What is DeFi (Decentralized Finance)?
Decentralized Finance (DeFi) is an umbrella term for financial applications powered by blockchain technology. DeFi is one of the MOST important blockchain use cases.
Decentralized Finance (DeFi) is an umbrella term for financial applications powered by blockchain technology. DeFi is one of the MOST important blockchain use cases.
The mind map below shows the major components of DeFi.
DeFi Categories
The most important DeFi categories are:
Bridges,
CDPs,
Derivatives,
Dexes,
Farms,
Indexes,
Lending,
Liquid Staking,
Options,
Oracles,
Payments,
Prediction Markets,
Staking,
Synthetics,
Yield,
Yield Aggregators.
1. Blockchain Bridges
A bridge receives one type of crypto, locks it as a deposit, and then "mints" an equal amount of another crypto and releases it on another blockchain.
Examples: Wrapped Bitcoin (WBTC), Multichain, and Just Cryptos (JST).
2. Collateralized Debt Positions
Collateralized Debt Positions (CDPs) are protocols that mint their own stablecoins using collateral.
Examples: MakerDAO (MKR), JustStables (USDJ), Liquity (LQTY).
3. Derivatives
Derivatives are Smart Contracts that get their value, risk, and basic structure from an underlying asset.
Examples: Synthetix (SNX), Keep3r Network (KP3R), dYdX (DYDX).
4. Dexes
Decentralized Exchanges (Dexes) are protocols that enable users to swap / trade cryptos without the need for KYC (Know Your Customer) processes.
Examples: Uniswap (UNI), Curve (CRV), PancakeSwap (CAKE).
5. Farms
Farms lock money in exchange for their token.
Examples: TokensFarm, ZoomSwap (ZM), and Goose Finance (EGG).
6. Indexes
Indexes are protocols that track the performance of a group of related assets.
Examples: Set Protocol, Index Coop (INDEX), Enzyme Finance (MLN).
7. Lending
Lending protocols enable users to borrow and lend cryptos.
Examples: AAVE, JustLend (JST), and Compound (COMP).
8. Liquid Staking
Liquid staking rewards liquidity for staked assets.
Example: Lido (LDO), Rocket Pool (RPL), and Marinade Finance (MNDE)
9. Options
Options are protocols that give you the right to buy or sell crypto at a pre-decided price.
Examples: Opyn, Ribbon Finance (RBN), and Friktion.
10. Oracles
Oracles are protocols that bring information from the outside to the blockchain and vice versa.
Examples: Nest Protocol (NEST), WitSwap (eWIT), and Umbrella Network (UMB).
11. Payments
Payment protocols enable the payment / sending / receiving of cryptos.
Examples: Flexa (AMP), Sablier Finance, and Lightning Network.
12. Prediction Markets
Prediction Markets are protocols that enable wagering/betting in future events.
Examples: Polymarket, Azuro, and BetHash (HASH).
13. Staking
Staking protocols reward users for “holding” their cryptos.
Examples: MoneyOnChain (MOC), Stafi (FIS), and ThetaCash (TBILL).
14. Synthetics
Synthetics are protocols that create tokenized derivatives that mimic the value of other assets.
Examples: Alchemix (ALCX), Injective (INJ), and Youves (YOU).
15. Yield
Yield protocols reward users for staking or providing liquidity.
Examples: Convex Finance (CVX), Arrakis Finance, and Alpaca Finance (ALPACA).
16. Yield Aggregators
Yield Aggregators are protocols that aggregate yield from multiple DeFi protocols.
Examples: Yearn Finance (YFI), Beefy (BIFI), and Badger DAO (BADGER).
DeFi problems
DeFi has become a "wild and lawless" environment where there are virtually no regulators (pun intended). There are many problems that are holding back the decentralized finance system from mass adoption.
1. High & unpredictable transaction fees
Public blockchains require fees to be paid using cryptocurrency. As the project becomes more successful, its cryptocurrency becomes more expensive.
2. Slow transaction speed
Many public blockchains have slow transaction speeds. See details here: https://alephzero.org/blog/what-is-the-fastest-blockchain-and-why-analysis-of-43-blockchains/
3. Zero support for KYC (Know Your Customer)
Most public blockchains are permissionless. This means that anyone can read, write and validate. There is zero KYC (Know Your Customer) compliance.
4. Zero support for AML (Anti-Money Laundering)
Most public blockchains are permissionless. This means that anyone can read, write and validate. There is zero AML (Anti-Money Laundering) compliance.
5. Fake dApps, apps, & wallets
Recently an Apple user lost his life savings of $600,000 in Bitcoin when he installed a fake Trezor wallet app on his iPhone. Something similar also took place through a fake app on the Google Play Store. In another case, malware that replaced victims' cryptocurrency wallet addresses also spread through a "MetaMask" impersonator app. Such incidents are fairly common.
6. Large number of scams and rug pulls
DeFi “rug pulls” and exit scams cost investors billions of dollars every year.
7. Unsustainably high energy consumption
The energy consumption and environmental cost of Proof-of-Work blockchains like Bitcoin and Ethereum are massive.
8. Creation of a new set of intermediaries
DeFi was supposed to reduce the cost and time taken for financial activities by removing intermediaries. Instead, it has created a new class of intermediaries such as miners and node operators.
9. Duplicate ticker symbols
Duplicate ticker symbols bring in a very high risk of financial loss as an investor can easily end up buying the wrong crypto. An example: BitDAO, BitRewards, Biconomy Exchange Token, BitMon, First Bitcoin and BitMoney have the same ticker symbol - BIT.
10. Low to zero grievance redressal mechanisms
Most public blockchains have not only anonymous users but also anonymous creators, developers, and managers! In such a scenario, there are very low to zero grievance redressal mechanisms.
11. Low to zero consumer protection
Many public blockchains have not only anonymous users but also anonymous creators, developers, and managers! In such a scenario, there are very low to zero customer protection mechanisms.
12. No insurance cover
Public blockchains do not have insurance coverage like banks do.
13. Vulnerability of Smart Contracts
A small mistake in the code of a smart contract can lead to a huge financial loss. A case in point is the multi-million Ethereum DAO hack of 2016.
14. Complexity
DeFi solutions are not easy to use. In many cases, less sophisticated users end up sending assets to the wrong address, leading to huge financial losses.
15. Unpredictable yields
DeFi is ruled by highly volatile cryptocurrencies. This adds a huge amount of unpredictability to the yields.
16. Regulatory uncertainty
Some jurisdictions are pro-DeFi, some are clearly anti-DeFi and the rest are still making up their minds. This creates a lot of fear, uncertainty, and doubt.
17. Usage by criminals and blacklisted entities
The absence of regulators and the high level of anonymity means you could end up transacting with criminals and blacklisted entities.
18. Low liquidity
There are thousands of cryptocurrencies out there. A majority of these have low liquidity which means you may get stuck trying to exit or book profits.