The term decentralized finance, or DeFi, dates back to a Telegram chat in 2018. It was around this time that a group of software developers and entrepreneurs were trying to decide what to call their next-generation financial services movement that would be automated, built on a blockchain. , and able to strip traditional banks.
Three years later, DeFi is big business. A user with a crypto wallet can trade digital assets, get loans, or take out insurance, among other things. Some $ 90 billion in collateral is stuck in these services, and more than 10 million people have downloaded MetaMask, one of the most popular digital wallets used to open access to these networks.
The roots of decentralized finance come from the 2008 Bitcoin White Paper which set the framework for a new digital money system; these creations exploded into something bigger when Ethereum was invented a few years later. “Bitcoin wanted to be peer-to-peer money,” wrote Camila Russo, founder of crypto news service The Defiant, in her book. The infinite machine. “Etherum wanted everything to be peer-to-peer.”
DeFi is an amalgamation of cryptography, finance, and software development, and it tends to be surrounded by its own lexicon and jargon. Let’s take it one piece at a time.
What is DeFi?
One of the main tenants of decentralized finance is that it is, well, decentralized. Take bitcoin, for example: the original crypto asset is essentially a ledger (its blockchain) that is decentralized because transactions are recorded in databases on many different computers. This unique record (stored in many databases) is cryptographically secured, and computers monitor each other to ensure it has not been tampered with.
Decentralization is part of what makes bitcoin hard to kill. No party is in charge, so it’s nearly impossible for someone to become a thug and change the rules that govern the virtual room. Likewise, even if a government succeeds in preventing a group of computers from supporting bitcoin, the digital asset may continue to function as other computers on the network keep full records of transactions and may continue to run the show. .
DeFi takes this concept even further. Decentralized exchanges and lending systems use blockchains like the Ethereum network, which was proposed by Canadian-Russian programmer Vitalik Buterin in 2013. While the bitcoin blockchain was designed to track bitcoin transactions, the Ethereum blockchain was created to host programs. Think of Ethereum as a decentralized computer for which software developers can build applications (dApps). Computers that provide Ethereum’s processing power are rewarded with Ether, which is now the second most valuable crypto asset behind bitcoin.
Like Bitcoin, the Ethereum network is difficult to shut down or corrupt. Anyone with an Internet connection can access it.
Decision-making, or governance, in DeFi organizations, from the fees they charge users to the products they offer, is often meant to be decentralized. (If the U.S. political system is a representative democracy, think of DeFi as a direct democracy.) A single person or a small group of people can drive a decentralized application at first, but they often seek to move away as the project takes hold. scale, hand over control to the community that uses it. This transition could take the form of a Decentralized Autonomous Organization (DAO), whose rules and regulations are incorporated into the programming code and can issue governance tokens, giving the holders of these coins a say in the decisions. decisions.
One of Bitcoin’s key innovations was the ability for two users to make digital payments directly to each other. It is easy to do in the physical world using paper or metal money. But until the arrival of bitcoin, the only way to do it electronically was through a bank or a payment company like PayPal.
Going through these third parties leaves a digital footprint that can be monitored, and these companies could potentially be “censored” by the government, ie pressured to prevent transactions for political or other reasons. Bitcoin was envisioned to get around this problem, as a digital form of cash for peer-to-peer payments.
DeFi applications can also be peer-to-peer. In a traditional stock exchange transaction, an order can be processed through a series of intermediaries – a broker and a stock exchange, among others – while the shares themselves are held in a custodian bank, which is supposed to prevent the securities from collapsing. lose or stolen.
In contrast, a DeFi exchange (DEX) does not have these intermediaries. If you use Uniswap, a decentralized exchange built on the Ethereum platform, to trade crypto tokens, those assets will end up right in your crypto wallet, facilitated by Uniswap’s automated programs called smart contracts. This means that there are fewer parties taking a share in your transaction.
ICO and NFT
Blockchain has enabled a series of digital gold rushes since its invention 13 years ago. Two of them are Initial Coin Offerings (ICO) and Non-fungible Token (NFT):
Initial Coin Offerings (ICO)
ICOs are a type of crowdfunding and they are often used to raise money for open source software projects. In exchange for capital, ICO investors get a unique token that may give them access to special software features… or may not give them access to much.
ICOs can look a bit like a stock offering – too much like stock offers, in fact, for the US Securities and Exchange Commission; Coin offerings may lack safeguards like the disclosure and auditing that an initial public offering (IPO) should provide in the regulated stock market.
ICOs raised more than $ 7 billion in 2018, before plunging about 95% to $ 371 million in 2019, the latest data of the year being available, as regulators cracked down, according to CB Insights.
Non-fungible tokens (NFT)
NFTs are kind of like a limited edition collectible card, only online. Just as blockchain allows users to prove ownership of their bitcoin holdings, it also allows people to create unique digital assets like collectibles and art. One of the best-known NFT auctions was a work by Beeple, the artist also known as Mike Winkelmann, who sold a collage at an auction at Christie’s for $ 69 million. Unlike a music MP3 which can be cut and pasted endlessly, NFTs are designed to be unique and have one owner at a time.
These acronyms are more than just a gold rush, says Matthew Leising, author of Out of the ether. ICOs have given startups and software developers a way to raise funds without the help of an investment bank or the support of a venture capital firm. Likewise, NFTs can offer musicians and visual artists a new way to monetize their work. “NFTs are really interesting because they have proven that a digital item can be scarce,” says Leising.
What are the advantages and disadvantages of DeFi?
DeFi’s strength can also be its weakness:
- Decentralization makes DeFi difficult to censor or eradicate, but it requires computation. Maintaining a database and records on a network of many computers slows things down and can make transactions more expensive. Ethereum is the most popular blockchain for DeFi applications, but the amount of computation going on increases fees and bogs down the network. As the developers of Ethereum try to find ways to make it more scalable, other channels like Solana and Avalanche are gaining momentum. “It’s really hard to get performance from blockchains,” says Emin Gün Sirer, computer scientist at Cornell University and Avalanche advisor.
- DeFi removes intermediaries like custodian banks, which should protect assets (usually digital tokens). This means you don’t have to worry about a financial institution going bankrupt and taking your assets with it, or a government seizing your tokens and confiscating them. On the other hand, the only thing that protects your assets is you and your password. If you lose this password (or if someone steals it), your assets are gone for good.
- DeFi upstarts often claim to be available to everyone. You may be able to get a loan or trade virtual coins without traditional financial credentials like an ID or credit score. This freedom promises to expand financial services to areas of the world that haven’t always had them, or where services are expensive or prone to fraud or confiscation. But you can easily see the downside: If there is no entity to know who is using a service or where it is located, the systems could be used by criminals or go against penalties. Regulatory repression has already started.
- Blockchains have proven to be quite difficult to decipher, but smart contracts and the apps that run on top of those chains are as smart as the people who designed them. The code is generally open source, which means it’s there for anyone to see and innovate, but it also makes it easier for hackers to attack. Nowadays, much more programming code is audited for bugs and vulnerabilities, and a growing number of people understand the need for formal verification (a process that uses algorithms to analyze other algorithms for problems), but a lot of money is still spent on code that hasn’t been substantiated that way, the Cornell Sirer said.
Three dApps you need to know
Uniswap, a decentralized exchange (DEX), was created by Hayden Adams, a mechanical engineer from New York. The idea arose from posts written by Ethereum founder Buterin about developing an automated market maker and decentralized exchange. These days, Uniswap facilitates $ 1 billion or more in daily crypto trading, and its governance tokens, UNI, have a market value of around $ 12 billion according to CoinGecko, a crypto data website.
Aave was founded by law student Stani Kulechov in 2017 (originally called ETHLend). The platform allows users to lend and borrow crypto tokens; users have put about $ 14 billion in collateral for loans on the network, according to Defi Pulse.
MakerDAO is a lending and borrowing platform that uses Dai, a stablecoin linked to the US dollar. MakerDAO was launched in 2014 and co-founded by Rune Christensen. On its website, MakerDao says it is one of the largest decentralized applications in the Ethereum blockchain and the first DeFi application to be seriously adopted. Users have placed around $ 6 billion in guarantees on the system.