DeFi, short for decentralized finance, is the foundation for a new, open financial system that gives people more control of their finances and reduces dependence on large financial institutions. A few popular categories include cryptocurrency exchanges, lending platforms, wallets, and stablecoins. The DeFi space has only been around since mid-2017 but has already seen serious growth. As of early February 2021, the total amount of virtual currencies locked in DeFi applications surpassed $39 Billion.
In this article, we’ll talk about what DeFi is— and what it isn’t. We’ll also look at the problems DeFi solves and discuss why it has gained so much momentum in recent years. Finally, we’ll highlight several examples of DeFi applications within the blockchain space.
DeFi applications foster an open financial system in which ordinary users can lend, borrow, and exchange money using software, rather than a bank. Whereas the traditional financial sector charges high fees and can be a painful experience, DeFi makes financial services cheaply available with a few clicks of the mouse.
Let’s now look at the technology required to run DeFi applications, define which applications are considered a part of the DeFi space, and examine potential security challenges.
Foundations of DeFi
DeFi applications are built on top of public blockchains or other varieties of distributed ledger technology that support the storage and transfer of virtual currencies. This stands in contrast to traditional financial applications, which use fiat currencies and rely upon a single database controlled by a financial institution.
DeFi applications require smart contracts that execute code automatically when certain conditions are met. After smart contracts are deployed on a public blockchain’s peer-to-peer network, DeFi applications are able to support user activity with little to no need for human intervention. Depending upon the design of the smart contract, a user can lend, borrow, and/or trade virtual currencies on platforms like marketplaces or exchanges.
Stablecoins are used as a means of representing the value of fiat currencies on decentralized blockchains. DAI, USDT, and USDC are three well-known examples. The value of each of these is supposed to remain pegged at or around $1.00 USD. This lack of volatility makes stablecoins a suitable option for DeFi borrowing and lending platforms. Compared to other crypto assets, lenders typically receive higher APR by lending stablecoins. Borrowers often choose to receive stablecoins to gain access to liquidity because their value doesn’t fluctuate with changes in market conditions.
DeFi and Degrees of Decentralization
The term “decentralized” is used quite frequently within the blockchain industry. It’s important to not let this word confuse you. Let’s take a look at what people really mean when they say that DeFi is decentralized.
DeFi is sometimes referred to as “open finance.” Essentially, we can think of DeFi offering financial services that are more open (user-controlled and available to everyone) than the traditional banking sector, which is composed of financial services that are more closed off (institution-controlled and only available to those deemed eligible).
In other words, we can look at DeFi in degrees of decentralization, with some applications being more open/user-controlled than others. Rather than a binary, black-and-white scenario, decentralization is best thought of as a spectrum full of various shades of gray. It’s also important to note that just because a financial application is built on a blockchain or uses virtual currencies, doesn’t necessarily mean that it belongs in the DeFi category.
On one end of the spectrum, peer-to-peer lending and borrowing applications like BlockFi, SALT, Celsius, and Nexo are actually closer to traditional financial applications due to their closed nature. Many people actually refer to these as centralized finance (CeFi) applications.
There are several criteria used to make this distinction. All of these applications are custodial, meaning that a single entity— the platforms themselves, in this case— have 100 percent control of user funds. The platform’s team, not the users, make the important operational decisions, such as when to initiate margin calls and provide liquidity for margin calls. The platforms also control price feeds and determine interest rates.
Moving along the spectrum, DeFi applications like MakerDAO and Compound are considered to be more decentralized. However, some aspects tend to be at least somewhat centralized. For instance, in October 2019, a MakerDAO whale controlled 94% of the voting power and used this to decrease the platform’s stability fee by 4%. Likewise, other DeFi applications may be deemed decentralized to a far greater extent but likely have some component that is centralized.
Stablecoins are another example. Although they are categorized as decentralized, it’s reasonable to say they are at least somewhat centralized, due to the fact that their values are often derived from government-issued fiat currencies or commodities, such as gold or silver.
Before looking at several areas where DeFi shines over traditional finance, it’s crucial to understand two of the biggest challenges that end users have to consider.
A lot of factors must be considered before determining how secure each DeFi application really is. It’s important to note that a security breach of a particular DeFi application doesn’t necessarily impact the underlying blockchain the application is built on. Unlike 51% attacks, which directly impact the entire blockchain network, DeFi security challenges typically only affect the funds that are locked in specific a DeFi app.
Let’s look at bZx as a case study. In February 2020, someone was able to execute two hacks using two separate procedures. The first was a sophisticated flash loan hack, which was caused by a bug in the bZx smart contract. The second was a price oracle manipulation attack. Instead of relying upon multiple oracles (decentralized), bZx used a single oracle (centralized) to secure data feeds. These two security breaches resulted in combined ETH losses totaling the equivalent of $954,000. Although these security issues affected funds locked in bZx, they did not directly impact funds stored in other DeFi applications or in other Ethereum wallets.
Limitations of Collateralized Loans
Traditional loans are much different than DeFi loans. Many types of traditional loans (e.g. personal loans, student loans and credit cards) are unsecured, meaning that the borrower doesn’t need to have collateral or make a down payment (unless it’s for a major loan such as a mortgage).
Other types of traditional loans (e.g. auto loans) are secured, meaning that the borrower has to sign a legal agreement called a lien. This is a legal document that states the lender can legally take possession of a borrower’s collateral— in this case, the vehicle itself— if the borrower defaults on the loan. Liens are structured so that borrowers who pay back funds on time don’t have to give the lender access to the collateral.
In contrast, DeFi borrowing relies on smart contracts to enforce the rules of collateralized loans. This means that borrowers are required to provide more collateral up front than they are actually borrowing. Many DeFi lending applications have a collateralization ratio minimum of 150% (or a similar percentage). If the ratio is 150%, the equivalent of $300.00 in virtual currencies must be sent to a smart contract as collateral for every $200.00 borrowed in virtual currencies (or pro rata). In other words, DeFI borrowers are required to already have access to capital, whereas traditional borrowers don’t necessarily have to.
DeFi borrowers also have to be aware of liquidation penalties, which are levied automatically by smart contracts whenever their collateralization ratio dips below the minimum requirements of a particular DeFi platform. If the value of a collateralized asset suddenly drops below the minimum, the borrower risks losing a portion of these funds.
This is actually a common occurrence since borrowers often use non-stablecoins as collateral. For instance, on a DeFi platform with a collateralization ratio minimum of 150%, only having $299.99 in collateral for a $200.00 loan would trigger a liquidation penalty. On MakerDAO Oasis, to give another example, the liquidation penalty is currently 13% of principal. Proactively avoiding liquidation is possible for DeFi borrowers who pay back portions of loans or add more collateral. However, knowing when to take these actions requires diligence and financial literacy.
How Does Traditional Finance Compare?
DeFi has emerged as an innovative alternative to traditional finance. Let’s examine a few notable categories to get a better understanding of how they compare today.
Sending fiat payments from one country to another is expensive with traditional banks and payment processing companies. Using one of the most popular services, converting $10,000 USD to EUR and sending to a European bank account would include a fee of around $80. That’s a transaction fee of 0.8%.
To put this into perspective, a Bitcoin whale was able to transfer $1.1 billion worth of BTC from one wallet to another for only $83, less than 0.00000755% of the transfer.
Savings and Lending
Saving and lending are both costly in the realm of traditional finance. Savings accounts typically provide an annual APR that is well below the inflation rate, which effectively means that the purchasing power of the savings is going down, not up. Over time, savers are steadily losing value on their funds held in ordinary savings accounts.
In the United States, for example, the national average for savings accounts is only 0.09% APR. Since 1956, there has only been one year in which the US annual inflation sat below that rate. In contrast, most DeFi savings accounts offer greater than 5% APR for at least one USD-backed stablecoin.
As of the time of writing, traditional personal loan interest rates vary from around 5.49 percent to 35.99 percent APR for most providers. Interest rates for loans on DeFi applications vary to a lesser degree but are significantly less in many cases, with most platforms charging less than 10% APR for at least one USD-backed stablecoin.
Onboarding User Experiences
User experience is difficult to quantify, but two potential quantifiable factors to consider are the amount of paperwork and approval waiting times required to access services. While these factors are clear in DeFi, there can be a lot of variables when dealing with traditional finance.
According to a Consult Hyperion whitepaper, the average bank took 32 days to onboard new clients in 2017. Actually being able to access financial services can take significantly longer. Ellie Mae disclosed in an October 2019 report that it takes an average of 47 days to close on a home, which is considered to start with the application filing date and end when funding is received. Personal loans can take up to three weeks with banks and credit unions.
DeFi, on the other hand, requires no lengthy wait times or paperwork. The equivalent of a signup process for using a DeFi platform typically only requires the end user to sign a few messages (verify blockchain transactions) with the private key associated with the wallet they are using. The terms of the agreement are determined and enforced via smart contracts.
Unbanked and Underbanked Populations
According to the World Bank’s 2017 Global Findex database, 1.7 billion adults remain unbanked, without an account at a financial institution or mobile money provider. This problem isn’t exclusive to developing countries.
A total of 8.4 Million US households, or 6.5 percent, were also unbanked as of a 2017 FDIC report. Around 18.7 percent of US households were underbanked—having either a checking or savings account, though rarely both. Households are also usually given the underbanked distinction if they've used alternative financing options during the previous year, such as money orders or rent-to-own services.
The same FDIC report also asked unbanked surveyees the reasons for not having a bank account. The top two main reasons were “Do not have enough money to keep in account” at 34.0 percent and “Don’t trust banks” at 12.6 percent.
These are problems that DeFi is working to solve. All you need is a cell phone and a data plan to get started. While having a bank account makes it easier to buy virtual currencies on centralized exchanges, blockchains make it simple to receive and store funds without the need for a bank account. Blockchains and DeFi applications generally don’t require users to maintain a minimum balance. They also use distributed ledgers as a technical solution to ensure that virtual currencies don’t require earning the trust of an intermediary, which is the case in traditional finance.
Why Is DeFi Gaining Momentum?
With the above comparison between DeFi and traditional finance, it’s evident that DeFi has several advantages from an end user’s perspective. Still, this doesn’t completely explain why DeFi has maintained such a high growth trajectory. The optimism surrounding DeFi is probably best attributed to the open nature of the space.
One of the greatest accelerators of DeFi adoption is the availability of open-source software for various smart contract platforms. Instead of having to write and test code for an entirely new blockchain or develop smart contracts from scratch, many blockchain projects provide the development infrastructure and documentation necessary to get started. This directly contrasts with the closed, proprietary software used for most traditional finance platforms. In essence, the DeFi space generally favors collaboration over competition.
New Applications and Use Cases
Most of the capital locked in DeFi today is confined to borrowing and lending platforms, yet there are numerous other use cases emerging. Blockchain-based insurance protocols, prediction markets, and asset management tools already exist. These are just a few examples of some of the more under-utilized DeFi use cases. While these applications may be lacking significant user adoption at the moment, they have the chance to catch up as the DeFi space steadily matures. As blockchain technology continues to evolve, additional applications and use cases will likely emerge.
Another factor for driving the adoption of DeFi is open participation. When thinking about financial sub-sectors like banking, lending, and trading, it’s easy to look at actual market size and current activity as a ceiling. What often isn’t considered is that DeFi could foster more participation and overall market growth due to increased accessibility.
Imagine someone who wants to apply for a loan or insurance coverage. Although these markets are enormous in traditional finance, a range of friction points (e.g. long approval processes, high costs, and complex qualification standards) currently prevent many people from gaining access. If DeFi applications provide a better alternative that eliminates these issues, there is potential to onboard people who aren’t able or willing to participate in traditional finance.
Komodo DeFi Applications
Komodo is a multi-chain platform that enables every third-party business to customize and launch an independent Smart Chain. Every chain can be customized along 18 different parameters, including the option to activate built-in modules like tokens, trustless oracles, instant micropayment channels, a quantum security, and much more.
In addition, the Komodo Development Team is working on DeFi applications and open-source infrastructure to support DeFi application development. Here are a few examples.
Peer-To-Peer Trading With AtomicDEX
With AtomicDEX, exchanges of digital assets are made directly from one trader to another. In short, this means that you never need to give up control of your funds to make trades. Since all trades can be completed via your personal crypto wallet, there’s no need to make deposits and withdrawals.
Komodo offers a stablecoin solution for developers and users in the Komodo ecosystem. The technology is still in alpha testing and development will continue throughout 2020. This technology is made possible by a pair of new Komodo Custom Contracts: Pegs and Prices. The addition of stablecoins in the Komodo ecosystem serves two primary purposes. First, the aforementioned Pegs Contract can be used to facilitate a collateralized debt/loan economic system. Second, stablecoins can serve as one-half of trading pairs in ordinary trades and swaps on decentralized exchanges like AtomicDEX.
Active User Rewards
The KMD blockchain supports 5% active user rewards for users who move their funds at least once per month. All you need to get started is a minimum of 10 KMD in your address as a single UTXO that is about 60 blocks (~60 minutes) old. Everything you need to know about collecting your active user reward on AtomicDEX can be found here. To see all of the wallets that let users easily claim their KMD rewards, check out the Komodo Wallets page.
Begin your blockchain journey with Komodo today.