DeFi and Transformation of Finance without Intermediaries
DeFi (Decentralized Finance) is a broad term for financial services that includes public blockchains and mostly focuses on Ethereum. Along with the help of DeFi you can do most of the things related to bank support such as earn interest, borrow, lend, buy insurance, trade derivatives, trade assets, and many more by which you don’t require paperwork or any other third party. As the crypto works similarly DeFi is global as well as it is peer-to-peer basically, it’s open to all. Decentralized finance, or DeFi, also uses new technology that helps to remove third parties. Hence, it uses security protocols, connectivity, software, and hardware advancements and this system removes intermediaries like banks and other financial service companies.
Current size and growth of the DeFi market
Market Share
DeFi, a global market, was valued at USD 9.4 billion in 2022 and is predicted to grow at a CAGR of 40% from 2023 to 2030. Its acceptance has revolutionized the finance sector, especially with decentralized blockchain platforms. The Total Value Locked (TVL) on DeFi protocols reflects their popularity and financial strength and TVL on DApps surpassed $1 billion in 2020 and reached $180 billion by the end of 2021. According to our prediction, the market share is expected to reach USD 1 trillion by the end of 2030.
Recent developments in DeFi protocols
Assessing the impact of DeFi on traditional financial systems
DeFi will allow a user to control their finances without any intermediates, making it more convenient than traditional financial systems. Here the users can have total access to their private keys that will support them in managing their assets. Decentralized finance provides transparency where the transaction on a decentralized blockchain network is recorded on the public ledger which anyone can change. It also offers security where we can be protected from the cyberattack whereas traditional finance systems are often vulnerable to cyber-attacks and other security breaches. As blockchain technology continues to progress we will be seeing more innovations in DeFi that will further improve its transparency, security and accessibility and it will lead to a faster decentralized system.
Mechanisms of DeFi
Analysis of Key DeFi Protocols in 2023
Lending and Borrowing Protocols
This protocol is a standardized set of rules that will allow computers to format, process and transmit the data. DeFi has protocols where it has a lending platform that lends money to enterprises or the public without any intermediaries and borrowers can obtain the loan immediately by using the Decentralized finance lending platform which helps to generate interest in crypto assets by lending them to others. By lending our assets through a lending protocol we can earn interest that will display as API or Annual Percentage Yield and by borrowing a token will be required for the payment of APR or Annual Percentage Rate.
Lending and borrowing protocols allow the users to:
- Earn interest: Individuals can earn interest based on their cryptocurrency holdings by lending them out.
- Access loans: Borrowers have access to funds without going through a standardized institution.
- Avoid credit checks: Borrowers have access to loans without the need for credit checks.
MakerDAO
MakerDAO is a decentralized blockchain protocol that was launched in the year 2015 on the Ethereum platform and allows users to lend or borrow cryptocurrencies that function as lending and borrowing services and a decentralized autonomous organization. MakerDAO follows a mechanism known as Collateralized Debt Position (CDP) that helps to create new DAI tokens when a total amount of other digital assets gets deposited as collateral. They have been the most influential in the DeFi that offers trading and earning yields on other DeFi-supported protocols.
Overview of DAI stablecoin
Dai Stablecoin is a collateral-backed cryptocurrency that is stable where its value is tied to another currency, commodity or financial instrument and it aims to provide a substitute for the high volatility of the most popular cryptocurrencies. The strength of Dai is upheld through a scheme of smart contracts and autonomous feedback mechanisms and the nature of the decentralized Dai and its collateralization model makes it resistant to the central points of censorship and failure. The generation of Dai creates the components that are needed for a robust decentralized margin trading platform such as :- Bitcoin (BTC) and Ether (ETH) are the popular digital assets that are very volatile to be used for everyday use currency.
Vaults and collateralized debt positions (CDPs)
Collateralized Debt Position (CDP) is a concept of financial cryptocurrency that was developed in the year 2014 and combined with the whole ecosystem of the Maker DAO project and the main purpose of Maker DAO is to reduce the price of a cryptocurrency through their own DAO stable coin (Dai). A collateralized debt position (CDP) vault is a smart contract that allows a user to deposit the collateral in exchange for fxTokens which is a multicurrency stablecoin and Collateralized Debt Positions are instances of Vaults that characterize the individual loan agreements between users and the MakerDAO protocol. Vaults and CDPs play a critical role in to function of MakerDAO allowing the users to control their cryptocurrency holdings to create Dai the stability and security of the stablecoin.
Aave
Aave is a decentralized platform where users have access to lend and borrow crypto and use smart contracts that will automate the process with a set of rules where how the funds are distributed and how the collateral along with the fees are handled and assessed.
It focuses on the department of overcollateralized loans which means that users will need to deposit crypto that is more than the amount they wish to borrow. It protects the lenders from losing money from loan defaults and gives them access to Aave protocol and it also offers native crypto tokens which can be traded on most stakes or exchanges to earn interest. Staking is earning rewards like crypto miners to validate transactions on a proof-of-stake blockchain which underlies Aave.
Compound
Decentralized Exchanges
A decentralized exchange (DEX) that allows for peer-to-peer cryptocurrency trading without any intermediaries that use blockchain-based smart contracts for non-custodial and transparent transactions. DEXs provide full visibility for exchange mechanisms, reducing counterparty and centralization risks.
It also acts as the foundation of “money LEGO,” which enables the creation of progressive financial products without any permission and also offers diverse designs, automated market makers (AMMs), and many more. DEXs aim to provide dynamic, community-governed platforms that provide transparent, secure, and efficient trading along with the principles of decentralization and empowerment in the cryptocurrency ecosystem.
Uniswap
Uniswap which is a decentralized cryptocurrency exchange uses smart contracts and it is also cryptocurrency which is represented with the symbol of UNI. It is known for its automated market maker (AMM) that guarantees liquidity which is always accessible to trade. The major blockchain ecosystems such as Ethereum follow Uniswap’s code base and the feature will give a high degree of composability to Uniswap across different Decentralized finance applications along with positions which is the cornerstone of the DeFi ecosystem. The Uniswap blockchain is held by the Ethereum platform and which are governed by UNI holders where it removes the third party such as a centralized exchange and it can reduce transaction processing fees.
There are mechanisms in Uniswap which are:
Automated market making (AMM) model.
AMM (Automated market makers) is a type of decentralized exchange (DEX) that uses algorithmic to make it easier for individual traders to buy and sell these crypto assets also it can be a substitute for trading directly with other people through the AMM.
It uses liquidity pools where users can credit cryptocurrencies to offer liquidity and these pools can use these algorithms to fix the token prices based on the ratio of assets in the pool. When a user needs to trade, they exchange one token for another directly through the AMM along with prices resolute by the pool’s algorithm. Uniswap, SushiSwap, PancakeSwap and Balancer are some of the known AMMs.
Liquidity pools
Liquidity pools are a collection of digital assets that are locked in a smart contract that provides crucial liquidity to decentralized exchanges and results in generating liquidity for quicker transactions where one of the major elements of a liquidity pool is automated market makers (AMMs).
An AMM is a protocol that is used by liquidity pools that allows assets to be traded digitally which is an automated way rather than through a traditional market manner and is designed to encourage the users of different crypto platforms known as liquidity providers (LPs). LPs are rewarded with small tokens of fees and incentives that are equal to the amount of liquidity they supply which are known as liquidity provider tokens (LPTs). Some of the commonly known liquidity pools are SushiSwap (SUSHI) and Uniswap.
Sushiswap
A sushiswap platform is a decentralized exchange that is built on the Ethereum Blockchain. It uses an automated market-maker instead of a traditional order book to facilitate trade. As the infrastructure of Sushiswap is decentralized lower fees are charged as compared to centralised exchanges. Liquidity pools allow users to provide liquidity to the platform and earn SUSHI tokens in the form of rewards. This incentive encourages users to trade more and improves the overall liquidity of the platform. SUSHI token holders have the power to vote on proposals related to the future development of the platform. Sushiswap has introduced several innovative features, such as the concept of
“vampire attacks” on decentralized exchanges and the use of liquidity provider tokens (LP tokens) to represent liquidity provider shares in a pool.
Derivatives Trading Protocols
dYdX
Margin trading, options, and derivatives are common tools for traditional traders and investors but in crypto these features were limited to centralized exchanges like Binance, Huobi and to name a few. These standard trading features for the first time are being built in a trustless and decentralized way on the dYdX. dYdX is a decentralized trading platform that offers margin trading and derivatives trading.
It allows its users to trade in derivatives such as options and futures in an easier and customizable way while ensuring that the users have full control over their funds and positions. It is also a fully decentralized exchange platform built on the Ethereum blockchain that allows users to trade a wide range of crypto assets with a leverage of up to 10x.
dYdX also offers a decentralized platform that allows users to carry out transactions without needing a third party. The main focus of dYdX is to ensure transparency and complete user control. It has gained a lot of traction from retail as well as institutional investors since its launch in 2019.
Margin trading platform
Margin trading is essentially borrowing money to make bigger bets. Crypto traders make bets that the price of a crypto asset will move in the way they predict–either up or down. Margin trading allows them to increase their profits if they bet right, but also their potential losses if they’re wrong.
dYdX is the best-known decentralized margin trading platform. It allows for over 5x leverage. In this platform dealers use their finances as a guarantee and magnify their original principle by several multiples and use these magnified finances to make larger investments. Dealers need to pay an interest figure as well as the costs associated with the sales.
The positions created aren’t synthetic and they involve real borrowing and purchasing/selling. Sometimes a dealer may not be able to completely recover the loan taken if the market moves in an unfavourable condition. To prevent this from happening the protocol will liquidate your position before getting to a certain liquidation ratio.
Synthetix
Decentralized synthetic assets
Synthetic assets also known as crypto synths are essentially tokenized derivatives. Let’s understand it better with the help of an example. In traditional finance, the value of derivatives is derived from an underlying asset such as a stock or bond. These derivatives enable traders to speculate on the price movements of an asset without actually owning it.
But crypto synths or tokenized derivatives take the concept of derivatives a step further by allowing them to be recorded on the blockchain and creating a cryptocurrency token for it. They are gaining a lot of popularity as you can benefit from the fluctuations of various tokens without actually owning them. As mentioned, synthetic assets do not require assets to be held on behalf of the users and no third party or know-your-customer (KYC) system is involved. This makes it more decentralized and cost-effective to trade as there is a very limited fee charged.
Impact of DeFi on Traditional Finance
Disintermediation of traditional financial institutions
Traditional banking systems involve many middlemen which adds to the complexity, delays, and increase in costs. DeFi reduces transaction costs and speeds up transactions by cutting off the need for middlemen. Decentralized finance transactions can be carried out directly between parties streamlining the process and saving time and money. DeFi allows people to have complete ownership of their assets and removes the need for them to rely on traditional financial institutions. This leads to greater financial inclusion as those who are underbanked or unbanked can now access financial services and take part in the global economy.
Emergence of borderless and inclusive financial services
Many people were unable to access traditional financial services due to various barriers, through DeFi anyone can get access to financial services with just an internet connection. It makes financial services available to the unbanked and underbanked population, increases financial transparency and helps people to gain full control over their assets.
Trading, Lending and borrowing are executed through Smart Contracts which are implemented by Decentralised Application (DApp) by facilitating peer-to-peer transactions. A smart contract is a program/protocol which is automatically executed when certain requirements are met.
Increased competition and incentive for innovation
As the Defi is new evolving field that will contain new and innovative ideas of financial services which are used now-a-days and you have authority to access cutting-edge financial tools which are not the part of traditional finance. For example, Decentralized finance protocols are being used such as – development of decentralized lending and borrowing platforms, exchanges, and insurance products DeFi is a major part of developing new types of financial instruments such as the tokenization of real-world assets and derivatives and these instruments can be used to speculate on future market movements. The cryptocurrency also covered the way for DApps when it took off with DEXs a few years later, touching every corner and making its mark on people’s lives around the world.
Emerging Trends in DeFi
Integration with Layer 2 scaling solutions
Scalability is one of the major issues faced by DEXs. As these exchanges gain popularity and traction, the user experience may be hindered by high transaction fees and congestion. The introduction of Integration with a Layer 2 scaling solution has emerged as a promising approach to address this issue. Layer 2 solutions are protocols built on top of existing blockchains that aim to enhance scalability and guarantee the security of the underlying blockchain.
They process transactions on the third-party network instead of the Ethereum mainnet which not only takes off the excess workload from the mainnet but also ensures that the security and decentralized standards have not been compromised. Types of Layer 2 Scaling solutions are :-
- State Channels
- Sidechains
- Rollups
- Plasma
- Zkrollups
According to industry data, the adoption of layer 2 solutions has increased by 150% in the past 12 months. This growth is further supported by the increasing volume of transactions processed through layer 2 protocols, which has exceeded $10 billion in the same period.
Growth of Decentralized Autonomous Organizations (DAOs)
DAOs are blockchain-native, decentralized organizations that are collectively owned and managed by their members via smart contracts. Some of the factors which lead to the growth of DAOs are :-
- Improved Smart Contract Security: – One of the main drivers of DAO growth is the significant improvement in smart contract security and this increases confidence in the reliability of smart contracts thus increasing trust in DAOs once again.
- Tokenization and Incentive Mechanisms: – Token holders get the benefit of having a say in the decision-making and also benefit from the success of the DAO leading to a cooperative relationship between the organization and its community.
- Growing interest in Decentralized Governance: – Individuals and organizations are realizing the benefits of participatory decision-making processes enabled by DAOs and the growing interest has led many different industries to explore integrating DAOs into their structures as it is proving to be beneficial.
- Widespread Blockchain Adoption: – As the blockchain demands has been increased the infrastructure supporting DAOs becomes more user-friendly and easier to access attracting more participants.
Rising adoption of DeFi among retail investors
DeFi aims to remove the barriers, high costs and limitations associated with traditional financial institutions and provide unrestricted access to financial tools and economic capabilities. A rise in retail adoption increases liquidity which leads to more capital available for trading and investing. Retail adoption increases the overall visibility and acceptance of DeFi, encouraging more financial institutions and investors to take notice and enter the space, which could lead to more investment in DeFi projects and make transactions much faster and easier. As Decentralized finance platforms become more user-friendly and secure they will attract a wider user base as they not only aim to increase retail participation but also compete head-on with traditional financial applications and companies.
Increased regulatory oversight
Decentralized finance has grown so rapidly that we need to establish a structure to enhance the industry where the regulators have also realized and this borderless nature also provides challenges for the regulators. In the year 2023, these authorities are giving importance to DeFi and they are working on the framework where they also focus on issues related to KYC and AML in Defi. Regulatory bodies need to adopt a dynamic approach and continuously assess DeFi’s evolution to introduce appropriate measures.
As DeFi continues to grow so rapidly regulatory bodies around the world have realized the need to establish a proper framework to govern this rapidly evolving industry. DeFi’s nature of operation is a decentralized and borderless environment, which presents unique challenges for regulators.
Conclusion
DeFi (Decentralized Finance) has come up with a major transformation in the financial space that offers various ways of financial services without the restriction of intermediaries. DeFi has shown a significant impact on traditional financial systems which also gives the ability to have control, transparency and majorly security. Trends such as – integration with Layer 2 scaling solutions and the development of Decentralized Autonomous Organizations (DAOs) and mechanisms like lending and borrowing protocols, MakerDAO, Aave, Uniswap and derivatives trading protocols which is giving the curve to have a better future of finance.
We recommend that businesses should adapt to the new evolving environment in the DeFi space which includes guaranteeing compliance with KYC and AML requirements, integrating Layer 2 scaling solutions to enhance scalability and transaction efficiency, embracing decentralized governance models and catering to the growing trade demand for DeFi. These measures will help the businesses achieve sustainable growth and success in the rapidly developing DeFi ecosystem.
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