Introduction to Decentralized Finance (DeFi)

September 26, 2019

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Will it be a game-changer to the existing financial system?

Decentralized Finance, known as DeFi, has been making waves in the crypto industry. Even Nasdaq has launched a new crypto index lately, called Defix, for the projects in the DeFi space, monitoring real-time information of DeFi protocols. With its enormous potential and ambitious growth of related projects over the past few months, it is believed that DeFi could undoubtedly be disruptive to the traditional financial institutions in just a matter of time.

What is DeFi?

As an alternative to traditional banking, DeFi provides the same financial services without any traditional central authority or intermediaries.

This brand-new financial ecosystem is built upon the use of blockchains that store digital information within an immutable, trusted and distributed network, as well as cryptocurrencies, and smart contracts. Without a central authority, DeFi allows everyone in the world to engage with a spectrum of financial services, like payments, lending, borrowing, and investing, managing their wealth portfolios with high autonomy and fewer barriers.

Developers can create DeFi applications (DApps) on blockchains for the purpose of minting, storing, and managing crypto assets. Smart contracts bind the irreversible agreements between two sides without the need for a middleman, making the whole financial system resilient and transparent.

The growth of DeFi

The total market cap of DeFi is ever growing along with the surge of DeFi protocols. The total value locked in DeFi’s applications has proliferated immensely throughout these two years. According to DAppTotal, the total locked value as of Sep 12, 2019 is over $1.22 billion, which is a big leap from only $180 million a year ago. The total ETH and EOS locked in DApp circulations is 3.11% and 10.02% respectively. The figures clearly demonstrate the significant growth of DeFi apps and are also positive signs for future DeFi development.

Popular DeFi applications

Out of the many sectors in DeFi, the most fast-growing and promising one is borrowing and lending.

With this kind of peer-to-peer and trustless lending platform, getting a loan would be straightforward and time-saving. Individuals can access a much wider pool of lenders and get a loan without complicated steps. At the same time, lenders can make passive income, or at least not make a loss since most crypto lending,so far is over-collateralized.

Thus, this open, secure, and transparent nature of blockchain allows DeFi to incubate more and more lending products and platforms, in which EOS REX and Maker are dominating the market, accounting for 32% and 24% of the total value locked in DeFi respectively.

EOS REX — Grow your holdings simply by staking

EOS REX, a resource exchange system, has surged to become the largest decentralized finance platform, with roughly $361.15 million in funds locked up since its launch in April 2019. According to DAppTotal, it has replaced the leading position of MakerDAO with $262 million which used to top the market.

EOS REX maintains a very niche position in the market because while almost every DApp is built on Ethereum, it is one of the few DApps built on EOS.

App developers need three essential resources, namely RAM, CPU, and NET, to build their own DApps. These resources are all held by EOS holders. However, a majority of them just stake EOS to simply keep the resources without utilizing them, and thus scarcity happens.

Given that the demand for resources is high, and the cost of purchasing them is high, too, EOS REX provides a resource rental option for developers to save much cost.

As the largest EOS decentralized financial platform, EOS REX allows EOS holders to stake their tokens and lend their resources to gain rewards. Borrowers pay EOS as a fee in exchange for the resources. In the end, when lenders unstake their EOS, they earn rewards in a passive and risk-free way.

MakerDAO

MakerDAO is a decentralized application that runs entirely on the Ethereum blockchain with automated smart contracts. In essence, it allows users to lock Ethereum (ETH) into smart contracts as collateral in order to secure loans in its unique stablecoin called DAI.

For each DAI, there is $1.5 of ETH locked into the MakerDAO smart contract as collateral. If the amount of collateral falls below 150%, then the smart contract is auto-liquidated with a 13% forced-liquidation fee plus the annual stability fee (annual interest rate for the loan).

Part of its charm is that DAI’s value is pegged to the US dollar, and it always stays around $1, thanks to its dual coin system, Maker (MKR) and Dai (DAI), which brings price stability to crypto assets.

What is more, it provides liquidity to ETH holders. While retaining ownership of ETH, holders have access to a liquid and non-volatile fund (DAI) for trading cryptocurrency with leverage, or other purposes. If the price of ETH increases during the loan period, their collateral will increase in value as well, thus earning more when they pay off the debt.

Despite the consistent increase in MakerDAO’s annual stability fees over the past few months, the fee has drastically reduced from 18.5% to 12.5%. It was once criticized for fluctuating too much and setting too high.

Benefits of DeFi

Easy access with untapped resources

The unbanked population can gain access to financial services such as savings, payments, loans, mortgages and insurance services. With access to the internet and a few clicks to create a crypto account, DeFi opens up unparalleled opportunities for people to control their assets, invest and trade, with minimum to zero barriers. They can even put their cryptocurrency in the wallet and earn interest and borrow money without any credit history but only with crypto as collateral, making it easy for start-ups to grow.

Interoperability

It provides more options when taking out loans or lending crypto. For example, after taking out a DAI loan from MakerDAO, users can convert it to other cryptocurrencies to gain leverage, creating different possibilities for other investments.

Cheaper, efficient and convenient

As everything is built on blockchain, financial services will never be the same. We can enjoy high efficiency and save costs, as the charges we pay for banking services cease to exist. You can imagine cross-border assets transferring quickly with zero transaction fees. Also, in politically or economically unstable countries, where inflation is serious,and loans are difficult, DeFi provides an option for residents to exchange their deposit into cryptocurrency, which could serve as a store of value.

More resilient and transparent

DApps rely on smart contracts, which are open-source and interoperable. This helps developers to understand more about different products and create and contribute different valuable projects to the whole DeFi space.

Downsides of DeFi

Fiat on/off difficulty for crypto

Too few platforms provide services to convert fiat money to crypto. At the same time, it is generally hard to redeem crypto loans for fiat currencies. As a result, it might be difficult to utilize the borrowed funds in the real economy.

DApp usability

Investors hesitate to explore the possibilities of DeFi since the public in general lacks knowledge about the space. They are unfamiliar with smart contracts and could easily lose money just by inputting an incorrect wallet address. Although it can be easily solved, it still stands as a barrier against broader DeFi adoption.

What to expect for DeFi’s future?

In the coming future, it is expected that a larger variety of cryptocurrencies, even assets such as property and collectibles, would be accepted as collateral, making lending services more accessible and fostering the development of DeFi.

At the same time, services will become more prevalent once more platforms allow people to convert fiat into cryptocurrency. By then, people must acquire relevant financial knowledge.

With the way developments in DeFi are unfolding, it may still be too early to predict the coming trend. Yet, we should be paying attention to how the dynamics of this brand new financial economy shift and become prepared as always.

This post originally appeared on OKEx Blog. Read more.

Disclaimer: This material should not be taken as the basis for making investment decisions, nor be construed as a recommendation to engage in investment transactions. Trading digital assets involve significant risk and can result in the loss of your invested capital. You should ensure that you fully understand the risk involved and take into consideration your level of experience, investment objectives and seek independent financial advice if necessary.

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