Blockchain in Finance
Introduction of DeFi
Decentralized finance, also known as DeFi, intends to offer a viable alternative to the traditional financial system in the form of a decentralized system. DeFi refers to a purely decentralized governing body. For example, Central Bank Digital Currencies (CBDC) is NOT a DeFi application, as it is minted and controlled by Central Bank.
DeFi aims to incorporate the decentralization concept of blockchain into the financial environment. The DeFi system provides a possible remedy for the increasing inequality of global population wealth due to the centralized nature of the traditional financial system.
The basic principle of DeFi is to use the deployment of blockchain and cryptocurrency to lead the global digital banking revolution in three aspects:
- Promotion of financial inclusion
- Lowering financial transaction costs
- Adopting a privacy and security-centric approach
To promote financial inclusion, DeFi aims to widen global access to financial services by removing the barriers to entry in the form of status, wealth, and location obstacles, and also lower the transaction costs.
What is DeFi offering?
DeFi is offering you control of your own assets. Although new-age bank and fintech enterprises promise that users can have more control, in fact, you are still trusting them to manage your assets. The objective of DeFi is to give you full control of your own assets using a decentralized approach and blockchain technology. Also, many developers of financial products are adopting open-source protocols to build decentralized products.
Open Lending Protocols
Open lending protocols are money lending platforms built on blockchain, which is one of the major DeFi applications and has gained popularity in recent years. Through a lending protocol, some users deposit funds and earn interest, while others can borrow and pay interest just like with banks. Nevertheless, smart contracts take the place of intermediaries and connect lenders with borrowers directly.
The transactions are executed based on the codes programmed in smart contracts without the need for any intermediaries or arbitrators. Investors can enjoy higher returns compared with the traditional financial system due to the reduced costs. Borrowers can get funds automatically without a credit check, once the over-collateralized conditions are met. Liquidation will also be triggered automatically in case of default or value depreciation of the collaterals, as most lending protocols are offering crypto-backed loans, the price of the cryptos are volatile. All protocols are open-source, which allows anyone to build new financial products on top of them. Developers can collaborate with each other to create new products, which leads to faster innovation and deployment.
Compared with traditional lending and credit services, the lending protocols have the following advantages:
- No credit check is required, meaning easier access for people that cannot tap into traditional services
- Allows for collateralization of digital assets
- Users can have full control of their assets
- Trust is built on transparent public blockchains, leading to reduced risks and costs
- Instantaneous settlement of transactions
- Interoperability of various DeFi protocols, as most are built on the Ethereum network
Other Types of DeFi Projects
The number of DeFi projects nearly doubled in 2019 as the global blockchain developer community made fast progress in building new products. Lending, payment and decentralized exchange (DEX) remain the most profitable sectors.
Decentralized exchanges enable peer-to-peer transactions of digital assets between two parties on the blockchain without the need for an intermediary. The trades are executed via smart contracts by connecting the trading parties’ crypto wallets directly. And thus DEXes usually charge lower trading fees than centralized exchanges.
Market Overview and Latest Trends
2019 saw DeFi gaining momentum. In January 2019, the total value locked (TVL) in the DeFi ecosystem was approximately US$280 million. By the end of the year, the total TVL amount had grown to US$700 million. It has expanded even further since then, and as of Aug 2020 it was 8 times greater at US$ 5.8 billion (source: DeFi Pulse). Also, the total market cap of the top 100 DeFi tokens was US$ 1 billion in Apr 2020 and US$ 10 billion by August, a 10-fold increase within only four months (source: DeFi Market Cap). In terms of networks, Ethereum continues to dominate the DeFi market. Among the 245 DeFi projects listed on DeFiPrime.com, 199 are based on Ethereum network.
Besides purely decentralized finance applications, there are CeFi applications offered on blockchain, which also involves digital assets, but users trust the company that offers the services rather than the codes from the protocol. The benefits of CeFi are a better user experience and access to higher liquidity, as the CeFi service provider can help customers handle funds. It is a hybrid model between the traditional finance system and DeFi. Examples of CeFi applications are the major crypto exchanges, such as Binance and Huobi.
Compared with the traditional finance system, the DeFi market is still very small. However its growth has picked up pace rapidly since last year and we will continue to see steady growth in the coming future.