How DeFi is eating financial services

Exploring the DeFi stack, use cases, benefits, risks and the ecosystem

The DeFi Hype: Why it matters

Today we have a financial system that depends on status, wealth and geography - where you were born and how much access to wealth & education your parents have a disproportionate correlation to financial outcomes in your lifetime.

Now imagine a global, open alternative to very financial service you use today, accessible with little more than a smartphone and internet connection:

  1. Borrowing loans automatically from a stranger in any part of the world with no middleman (e.g. Compound)

  2. Money in your account automatically finding the highest yield & return, given your risk appetite (e.g. Yearn.finance)

  3. Make real-time, instant payments to friends, family and pay for goods and services anywhere in the world without exorbitant fees (e.g. DAI Stablecoin)

  4. You can remain pseudonymous/anonymous to preserve your privacy, build reputation on the blockchain and use your digital identity to access financial services on the internet - all while keeping out the bad actors (E.g. Bloom)

  5. Enter into a smart contracts with a stranger for engaging their services or betting on sports - with no worries about payments & settlement

According to DeFi Pulse, the value of digital assets locked into DeFi applications grew 10X from less than $1 billion in 2019, to over $10 billion in 2020, and over $80 billion at its peak thus far in 2021. Yet the DeFi applications and underlying infrastructure are still in its nascent stage of development.

Dune analytics chart below shows the explosion in # of unique addresses (proxy for users) reaching ~3M in June 2021, growing 10x from last year in June 2020

While it’s been a few years for DeFi, its associated economy is already large and consequential: Ethereum, the backend infrastructure for DeFi, settled about $1.5 trillion in transactions last quarter, or 50% of Visa’s payment volume; decentralized money markets are issuing billions of dollars worth of loans every month; with similar volumes for individuals and businesses using platforms like the Uniswap protocol.

While arguments for Defi are grounded in greater choice to consumers, lower costs to legacy finance 1.0 system and greater return on capital - there are detractors who don’t believe in Defi given the complexity of onramps, lack of financial education (i.e. scams), security concerns and regulatory overhang (KYC/AML/financial crimes). I believe these are short to-medium term challenges which exist with any emergent technology. Let’s focus on the underlying use cases and real value of Defi - it starts becoming clear that its a 10x improvement to today’s financial primitives

Centralized/Traditional Finance (CeFi or TradFi) Vs Decentralized Finance (DeFi)

Your Chase Bank or Wells Fargo bank works well for you, but not for everyone. You can feel the pain of those merchants who don’t get money due to antiquated ACH rails for 3-5 business days, immigrants without documents & unbanked users cannot open an account easily and sending a cross-border remittance can be as pleasant as a root canal. Try getting a mortgage from your bank and telling them you want to put up your Robinhood/Crypto account as collateral :)

Compared to traditional financial applications which use core banking systems such as Fiserv & FIS as the underlying ledgers of record, DApps (decentralized applications) use blockchains as their underlying core ledger. DeFi allows users to custody their own funds or engage directly with smart contracts. Censorship-resistant, permissionless use promotes financial inclusion. Faster, borderless operations 24/7/365. Cheaper transactions than TradFi (assuming gas prices eventually come down). Stablecoins act as a hedge against local currency debasement. High yields…. and many more 10x improvements!

Source: Race Capital

The first wave of crypto relied on centralized finance (CeFi) wallets and exchanges such as Coinbase and Gemini for storing, buying, selling, or trading different cryptocurrencies. And like traditional financial services (TradFi), CeFi customers had to go through standard know-your-customer (KYC), anti-money laundering (AML), and other compliance procedures before they could deposit funds, and they had to initially use fiat funds to buy crypto. Funding accounts or withdrawing funds could take days and often involved high transaction fees.

Enter DeFi. Instead of relying on an intermediary for custody, clearing and escrow services, DeFi relies on smart contracts operating on a blockchain, often Ethereum. This provides resistance to censorship: central financial regulatory bodies are unable to dictate monetary policy or compliance procedures, and there’s no native state-sponsored currency. Instead of relying on a trusted party, users trust the code in the smart contract, which can be audited.1

So what is DeFi?

The term decentralized finance (DeFi) refers to an alternative financial infrastructure built on top of the Ethereum blockchain. DeFi uses smart contracts to create protocols that replicate existing financial services in a more open, interoperable, and transparent way. 

The main benefits that DeFi combines are as follows:

  1. Permissionless (most important!): No permission is required to create or access DeFi applications which can serve anyone in the world with an internet connection

  2. Non custodial: DeFi protocols' creators do not have control or ownership over your assets

  3. Programmable: Rules are written in code; computers can make commitments
    Contracts run without human intervention

  4. Openly auditable: In theory, smart contracts and application logic are open source and can be audited by anyone

  5. Composable: DeFi protocols can be used as building blocks and programmed into higher order applications. This is DeFi’s core property: new applications can be built by combining same and new protocols differently. Devs can do more with less: more rapid and compounding innovation

  6. Natively global in nature: The absence of geography specific regulation and the distribution of crypto users, DeFi is built with a global user experience in mind

  7. Flexible user experience: Because protocols are open source, forkable, and composable, different UX can be built on top of them

The Defi Stack

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  1. The settlement layer (Layer 1) consists of the blockchain and its native protocol asset (e.g., Bitcoin [BTC] on the Bitcoin blockchain and ETH on the Ethereum blockchain). It allows the network to store ownership information securely and ensures that any state changes adhere to its ruleset. The blockchain can be seen as the foundation for trustless execution and serves as a settlement and dispute resolution layer. 

  2. The asset layer (Layer 2) consists of all assets that are issued on top of the settlement layer. This includes the native protocol asset as well as any additional assets that are issued on this blockchain (usually referred to as tokens).

  3. The protocol layer (Layer 3) provides standards for specific use cases such as decentralized exchanges, debt markets, derivatives, and on-chain asset management. These standards are usually implemented as a set of smart contracts and can be accessed by any user (or DeFi application). As such, these protocols are highly interoperable.

  4. The application layer (Layer 4) creates user-oriented applications that connect to individual protocols. The smart contract interaction is usually abstracted by a web browser-based front end, making the protocols easier to use. This is layer users interact with; It earn fees as it wants, sometimes it shares them with their users

  5. The aggregation layer (Layer 5) is an extension of the application layer. Aggregators create user-centric platforms that connect to several applications and protocols. They usually provide tools to compare and rate services, allow users to perform otherwise complex tasks by connecting to several protocols simultaneously, and combine relevant information in a clear and concise manner.2

Unravelling the DeFi Ecosystem

The most prominent blockchains used to build DeFi apps are Ethereum, Solana, and Binance Chain. These underlying blockchains store the ledger state of what is deposited into the DeFi apps, what is stored within the smart contracts, all of the transactions, and withdrawals. All of the core accounting functions to ensure matching inputs and outputs are handled by the blockchain itself, the DeFi apps don’t need to create external systems to reconcile balances, because all of the transactions are queryable across the various block explorers. In addition, compared to the traditional system there is no separate process of settling & clearing transactions. The transaction processing, clearing, and settling all happen at the same time when the transaction is broadcasted. 3

The DeFi apps themselves are composed of all of the core financial applications which can be used directly, or embedded into other various apps within the crypto ecosystem.

Use Cases DeFi can unlock

1. Payments, including remittances and cross-border

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Let’s take the example of a typical consumer transaction with the consumer having to pay the merchant in exchange for goods or services. Under the existing set-up the process of transferring money from the consumer to the merchant is rather complicated involving several parties, i.e. an issuer, an acquirer, a payment network like Visa or Mastercard and in most cases a gateway provider. All of these parties exert a centralized type of control.
In a DeFi version of the same transaction there would be only one reference point between the two parties, allowing direct communication, validated only on a distributed ledger. The decentralization refers exactly to the fact that there is no company or party association behind the ledger. Although there seems to be an obvious saving in terms of fees, the discussion is far from complete given the fact that there is no standardized DeFi set-up or solution with the final outcome depending on factors such as the protocol type, the network speed or the network fees, which tend to be fixed rather than variable.

Algorithmic stablecoins (there are decentralized) are a seamless, faster, and cheaper way to make domestic payments, remittances and cross-border payments. In Korea, ~$60M monthly of Ecommerce transactions are already taking place using the Chai Wallet with KRT, the Terra Korean Won-pegged algorithmic stablecoin.

2. Yield seeking (Lending, Borrowing, Spending rewards etc.)

There are 100s of dApps, which utilize trustless smart-contracts to create a market of buyers, sellers, lenders, borrowers, and service providers. Three of the top five DeFi protocols relate to lending & borrowing. By depositing funds in these dapps you are eligible for yield/returns. However, DeFi is still risky as crypto accounts are not FDIC insured and leverage amplifies risk.

Note, when you use Defi, oftentimes you see two types of yield. One is denominated in the token(s) you are depositing in the protocol, and another is denominated in the native protocol/dApp token that some protocols give out for users of the dApp. DeFi protocols enable high yields of 10-50% due to the ability to borrow for leverage:

  • Yield farming: Borrowing crypto from one protocol and depositing it in another that offers higher interest rates

  • Liquidity mining: offering tokens to an exchange that lends them to others, offering you a percentage of their returns

For instance, when you “Yield Farm” $USDC on Compound, you are effectively lending money to the protocol PLUS getting equity (in the form of the protocol token, $COMP). You will be paid out yield in USDC (minus a small fee to compound for providing this service) and “yield” through $COMP.

Yearn Finance is a suite of products in Decentralized Finance (DeFi) that provides lending aggregation, yield generation, and insurance on the Ethereum blockchain.

3. Trading (Exchanges & Liquidity)

To broaden access to advanced trading & financial services across border without permission, DeFi can solve this through three innovations: using decentralized exchanges (DEXs), Automated Market Makers (AMM) and trading synthetic assets.

Decentralized exchanges
DEXs like Uniswap allow anyone with a crypto wallet to swap tokens directly using self-executing smart contracts called Automated Market Makers (AMMs) without an intermediary organization for custody and clearing transactions. This dynamic enables more asset pairs and instantaneous trades on DEXs

Automated Market Makers

  • Non custodial; trade is executed close to market price; everyone can become liquidity provider and earn share of the transaction fees

  • Liquidity is provided by token holders who receive fees proportionally to the share of the pool

  • Price of the asset is not driven by order book but deterministic, depending on the relationship between the size of the liquidity provided to each side of the pair

Synthetic assets

  • Those who cannot easily access the US capital markets can trade synthetic assets that track real-world assets, giving them price exposure without holding actual shares.

  • For example, Mirror Protocol allows you to trade synthetic shares of Tesla (TSLA) using smart contracts that guarantee you the difference in TSLA’s real-world price between the time you buy and sell your mTSLA shares.

Through DeFi, you can invest in Gold. You can invest in stocks like Amazon and Apple. You can short Tesla. You can access the S&P 500. This is done through crypto-based synthetics — which gives users exposure to assets without needing to hold or own the underlying asset. This is all possible with protocols like UMASynthetix, or Market protocol. Maybe your style of investing is more passive. With PoolTogether , you can participate in a no-loss lottery.

Maybe you’re an advanced trader and want to trade options or futures. You can do that with DeFi protocols like ConvexityFutureswap, and dYdX. Maybe you live on the wild side and trade on margin or leverage, you can do that with protocols like FulcrumNuo, and DDEX. Or maybe you’re a degenerate gambler and want to bet against Trump in the upcoming election, you can do that on Augur.

With as little as $1, people all over the world can have access to the same investment opportunities and tools that used to be reserved for only the wealthy, or those lucky enough to be born in the right country.

You can start to imagine how services like Etrade, TD Ameritrade, Schwab, and even Robinhood could be massively disrupted by a crypto-native company that builds with these types of protocols at their foundation.4

How do know which tokens to buy?

As the crypto market goes through a cycle of volatility, when it comes to DeFi tokens, the optimal way to invest is to “do your own research”. Try to study projects and learn some of the fundamentals before putting any significant amounts into them. 
A basic approach on how to do some high-level research when it comes to DeFi tokens or NFT projects:

#1 find token in CoinGecko
#2 check market cap, fully diluted valuation, volume and Mkt Cap/TVL ratio
#3 check website
#4 study tokenomics & pre-sale
#5 analyze team
#6 check github activity
#7 visit telegram/discord rooms
#8 search ticker on twitter
#9 check reddit/4chan
#10 analyze holders
#11 chart & trade history

For NFTs, determine how on-chain the NFTs are and analyze on-chain activity (using tools like OpenSea's Rankings page and NonFungible.com's Market History hub).

Pick a DeFi token today that you want to get familiar with and do your own research by applying some of these steps.

Risks in the DeFi system

  1. Smart contract risk (Contract bugs, attackers finding exploits) E.g. bZx incident

  2. Poor protocol design and parameterization (gaming incentives due to flaws in token)

  3. Liquidation risk (volatility in collateral, inability to source specific currency to repay borrowed funds)

  4. On-chain congestion (scalability is a challenge but many L2 solutions are addressing this)

  5. Protocol change risk (Maker system breaks down and DAI loses its peg)

  6. Changing interest rates

  7. Front-end risk (DDOS, single point of easy access)

So how is DeFi going to evolve?

DeFi is really in a position to disrupt financial services from the ground up. The basic concept behind Decentralised Finance is an open, permissionless and decentralized set-up without the need to trust centralized parties that are controlling financial services as we know them today. With the additional promise to lead to significant improvements in terms of decreased costs, increased security, enhanced accessibility and higher privacy levels.

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Nakul


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1
https://medium.com/lightspeed-venture-partners/defi-ing-the-rules-of-traditional-finance-39176e785947
2
https://research.stlouisfed.org/publications/review/2021/02/05/decentralized-finance-on-blockchain-and-smart-contract-based-financial-markets
3
https://medium.com/racecapital/defi-infrastructure-101-overview-market-landscape-78e096a85834
4
https://medium.com/genesisblock/crypto-powered-the-most-promising-use-cases-of-decentralized-finance-defi-949d8e6a12d3