The rise of decentralised finance (DeFi) and its potential benefits and risks.

The rise of DeFi presents exciting opportunities for financial innovation and inclusion, but it’s essential to approach it with caution and stay informed about the potential risks involved.

What actually is decentralized finance?

Decentralised finance (DeFi) as the name implies is simply finances that are not controlled by the government or any third party. DeFi, short for decentralised finance, is a rapidly growing sector within the cryptocurrency space. It aims to provide traditional financial services, such as lending, borrowing, and trading, through decentralised platforms built on blockchain technology.

DeFi is an umbrella term for peer-to-peer financial services on public blockchains, primarily Ethereum. Users typically engage with DeFi via software called dapps (“decentralized apps”), most of which currently run on the Ethereum blockchain. Unlike a conventional bank, there is no application to fill out or account to open.

With DeFi, you can do most of the things that banks support; earn interest, buy insurance, trade derivatives, trade assets, and more; but it’s faster and doesn’t require paperwork or a third party. As with crypto generally, DeFi is global, peer-to-peer (meaning directly between two people, not routed through a centralized system), and open to all. DeFi is “crypto-anonymous”, meaning it conceals the true identity of its user.

History and rise of DeFi

One could actually point to the launch of Bitcoin in 2009 as the beginning of the DeFi movement. This is true because Bitcoin was responsible for the rise of cryptocurrencies more broadly as an industry. Bitcoin popularized the idea of decentralized tokens and related services like exchanges. However, the Bitcoin ecosystem is not built to enable DeFi protocols. Those rely instead on Ethereum.

One of the key developments of Ethereum was the use of smart contracts which allow developers to create a wide variety of decentralized apps, including those related to DeFi. To this day, most DeFi protocols exist in the Ethereum ecosystem.

The concepts of some of the most well-known DeFi protocols, such as MakerDAO, predate the launch of Ethereum. Maker is a lending protocol that allows users to borrow cryptocurrencies instantaneously, or to earn interest from lending out crypto tokens, and it also provides its own stablecoin. Maker was created in 2014, though it officially launched in 2017.

A number of other popular DeFi protocols launched in 2017 besides MakerDAO. Among them were some of the earliest decentralized exchanges, automated market makers that utilize liquidity pools to provide users access to trades with any ERC-20 token.

EtherDelta was one of the first decentralized exchanges and a pioneer in allowing traders to exchange tokens without the use of a centralized authority. It remained significantly popular through the initial coin offerings of 2017 and beyond, but ran into difficulties when it suffered a major hack in 2017 and when its founder Zachary Coburn was charged with operating an unlicenced exchange in 2018.

ICOs surged in popularity in 2017 and represent another step in the development of DeFi. ICOs allow non-institutional organizations and even individuals to participate in the funding of a new financial project. Again, Ethereum was key to the launch of many ICOs, as new token projects typically exchanged their crypto offerings for ETH. As with many popular and lucrative ventures in the cryptocurrency space, however, ICOs quickly began to draw bad actors and others searching for a quick payday without delivering much by way of useful tokens or developments. Still, the ICO era led to the launch of some DeFi protocols which remain popular to this day, including lending and borrowing system and peer-to-peer asset exchange network.

At the same time that the ICO craze took off, protocol developers began to adapt the peer-to-peer focus of the DeFi movement to one relying more on pooled funds. This might be thought of as a “user-to-contract” approach, since users would no longer directly interact with other users but rather would engage with smart contracts themselves.

One of the most popular protocols to utilize this approach was Uniswap, which launched in 2018. It utilizes liquidity pools and automated market makers to facilitate the exchange of any ERC-20 token and to offer users an incentive reward by adding liquidity to the market for those tokens. Uniswap remains one of the major DeFi protocols today.

Compound was another protocol to emerge in 2018 and which helped to build the lending protocol space. However, it could be argued that Compound became most influential for the broader DeFi movement only in 2020, as we’ll see below.

Early in the COVID pandemic in March 2020, the price of ETH crashed, plunging by about a third in just a day. The dramatic price volatility led to a rapid increase in gas fees and liquidations, which in turn led to shortfalls for Maker. Maker created and auctioned additional native tokens in response. DeFi saw some of its earliest stress tests with the start of the pandemic in 2020, as values plunged.

Later in 2020, a number of factors led to the rapid growth of the DeFi space. First, Compound launched COMP tokens mid-year, providing an additional incentive for users to borrow and lend through this system and helping to bring about the controversial but popular practice of yield farming, in which users rapidly borrow and lend different tokens in an effort to achieve the best yields. COMP also allowed users the ability to participate in governance of the Compound protocol, further decentralizing authority and inspiring many subsequent protocols to adopt similar rules.

Other crucial developments for DeFi in 2020 include the advent of Yearn, which switches between different DeFi lending protocols to achieve gains, and SushiSwap, which attempts to gain liquidity from other protocols by incentivizing providers of liquidity with its own native tokens.

Since 2020, new protocols have continued to launch, and the DeFi space has seen interest and values rise and fall along with the larger crypto industry. More and more DeFi protocols are launching on non-Ethereum blockchains, attempting to take advantage of improvements that have been made to the preexisting smart contracts format. While it remains to be seen how successful DeFi will be going forward, interest in this movement has climbed rapidly in just a few years.

Benefits of DeFi

• One of the key benefits of DeFi is its potential to provide financial services to individuals who may not have access to traditional banking systems. It promotes financial inclusivity by allowing anyone with an internet connection to participate in various financial activities.
• DeFi also offers transparency and security through the use of smart contracts. These self-executing contracts automatically execute transactions when certain conditions are met, eliminating the need for intermediaries and reducing the risk of fraud.
• Pseudonymous: You don’t need to provide your name, email address, or any personal information.
• You don’t need to apply for anything or “open” an account. You just get access by creating a wallet.
• You can move your assets anywhere at any time, without asking for permission, waiting for long transfers to finish, and paying expensive fees.
• Interest Rates and rewards often update rapidly (as quickly as every 15 seconds), and can be significantly higher than traditional Wall Street.
• Everyone involved can see the full set of transactions (private corporations rarely grant that kind of transparency.

Risks of DeFi

• One major risk is the volatility of cryptocurrencies. Since most DeFi platforms operate using cryptocurrencies as collateral or for transactions, the value of these assets can fluctuate greatly, potentially leading to significant losses.
• Another risk is the potential for smart contract vulnerabilities. While smart contracts are designed to be secure, there have been instances of hacks and exploits, resulting in the loss of funds. It’s crucial to conduct thorough research and due diligence before participating in any DeFi project.
• Regulatory uncertainty is also a concern in the DeFi space. As governments and regulatory bodies catch up with the rapid growth of DeFi, there may be changes in regulations that could impact the industry.
• Fluctuating transaction rates on the Ethereum blockchain mean that active trading can get expensive.