August 2019

Decentralized Finance (DeFi)

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Decentralized finance, also known as DeFi, has been a growing movement in the world of blockchain and smart contracts. New projects are launching with increasing frequency that focus on areas such as decentralized lending and insurance, trust-less trading, stablecoins and zero fee payments.

Decentralized finance, also known as DeFi, has been a growing movement in the world of blockchain and smart contracts. New projects are launching with increasing frequency that focus on areas such as decentralized lending and insurance, trust-less trading, stablecoins and zero fee payments. Owing to the open source nature of smart contract development, every new DeFi contract can be replicated and shared, leading to a compounding of innovation. The combination of different DeFi ideas is leading to a rapidly growing financial ecosystem running on blockchain technologies. This month we are going to dive into what DeFi is, who the leading players in the space are and how it might disrupt the existing world of finance.

Global financial markets consist of many building blocks that combine to make the complex system we see today. At its base is the concept of money, with many global currencies vying for attention and relevance. We then have institutions, such as commercial banks, that offer simple products like loans and interest rate savings accounts. Beyond this, there are more complex financial instruments like derivatives, prediction markets and insurance contracts. Today all of these products are managed by middlemen that take a fee for operating the markets. DeFi is recreating these markets, but in a decentralized setting without the need for middlemen.

The earliest DeFi product, and the base building block for much of the DeFi ecosystem, is the stablecoin. Stablecoins are digital assets that hold a stable value relative to some peg. On Ethereum, the leading stablecoin is DAI, which is pegged to the US dollar and is backed by ETH. DAI is becoming the default payment method for people working on and using Ethereum. Dapps are increasingly asking for payment in DAI rather than in ETH as DAI holds a fixed USD value, providing a better user experience.

As a financial primitive located at the lower levels of the Web3 application stack, it can be difficult to gauge the success of DeFi applications. Traditional metrics, such as daily active users and transactions per second, are not as relevant for these services. Instead a focus on the amount of value locked up on the platform and the security of that value is more relevant. The growth in DeFi usage on Ethereum is clearly illustrated by the amount of ETH locked up in DeFi smart contracts. The importance of the DAI stablecoin can be seen from the fact that most of the ETH locked up today is in the MakerDAO contracts, the protocol underpinning DAI.

Outside of stablecoins, the next most prominent DeFi applications are decentralized exchanges. Also known as DEXs, these allow for direct peer-to-peer trading of digital assets, where the user does not require a third-party custodian to hold assets. Earlier this year, we wrote about the technical architecture behind decentralized exchanges; DEXs tend to use either proxy tokens or atomic swaps to enable peer-to-peer trading. Now, a new form of DEX has emerged that is rapidly gaining liquidity and usage. This DEX is called Uniswap and is the ushering in a new exchange mechanism.

Uniswap takes a unique approach to facilitating peer to peer trading, by removing the concept of an order book. Instead, Uniswap’s smart contracts pool liquidity and make markets dependent on a deterministic algorithm. The algorithm quotes prices to users dependent on the amount of liquidity in the pool and the amount being bought or sold. The system can always provide liquidity, regardless of how large the order is or how small the liquidity pool is. It does this by asymptotically increasing the price of the asset as the quantity requested increases. The system is extremely elegant, algorithmically smoothing out the depth of an order book. There can be no large holes or bid/ask spreads. Liquidity providers also have no need to manage orders or positions, but instead passively make fees from the protocol.

Another growing DeFi vertical is lending. Compound, one of the leading companies in the lending space, allows users to lend and borrow digital assets with floating rates based on real-time demand. Currently, Compound is offering 9.9% annual interest on loaning out DAI, the USD pegged stablecoin on Ethereum. This is a staggering interest rate on effectively lending out USD. While Compound is a non-custodian solution, meaning that the company never holds user’s assets, there are centralized safeguards built into its smart contracts. Compound has the authority to suspend assets, upgrade the price feed oracle, upgrade the interest rate models, and withdraw sponsor equity.

The team sees this centralization as necessary at this experimental stage of development. Over time, the plan is for the protocol to become “fully decentralized,” with the central control eventually being replaced by a decentralized autonomous organization.

The next most prominent lending project is Dharma, which has created a permissionless, decentralized credit market.The system works in a peer to peer manner, with one individual lending digital assets directly to another. Dharma asks borrowers to put up 150% of the value of their loan as collateral. Owing to the high demand for lending out digital assets, borrowers are matched with a lender quickly, often in under a minute. This provides a vastly superior experience to traditional lenders. Once matched, users can borrow ETH or DAI on28-day terms with a fixed interest rate. If the value of collateral drops to below 125% of the principal, then the smart contract automatically starts to liquidate the borrower’s collateral to pay back the original loan.

The explosion of DeFi products is important not just for the growth of blockchain platforms, but also because it is likely to seep through into the world of traditional finance, remodelling financial systems. Decentralized and open finance platforms are cheaper and more inclusive than existing institutional products, meaning that developing markets might now be able to benefit more broadly from things like insurance and lending services. Over time, we anticipate DeFi products abstracting away the current complexities of user-facing blockchain applications. Users of decentralized finance will not know that they are using a blockchain-based application but will experience cheaper, faster and feature rich financial services.

An example of this DeFi future in action is the Terra payment network, out of South Korea. Terra has gone to great lengths to abstract the technical complexities of blockchain and its native stablecoin away. The Terra team recently announced a partnership with Nexos, aDeFi lending platform, to add instant credit lines and interest rate savings of8%. Few of Terra’s 240k+ users know they are using a blockchain-based application with DeFi integrations. What they experience is that by using Terra for e-commerce payments they have lower transaction fees, faster settlement, instant credit lines, and a savings rate of 8%.

The benefits of blockchain technology coupled with DeFi innovation will be a superior financial services sector with greater efficiencies, cheaper products and more inclusive coverage. CMCC is invested in a number of base layer smart contract platforms, such as Ethereum, that will house the DeFi solutions of the future. We also have direct investments in consumer facing products like Terra, that are enabling users to interact with decentralized financial products. Blockchain will disrupt value industries like financial services in the way that the Internet has disrupted information industries. We look forward to supporting the leading global projects as they release their innovative and disruptive solutions.