Has the recent DeFi (Decentralized Finance) hype caught your attention? Have you lost track of all the innovation that is happening on Ethereum and driving gas prices to levels not seen before? Then this post is for you. We elaborate on the basics of decentralized finance protocols and explore the various money legos that form the DeFi ecosystem on Ethereum.
Essentially it all started off with stable coins. Stable coins are among the oldest DeFi cornerstones and their existence forms the base for several other DeFi protocols.
The leading decentralized stable coin is issued by Maker. Maker initially used ETH, the native token of the Ethereum blockchain, as single collateral to issue a stable currency called Dai. Dai is begged to the USD.
More recently Maker has shifted to multi collateral stable coins and supports now other ERC-20 tokens along ETH as collateral. ERC-20 tokens are fungible tokens that live on the Ethereum blockchain. Dai has survived a dramatic price decrease in the underlying collateral during the most recent bear market and since then forms part of the DeFi establishment.
The year 2020 has brought massive growth for decentralized money market protocols such as Aave or Compound. These protocols allow users to lend or borrow ERC-20 tokens against an interest rate. Along with the yield-farming hype the Total Value Locked (TLV) of these protocols has skyrocketed.
Industry observers may wonder why the interest rates in DeFi are so much higher than in traditional finance? The explanation is actually manifold.
While banks are allowed to create money when issuing loans, DeFi protocols can only lend you funds that they actually have available. Nevertheless the supply of tokens available for borrowing is limited and can not be expanded by anyone. This is one of the factors why the APY (Annual Percentage Yield) is much higher than in traditional finance.
Another factor is smart contract risk. Investors require a risk premium for their tokens due to the risks that are inherent in smart contracts. Higher yields are also a consequence of the high volatility of the assets used as collateral.
Just as in the traditional financial system, DeFi allows you to use stable coins for payments. You can acquire other assets for investing purposes and then apply leverage through collateralization.
All of this can be done fully decentralized without the need to trust an intermediary. In the same fashion you want to exchange digital assets on the Ethereum blockchain without using centralized third parties.
While decentralized exchanges have been among the first apps on Ethereum their usability has constantly been lagging behind the large centralized exchanges. The creation of Uniswap with it’s incredibly easy to use user interface has changed that.
Uniswap, a protocol for exchanging tokens and providing liquidity, has increased dramatically in popularity and even exceeded Coinbase Pro’s trading volume recently:
This development must have occurred to the delight of Ethereum’s founder Vitalik Buterin who famously said centralized exchanges should burn in hell.
Option & Prediction Markets
In traditional finance a number of derivatives have emerged over the centuries that allow economic agents to hedge against risks and to apply leverage for financial speculation purposes.
It was just a matter of time until options would eventually emerge on Ethereum. With the Opyn protocol DeFi users now have the availability to create and trade Ethereum put and call options.
Furthermore, the prediction market Augur has just released its version two which allows users to bet using the stable coin Dai. New prediction markets can be created by anyone and besides betting Augur also serves to hedge against risk.
One of the most popular vehicles of the traditional financial system are investment funds which provide an easy way for investors to deploy their capital. ETFs (exchange traded funds) which are mostly designed to match stock indices have gained a lot of popularity in recent years.
It didn’t take long until the DeFi community developed an equivalent to the investment vehicles of the classical financial system.
The speed of the ascend of Yearn.Finance was mind-blowing. Yearn.Finance is a protocol that moves funds autonomously between the most profitable money market protocols. It is basically an investment fund that automatically seeks and invests into the highest yield throughout the DeFi ecosystem.
The development of Yearn.Finance is a typical example of how DeFi money legos build on top of each other. Developing Yearn.Finance wouldn’t have been possible without the existence of stable coins and money market protocols.
Liquidity Providers & Market Makers
Liquidity providers take an important role for the functioning of the DeFi infrastructure. Liquidity providers in protocols such as Uniswap are incentivized through fee rewards to supply their liquidity to the protocol.
Notable here is the Balancer protocol which automates liquidity management for liquidity providers and at the same time engages in market making.
Among other things Synthetix allows you to long or short cryptocurrencies and potentially one day in the future a large number of stocks and precious metals.
The list above covers only the peak of the iceberg of the innovation that is occurring in DeFi. Besides ERC-20 tokens non-fungible tokens provide another groundbreaking space for innovation and will be covered soon in another post on FrontierProtocols. One thing is for sure: we’re living in exciting times and DeFi is not going to stop innovating any time soon.