Understanding DeFi and Its Importance in the Crypto Economy

Decentralized finance, or DeFi, is one of the most important topics in cryptocurrency. The aim of DeFi is to create an entirely new financial system, completely independent of the traditional financial (TradFi) economy. There are billions of dollars being invested into this goal, along with the efforts of thousands of developers around the world.

This is part one of our series on DeFi. The aim of this series is to provide a deep dive for financial advisors to further our understanding of this space and create a bridge that we can use efficiently to merge the TradFi world we work in with the new and innovative DeFi space that is being created.

This article originally appeared in Crypto for Advisors, CoinDesk’s weekly newsletter defining crypto, digital assets and the future of finance. Sign up here to receive it every Thursday.

The origins of Ethereum and the DeFi ecosystem

In 2013, programmer Vitalik Buterin co-created Ethereum as an additional cryptocurrency project after his work on Bitcoin. Ethereum is different from Bitcoin because it’s designed to be a blockchain with multiple different functions: to be a digital money, to be used for global payments and to have blockchain applications run on top of its code. There’s currently an entire digital economy running on top of Ethereum, one of which is the DeFi ecosystem.

DeFi is a crypto movement that is built on cryptocurrencies like ether, open to anyone in the world (with an internet connection). DeFi is a trustless application, meaning the applications are not controlled or hosted by a central party such as a bank or a government. The aspects of cryptocurrency such as cryptography, smart contracts and blockchain technology allow this system of decentralized finance to exist for the global community to utilize.

Ethereum utilizes a robust smart contract programming language called Solidity, which allows for all of the necessary logic that financial contracts require to be included in the application code. Many other cryptocurrencies now compete with Ethereum to run DeFi applications, such as Avalanche, Terra, Fantom and others, but it is important to note that Ethereum is the largest network and was the first project that was used to create DeFi.

The first DeFi project, MakerDAO, was created in 2015 on top of the Ethereum blockchain. MakerDAO allows any user to lock ether, or ETH, via smart contracts and generate dai, a stablecoin pegged to the U.S. dollar. Dai is often used in the MakerDAO savings platform called Oasis, effectively creating a decentralized bank. Through the power of stablecoins and smart contracts, Oasis created a lending and borrowing platform for its users.

Lending and borrowing in the DeFi ecosystem

Lending and borrowing platforms have become a tremendous part of the DeFi ecosystem. Users are able to lock crypto positions into a smart contract and borrow against their position. Other users are able to lock crypto positions into a smart contract and generate yield by allowing their coins to be lent out to borrowers.

An interesting thing to note is the yields generated by lenders in the DeFi ecosystem are substantially higher than the traditional financial system. Running a smart contract is much more cost-effective than running a traditional bank; therefore, nearly all of the yield generated from lending money is passed directly back to the lender via the smart contract. Many people place their trust in these transparent smart contracts and are able to generate a significant income from their utilization.

In a world of ultra-low interest rates, the cost-effective smart contracts are providing a technological solution to this problem. Many people are upset with central bankers for allowing interest rates to be so low, and a solution isn’t found by political persuasion but rather through technology, which has yet again created an opportunity for borrowers and savers alike. Perhaps it would be wise to hedge your bets on the traditional banking system through building a robust DeFi portfolio.

Compound

Compound, an autonomous algorithmic protocol that allows users to supply various crypto assets and start generating interest, is another large application in the lending and borrowing category of DeFi. Its native cryptocurrency is COMP. There is currently $8.9 billion locked into Compound contracts (according to DeFi Pulse). Compound also allows its users to borrow against crypto positions such as ETH and borrow stablecoins (with interest) used for spending. This is very similar to the traditional finance concept of borrowing dollars against an appreciated security. Anyone can lock assets into the Compound protocol and immediately begin earning continuously compounding interest on their position.

Unlike traditional banks, Compound interest rates adjust automatically depending on supply and demand. When a user supplies tokens to the Compound protocol, they are credited with cTokens, representations of underlying assets that are generating interest and that are acting as collateral. Compound users are able to borrow up to 50% of their cToken value. Just like traditional financial systems, there are liquidation points on the borrowed position. Users have immediate liquidity and can withdraw their assets at any time.

Aave and flash loans

Another large lending and borrowing platform in the DeFi ecosystem is Aave. Similarly to Compound, Aave is a decentralized, open-source, non-custodial protocol running on Ethereum. Its native cryptocurrency is AAVE. There is currently $11.8 billion locked in Aave smart contracts. Aave allows users to lend or borrow crypto assets. Lenders are able to earn a yield on their assets that are supplied to the protocol. Like Compound, the earned yield adjusts depending on supply and demand of the market.

Aave also offers a unique service called “flash loans.” Flash loans are “one block borrow transactions,” which are transactions in which a user borrows and repays a loan in the same block. The smart contract only allows the loan to occur if the borrow and repayment of the loan occurs in the same block (transaction). This technology is a new feature that is used in arbitrage and quick trading. This type of loan does not exist in traditional finance and is seen as a major improvement to the TradFi system.

Flash loans enable cross-exchange arbitrage to exist in the crypto ecosystem, as detailed in this CoinDesk explainer: “Traders can make money by looking for price discrepancies across a number of different exchanges. Say two markets are pricing pizzacoin differently. It’s priced at $1 on Exchange A and $2 on Exchange B. A user can use a flash loan and call a separate smart contract to buy 100 pizzacoins for $100 at Exchange A, then sell them for $200 at Exchange B. The borrower then repays the loan and pockets the difference.” Thus, flash loans increase price stability across cryptocurrency exchanges and ultimately strengthen the crypto economy.

Decentralized exchanges

The creation of smart contracts, stablecoins and lending and borrowing platforms, led to another important creation in DeFi: decentralized exchanges (DEX), another incredibly important component of decentralized finance. DEXs saw over $1 trillion in trading volume in 2021. In my next article in this series, we will go through the creation of DEXs, their value to the crypto economy, how they interact with lending and borrowing platforms, and how users benefit from their existence.

Why DeFi is so important

The goal of DeFi is to create an open financial market that is trustless and permissionless. Significant development and investment has been placed into the advancement of DeFi, and as financial advisors, it’s important to understand this space. Much of the technology in the DeFi space builds upon, and improves, the TradFi system, possibly resulting in a better outcome for users – you and your clients. As the space continues to evolve and strengthen, it’s vitally important to have an understanding of decentralized finance and to be prepared to interact with, and rely upon, these applications.