Decentralized finance (DeFi) has been making waves over the last several months following the surge in platforms and products offering DeFi services.
Lending protocols, security tokens, derivatives, exchanges, and more, Ethereum’s DeFi landscape is playing out as one of its most profound application environments so far — despite the network’s scaling woes.
Understanding DeFi can become convoluted with so much innovation currently ongoing, so let’s look at some of the critical components of the blossoming ecosystem.
What is DeFi?
DeFi is essentially just conventional financial tools built on a blockchain — specifically Ethereum. They are mostly predicated on open-source protocols or modular frameworks for creating and issuing digital assets and are designed to confer notable advantages of operating on a public blockchain like censorship-resistance and improved access to financial services.
Decentralizing everything is not a prudent move, and many DeFi applications take this into account by offering hybrid digital asset/traditional financial services, such as BlockFi.
An alternative term that is more encompassing of the ongoing focus on financial products is open finance, where an ecosystem of integrated digital assets, blockchains, and open protocols are ingratiating themselves with conventional financial structures.
The striking shift in Ethereum’s application narrative has coincided with the sheer popularity of open financial tools on the products. For example, a recent report by Bloqboard on open lending protocols highlighted that active outstanding loans from four open lending protocols — MakerDAO, Dharma, dYdX, and Compound Finance — rose 1,200 percent in 2018 to reach $72 million.
So, what exactly are some of the primary open financial sectors on Ethereum? Let’s look at some of the most popular — Open lending protocols, issuance platforms and investing, prediction markets, exchanges and open marketplaces, and stablecoins.
Open Lending Protocols
Open lending protocols have probably achieved more recent attention than any other categories of open finance on Ethereum. Largely due to the meteoric rise in the use of Dai and other P2P protocols like Dharma and liquidity pool designs such as Compound Finance, decentralized lending is making significant noise.
Open, decentralized lending offers numerous advantages over traditional credit structures including:
- Integration with digital asset lending/borrowing
- Collateralization of digital assets
- Instant transaction settlement and novel secured lending methods
- No credit checks, meaning broader access to people that cannot tap into traditional services
- Standardization and interoperability — can also reduce costs with automation
Secured lending using open protocols like MakerDAO and Dharma are designed to rely on the trust-minimization that Ethereum affords to reduce counterparty risk without requiring an intermediary. This is accomplished via the basic cryptographic verification methods prevalent on public blockchains.
Open protocol lending is entirely restricted to public blockchains like Ethereum and has some intriguing long-term implications for expanding financial inclusion across the globe. MakerDAO is the most prominent decentralized lending protocol, soaring in popularity in 2019 so much that multiple stability fee raises have been proposed to maintain parity with its Dai: USD price peg — caused by scaling problems.
Other lending services that leverage digital assets include BlockFi, which enables users to lend and borrow digital assets but employs familiar credit models like credit checks and a company processing loan requests behind the scenes.
Issuance Platforms and Investing
Issuance platforms encompass a broad range of platforms, including several exchanges that double as issuance mediums (i.e., tZERO).
A significant portion of issuance platforms is honing in on the security token market, where pending regulation and the promise of more flexible securities is quickly becoming a widespread narrative in the crypto space.
Well-known security token issuance platforms like Polymath and Harbor provide the framework, tools, and resources for issuers to launch tokenized securities on a blockchain. They prepare their own standardized token contracts for securities (i.e., ST-20 and R-Token) that enable automated compliance and customizable trade parameters to meet regulatory requirements.
Similarly, they are integrated with service providers such as broker-dealers, custodians, legal entities, and more to assist issuers in their process.
Read: What is an STO?
Dual exchanges/issuance platforms include the likes of tZERO from Overstock, which recently went live.
Asset management platforms such as Melonport have also gained traction, offering a front-end digital asset management interface built on IPFS and a back-end that runs on Ethereum smart contracts. Melonport integrates price feeds, risk management, compliance, exchanges, and more.
Issuance platforms and investment management frameworks are likely to increase in prevalence rapidly as more participants enter open finance — particularly institutions.
Decentralized Prediction Markets
Decentralized prediction markets are one of the more compelling components of open finance that are highly complex but offer enormous potential. Augur launched last year to much fanfare as a censorship-resistant prediction market based on Ethereum, and other platforms like Gnosis are set to follow suit.
Prediction markets have long been popular financial tools for hedging risk and speculating on world events, and decentralized prediction markets allow for the same — but rather with cryptocurrencies and no ability to censor the markets.
No censorship inevitably leads to concerns over ‘Deadpools’ for assassinations, but many view those as a collateral risk that comes with no censorship.
Augur cites its use for everything from political and weather forecasting to hedging all types of risk in financial or adverse real-world events.
Augur has struggled to attract significant volume since its launch, mainly due to the high barrier to entry for using a decentralized prediction market. That being said, markets like Augur and Gnosis — which is planning on offering features like governance and micro-insurance products — should gain more favor as cryptocurrencies gain more exposure and mainstream users begin to realize their full potential.
Exchanges and Open Marketplaces
Exchanges in open finance primarily regard decentralized exchange (DEX) protocols and P2P marketplaces. First, DEXs are P2P exchanges of assets on Ethereum between two parties where no third-party acts as the intermediary in a transaction such as Coinbase or other centralized exchanges.
DEXs suffer from lack of volumes due to their more obscure nature and non-friendly UIs, and as such, are still in their early stages of adoption.
DEXs also use some highly innovative methods for swapping tokens such as atomic swaps and other non-custodial means for exchanging one asset for another with minimal settlement time or risk.
The consistently most popular dapp on Ethereum is IDEX, a decentralized exchange, and others such as EtherDelta have been in the mainstream news cycle before, albeit for adverse regulatory developments ushered by the SEC.
Many ‘DEXs’ make dubious claims that they are truly decentralized or non-custodial, so it is always prudent to do your own research before using them.
Some DEX’s we have covered on Blockonomi:
Other types of open marketplaces emphasize the exchange of non-fungible tokens (NFTs), often referred to as crypto-collectibles. Platforms like OpenSea and Rarebits facilitate the exploration, discovery, and buying/selling of crypto assets that range from NFTs in games like Cryptokitties to virtual land parcels in the Ethereum-based game Decentraland.
Some marketplaces like District0X even let users create their own marketplaces and vote on governance procedures. District0x’s MemeFactory is expected to launch soon.
P2P marketplaces on Ethereum have substantial long-term potential, and could eventually encompass markets for native digital assets and tokenized real-world assets like fractionalized paintings listed side-by-side.
Stablecoins have flooded the cryptocurrency markets recently with new models for issuing tokens, auditing their reserves, and managing their price pegs. Stablecoins are just blockchain-issued tokens designed to maintain a stable peg with an outside asset — mostly the USD but also sometimes gold or another asset.
Stablecoins primarily fall into 3 categories:
Crypto-collateralized stablecoins include Maker’s Dai, where the underlying asset (e.g., ETH) is over-collateralized against the loaned asset (Dai) based on the current collateralization ratio.
So, if the ratio is 150 percent, then depositing $150 worth of ETH into the Maker CDP would return 100 Dai. Interestingly, Maker only is composed of borrowers, since the protocol is the lender and mints/burns the Dai token based on the CDP and governance parameters.
Dai is unusual because it is censorship-resistant and can offer decentralized leverage.
Read: our Guide to Stablecoins
Fiat-collateralized stablecoins are by far the most popular and include regulatory-compliant and audited coins like Tether, USDC, and Gemini Dollars. The models for these stablecoins do not differ very much at all, and they rely on their users trusting them by providing transparent audits that their USD reserves can back the current circulating supply of the token to maintain the price peg.
Fiat-collateralized stablecoins don’t really make sense from a cypherpunk perspective, as they remove the advantages of a public blockchain-based cryptocurrency and add a layer of risk.
Companies behind these stablecoins earn revenue from the interest earned on the deposited funds (in USD) from users that they store in a bank account. Fiat-collateralized stablecoins are supposed to be redeemable at a 1:1 ratio with their peg — the USD.
However, due to competition in the marketplace, some intriguing analysis indicates that interest rates may become the next competitive trend in the stablecoin market, effectively diminishing margins for stablecoin providers and benefitting consumers.
Non-collateralized stablecoins are neither centralized nor over-collateralized with crypto assets, and instead, rely on contractions and expansions of the supply based on an algorithm to maintain a stable peg. Basis was the flagship example of such a stablecoin but stumbled and shut down following regulatory concerns with its model late last year.
There are many more types of participants, services, and products in the DeFi and open finance ecosystem — including custodians, infrastructure platforms, insurance, and payment avenues.
It is always prudent to do your own research and understand that DeFi products often involve high-risk assets in uncertain and unprecedented platforms.
However, they present a compelling glimpse into a future of digital assets, blockchains, and conventional financial systems interoperating with each other in an open and accessible environment.