ease of Access

DeFi offers less bureaucratic and more user-friendly services than TradFi. For instance, taking loans, opening an account, or purchasing insurance is more straightforward in DeFi.

To gain a more nuanced understanding, check out our dedicated article on the differences between Traditional Finance and Decentralized Finance.

DeFi Growth Potential

Now that we have a basic understanding of DeFi and its origins, let's focus on its growth potential and how investors can capitalize on it.

The DeFi sector has experienced remarkable growth in recent years. For instance, its Total Value Locked (TVL) escalated from about $600 million at the start of 2020 to an astounding $260 billion by the end of 2021, as the chart below demonstrates.

Despite a challenging 2022 marked by high inflation and interest rate hikes, which reduced the liquidity for risk assets, affecting the crypto market in a very correlated way as it affected tech companies and other stocks, the DeFi sector managed to hold a TVL of around $60 billion, representing a 100x growth in just three years.

DeFi aims to provide financial services worldwide, which is a threat to banks and other financial institutions. Knowing that, let's compare DeFi's market capitalization to that of the world's largest bank, JP Morgan, to understand its potential.

Total Value locked represents the sum of all assets locked in DeFi protocols, which is not the same thing as market capitalization.

• JP Morgan: U$400 Billion
• DeFi: U$35 Billion
• Growth Potential: 11.4x

When we measure DeFi against the entire banking sector, the growth opportunity appears even more compelling:

• Banking sector: U$7.1 Trillion
• DeFi: U$35 Billion
• Growth Potential: 202x

Though the banking sector has centuries of establishment and growth under its belt, these comparisons help highlight the immense potential that DeFi holds.

Commonly, stocks are valued by discounting potential future cash flows to the present value through a variety of analyses. However, DeFi tokens may not always reflect the revenue generated by their respective applications. As tokenomics can vary from project to project, comprehensive research is vital before investing in any DeFi initiative.

The emergence and rapid growth of DeFi suggest a promising and transformative future for global finance. Investors and enthusiasts alike should closely watch this space for potentially profitable opportunities.

A Look at the DeFi Subsectors

Though still in its infancy compared to other financial sectors, Decentralized Finance (DeFi) has seen a surge in innovative applications, drawing a plethora of investors to deploy money into them.

That being said, we’ll now present you with a cursory overview of the main subsectors within DeFi.

If you seek a more comprehensive understanding of each subsector, we recommend reading our in-depth articles. These resources delve into each domain, showcasing the primary protocols you can interact with.

Trading

Currently, trading constitutes the largest DeFi subsector. Protocols within this sphere are referred to as Decentralized Exchanges (DEXes). DEXes empower users to trade assets swiftly and effortlessly without the need for third-party interaction or the submission of personal documentation for account creation on a trading platform.

Many of these protocols leverage a cutting-edge model known as the automated market maker (AMM). With AMMs, traders aren't exchanging assets directly with each other, but rather with a liquidity pool, benefiting both liquidity providers and traders.

Lending and Borrowing

The practice of lending and borrowing is as old as the financial institutions that have been facilitating it for centuries. DeFi introduces a new perspective to this traditional service. Users can lend their assets to a protocol, providing liquidity and earning interest. Conversely, users can borrow cryptocurrencies by depositing collateral in a protocol.

Institutions and traders looking to diversify their investment strategies or leverage their positions widely utilize these protocols.

Liquid Staking

An intriguing and relatively new subsector, liquid staking addresses a crucial issue. While staking is a vital mechanism that proof-of-stake blockchains employ to secure their networks, validators that lock their tokens in the staking process are unable to use these locked tokens to interact with DeFi protocols. This constraint results in less ecosystem liquidity than might be possible.

Liquid Staking protocols address this issue. Users can deposit their tokens into a protocol, which validators then use to stake and secure the network. In return, users receive a stToken (e.g., stETH) that can be used across various DeFi protocols, thereby boosting the ecosystem's liquidity.

Derivatives

Despite being closely related to trading, derivatives constitute a separate subsector since most spot trading protocols do not offer derivatives trading. Derivatives are financial instruments whose value is derived from an underlying asset. This arrangement allows investors to execute diverse investment strategies, such as hedging, leveraged positions, and straddles.

While derivatives are a large segment within traditional finance, they are only beginning to take root in DeFi. This growing area is one to watch as protocols continue to develop decentralized derivatives trading.

Indexes (Asset Management)

Asset management caters to individuals who may lack extensive financial knowledge but wish to invest and grow their net worth over time. Even seasoned finance professionals can take advantage of the diverse investment strategies it offers.

Well-established in traditional finance, this subsector is still a fledgling space in DeFi, presenting significant opportunities.

For example, Kassandra DAO is a protocol that allows anyone to create investment funds. 

Privacy

Most popular blockchains are transparent, which means that people can track a user's wallet activity and balance.

This level of transparency is beneficial for validating the operation of a protocol, yet can be a deterrent for entities that require discreet transactions. Protocols like Tornado Cash address this issue, providing privacy-centric transaction services.

Although being good for many use cases, this sub-sector was a target of regulatory entities because it enables the possibility of money laundering for malicious users on the blockchain.

Hideyour.cash is a protocol that is featuring a possible solution to this problem and might be the answer to delivering a good product that malicious individuals can’t take advantage of!

Insurance

Just as conventional insurance companies profit from premiums to safeguard customers from unforeseen incidents, DeFi insurance protocols offer protection in exchange for premiums.

While future applications may extend to issues like car accidents or health concerns, current coverage primarily targets blockchain-specific issues, such as de-pegging and smart contract vulnerabilities.

Blockchain Bridges

As the number of blockchains continues to grow, each offering unique advantages over the others, Blockchain Bridges have been developed to enable seamless interoperability between them. These bridges are crucial as users often aim to maximize the benefits of multiple blockchains by transferring assets from one to another.

Blockchain Bridges reinforce the concept of interoperability thesis, which postulates that in the future, there won't be a single dominant blockchain. Instead, we may see a plethora of blockchains, each catering to the unique needs of users and protocols.

The most popular DeFi protocols

Uniswap

The mention of Decentralized Finance invariably brings Uniswap to mind.

Originally built on the Ethereum blockchain, this Decentralized Exchange (DEX) utilizes the Automated Market Maker (AMM) model to enable seamless spot trading for users. Uniswap has since expanded its services across five different blockchains, offering opportunities for cryptocurrency trading and interest-earning through liquidity provision.

With more than 4.5 million unique users and a cumulative trading volume exceeding $1.34 trillion, Uniswap has cemented its place at the forefront of DeFi.

Maker DAO

Ranking second in terms of Total Value Locked (TVL), MakerDAO's impressive $7 billion underscores its popularity.

This decentralized protocol delivers lending and borrowing services for its users. Notably, the platform only offers loans in the form of DAI token, an algorithm stablecoin pegged to the US Dollar, issued by MakerDAO itself.

Lido Finance

Lido Finance has emerged as the leading Liquid Staking and DeFi protocol, boasting roughly 6 million ETH deposited in its ETH staking pool. Thanks to recent Ethereum updates, Lido Finance now tops the TVL charts with approximately $9.12 billion.

Understanding the Risks of DeFi

While we've explored the promise and potential of Decentralized Finance, along with its key protocols, it's equally critical to understand its associated risks before making an investment decision. Here are some potential challenges:

Regulatory Risk

DeFi protocols, being decentralized, are not subject to the same regulatory oversight as traditional financial institutions. As regulation in this space continues to evolve, it's essential to stay updated with crypto-related news. The case of Tornado Cash exemplifies this risk, as regulatory sanctions by the US government led to a nearly 90% drop in the value of its token, TORN, between 2022 and 2023.

Liquidity Risk

Protocols like Uniswap and MakerDAO rely on liquidity pools for their trading, lending, and borrowing features. If a pool lacks sufficient liquidity, it may disrupt the protocol's functionality. While this is unlikely with leading DeFi platforms, smaller projects might be susceptible, especially when dealing with large capital amounts.

Smart Contract Risk

DeFi applications are built on smart contracts, which, despite being self-executing, are designed by developers. This presents potential vulnerabilities or bugs that might lead to fund losses. Mitigate this risk by ensuring a protocol's smart contracts are audited by a reputable firm.

Market Risk

The volatility of assets traded in DeFi protocols presents a market risk. Remember to invest only what you can afford to lose.

High risk may generate big profits, but also irreparable losses.

Conclusion

Despite the age-old nature of financial services, fintech companies have only made minor tweaks to century-old practices. Decentralized Finance, on the other hand, offers groundbreaking innovation that is still unfolding.

With even conventional banks like JP Morgan exploring decentralized features, it's clear that DeFi's potential is immense. Comparing the traditional finance market with DeFi reveals the exponential growth yet to come.

With trillions of dollars already transacted through existing protocols, the DeFi space, although relatively new, could present significant investment opportunities. Early investors might strike gold with projects that could become the next giants in their respective sectors, like Amazon, Apple, or Netflix.

DeFi is set to revolutionize finance, and its rapid growth, powered by blockchain technology, is impossible to ignore.