6 Key Pillars of DeFi
Expand your knowledge in the DeFi world
Defi (decentralized finance) has seen huge growth since 2019, and it only excelled from there. The current TVL (Total value locked in smart contracts) sits at around 60B $ at the time of writing and topped this year at around 90B $ in May (find the statistic at DeFi Pulse). DeFi is not a project or entity, it is an umbrella term for decentralized protocols that are set to disrupt traditional financial services. In this post, I would like to break down the DeFi ecosystem into its pillars.
Let’s move on to the key pillars of the DeFi space
Stable coins are cryptocurrencies, which are pegged to a stable asset such as the US dollar or a basket of assets. Cryptocurrencies are generally known as being highly volatile. The first stable coin was USDT or Tether that is supposedly backed by $1 in the issuer’s bank account. USDT and USDC are centralized stable coins managed by one entity and the user will need to trust the company that the USD reserves are fully collateralized and actually exists, which was one of the critiques in the past month. Decentralized stable coins are using an over-collateralized method, and they operate fully decentralized. The latest research focuses on algorithmic stable coins that can keep their peg by dynamically controlling supply and demand by the protocol. Stable coins are not really financial applications themselves, but they are essential to make DeFi more accessible to everyone.
Lending and borrowing is another large pillar of DeFi. Aave and Compound are examples of borrowing and lending protocols. In the traditional financial system, if you apply for a loan, you will need to provide various financial and non-financial information. The financial institution will conduct a credit risk assessment and evaluate whether you should receive a loan or not. In decentralized lending and borrowing, this barrier is lifted. You borrow against the collateral that you provide and the protocol manages liquidations based on a targeted loan-to-value (LTV) ratio. For example, you could provide Ethereum worth 10000 USD and borrow 4000 USDC with an LTV of 40%. The protocol could be designed such that you are required to not have your LTV exceed 50%. In a scenario where your Ethereum collateral value drops to 8000 USD and hence your LTV being now 50%, you either need to start repaying USDC or provide more collateral or you will start getting liquidated.
Exchanges are used to exchange one cryptocurrency for another one. You can use, for example, Coinbase or Binance. But it is highly recommended to remove your coins from exchanges because they are having custody over your private keys and hence coins and when they go bust your coins go with it. There are countless stories, hacks, and scams where people lost money in centralized exchanges. Alternatives are decentralized exchanges where you can trade peer-to-peer. Examples are Uniswap, Pancakeswap, 1inch and many more. These platforms make use of liquidity pools and AMM (automated market maker) to enable efficient trading. More to these topics another time.
A derivative is a contract whose value is derived from other assets such as stocks, commodities, currencies, etc. Traders can use derivatives to hedge their position and decrease the risk in any particular trade. For example, if you are a global manufacturer of rubber gloves and want to hedge yourself from an increase in the rubber price you can buy a futures contract from your supplier to have a specific amount of material delivered at a specific future delivery date at an agreed price today. These contracts are mainly traded on centralized platforms and DeFi platforms are starting to tap into this huge industry. Some estimate the market to be $1.2 quadrillions (!) or 10 times the world's GDP (gross domestic products). DyDx and Synthetix are examples of such blockchain platforms starting to explore derivatives.
Insurance is another large area in DeFi. The definition of insurance is that a financial institution covers you for any future loss in exchange for premium that you pay. In the DeFi space, code and smart contracts manage a large amount of money and there are already today countless examples of exploits and hacks on smart contracts where billions were stolen. DeFi insurance protocols would allow you to hedge against the risk of an exploit of protocols where you have money locked. It can go further than that. Smart contracts can allow insurance companies to build a more cost-effective business by storing and managing policies using permissioned blockchains.
Governance of crypto projects is also becoming more decentralized. A trending term, which will grow in the future is a decentralized autonomous organization or in short DAO. These are smart contracts that manage the governance of a company. Decisions are not anymore made by board members or executives but by the community. Imagine for example a fund that collected money from its investors to invest in a new venture. In a DAO, all the people have a say whether this investment should pass or not. As everything is coded into the smart contracts, the funds also wouldn't be released until the vote is passed. Future companies may have a much more flat and decentralized structure giving intentional power away from the founders and board and making the venture a community-driven entity. The successful DEX aggregator 1Inch for example is run entirely by the community and strategic decisions are made through the DAO setup.
I hope, this article gives your more insights into the DeFi world and helps you to expand your knowledge in the blockchain space.