What is DeFi?
Decentralized Finance often referred to as DeFi or Open Finance attempts to improve on traditional financial systems by replacing the middleman and intermediaries with automated code known as smart contracts.
A large majority of these smart contracts exist on the Ethereum blockchain which provides the underlying infrastructure that gives these smart contracts the ability to transfer value in a decentralized, immutable and transparent manner which cannot be censored. However, they can also exist on any smart contract platform.
This allows for the following benefits over legacy financial systems :
✅Non-custodial : Retain full control and ownership of your assets while utilizing these financial services. No need to transfer assets to any financial institution ever.
✅Fast, Borderless Settlement : Decentralized blockchain technology allows for near-instant, borderless settlement.
✅Permissionless : No need for centralized bank approval or paperwork.
✅Censorship Resistant : No one is able to censor transactions on a public permissionless blockchain.
✅Transparency : DeFi defaults to a transparent ledger accessible to all (unless specific privacy protocols are used), as opposed to the opaque centralized legacy systems currently used.
✅Efficient : Lower fees due to disintermediation results in greater yields from financial services on most cases.
✅Greater Returns : Financial Innovation creates new financial instruments that afford much greater returns.
Through the use of automated smart contracts, you are able to avoid using a trusted intermediary which results in lower fees and near-instant processing times. This leads to cost savings and greater returns for your money.
We will outline some examples below :
In traditional financial markets, a trusted financial intermediary takes lender's funds, charge a high spread and lend them out to borrowers after credit scoring is done via a lengthy loan approval process. Decentralized lending platforms like Compound, dYdX and Fulcrum allow users to programmatically take out a loan on the Ethereum blockchain without any bank accounts or loan approvals. This is done by replacing the trusted financial intermediary with smart contracts.
Lenders lend their funds directly into a smart contract where borrowers can directly borrow by providing collateral to the smart contract. These loans are always overcollateralized to hedge against volatility risks. This ensures that their collateral can be seized and liquidated to cover the loan in the event that prices of these collateral drop below their loan amounts.
As a result, these decentralized lending protocols could offer interest rates that are much higher than traditional bank rates of 0.5%-2% APR.
A quick comparison of stablecoin lending rates can be seen here:
Stablecoin lending rates at https://loanscan.io/
The true value of Decentralized Finance on Ethereum comes from its composability.
This means that smart contracts from different financial applications can connect and interact with each other like lego pieces ("Money Legos") similar to the image below.
These "Money Legos" combine to create completely new and innovative products that have not been contemplated and cannot exist in traditional legacy financial markets.
Credits to Totle for Money Lego graphics
This offers everyone an opportunity at greater returns - generating alpha over traditional financial instruments - all while empowering digital asset owners with full financial control and custody of their assets.
Some of the innovations we have seen today include the following:
Participants buy lottery tickets with Stablecoins that are put into a Compound Lending Protocol to earn interest. At the end of the lottery draw, every participant gets their principal back, while one lucky winner gets all of the interest earned on the Lending protocol. Thus creating a lottery with zero chance at loss capital !
Lending protocols pool funds from lenders into a smart contract to be lent out to borrowers that take out a loan with a digital asset collateral - providing an amount much greater than the borrowed amount so that the loan is overcollateralized.
Liquidity Pools like Uniswap incentivizes liquidity providers who provide equal values of both pairs in the pool with exchange fees from traders who use the pools to swap tokens. This essentially creates a synthetic position that benefits liquidity pool providers most when they expect a narrow trading range during the duration of the liquidity provision. This is similar to a short straddle position in option markets.
Yield Enhancing Liquidity Pools thus combine the best features of all the above into a product ideal for generating yield on Stablecoin trading pairs or any asset with a expected 1:1 value in the long run.
This allows funds provided to be simultaneously lent out to Lending Protocols while sitting in a Liquidity Pool's order book waiting to be filled. As each trade happens, exchange fees are earned by the liquidity pool providers that serve as yield enhancement to the existing lending interest rates generated.