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Decentralized Finance or DeFi , the new gold rush for crypto passive income

By Inkarias - 2020-09-26

DeFi is simply the equivalent of our current financial system, but in a decentralized version, that is to say without intermediaries, central authorities, trusted third parties such as banks. In traditional finance, to send money to someone, you have to go through these famous intermediaries. To make any transfer, you must use the services of your bank or a company such as PayPal or Western Union or other third-party providers. You cannot send money directly to someone except if you put banknotes in an envelope that you send by post, which is not recommanded at all.

The same principle apply for the different investments you make with your money income. Again, you need to trust a third party, a financial advisor who will control your holdings and hopefully make a profit for you. DeFi proposes to change the paradigm by creating a financial system open to all and by reducing this notion of “mandatory trust” to a minimum level. This alternative option is made possible because technological tools now allow it and tends to become way more powerful in the future. Thanks to the internet, cryptocurrencies, blockchains, and smart contracts, it is now possible to build this new financial model to build a long-term passive income with innovative banking solutions.

The characteristics of DeFi

ethereum

DeFi works primarily on the Ethereum protocol (but not exclusively) and uses decentralized protocols and applications (dApps). Ethereum is an open and decentralized network which has the particular advantage of offering developers a platform on which they can program open source applications allowing, and this is where DeFi is concerned, to create, store and manage digital goods or tokens/assets. These applications are decentralized and use smart contracts which are small, fully automated programs or scripts. Thanks to them, it is possible to establish complex and irreversible agreements between different entities without the need to resort to an intermediary as in the case of traditional finance. This decentralized system is resistant, transparent and accessible to anyone with an internet connection. One of the great strengths of DeFi and its smart contracts is that they are not only open source, but also interoperable with other smart contracts and between different DeFi platforms. Users can therefore analyze the code and choose their smart contracts with full knowledge of the infrastructures and available possibilities.

If there are very many projects, products and services in the world of DeFi, if they are very different, we note however that the most popular projects at present, are the platforms of borrowing systems. It's the same principle as real life banking offers as some users lend money and earn interest from other users who borrow. The only difference is that it doesn't go through a bank anymore. This role of “verifier”, a trusted third party, is played by smart contracts which manage like incorruptible robots the various relationships which unite lenders to borrowers, and it is they who in particular ensure the distribution of interest.

Loans

Access to loans is not possible for everyone, even if a guarantee is involved (mortgage, etc.). In addition, the drop in interest makes lenders reluctant to make their funds available. The different loan systems offered by the ecosystem are an interesting alternative, both for borrowers and lenders. Indeed, operating on a P2P basis (without an intermediary), this allows users to lend their cryptocurrency to earn some interest.

A decentralized loan system therefore brings many advantages. The immediacy of the transactions allows the loan over very short periods, a few weeks for example. No salary verification is needed, anyone can borrow. People outside the banking system could therefore access their first loans in this way. Most of the loans made are made to be used on exchange platforms using leverage or other brokers currently.

Decentralized oracles

Decentralized market predictions are a somewhat obscure component of decentralized finance. While this kind of system is widely used in today's finance, they are mostly internal, or completely centralized like Aladdin. Setting up these systems is complex, despite the potential of this kind of service. Different solutions are provided by the players in this sector, such as setting up guarantees in the event of failure of predictions, and rewards in the opposite case. Today the main players are Augur, which makes it possible to make predictions on many subjects, as well as Gnosis, focused on the crypto markets. Today these players are still struggling to pull out of the game to attract users. The prediction volumes are still quite low, but the next features should allow us to obtain more pulls towards their services.

Few examples of DeFi related projects

Another DeFi playing field: stablecoins (cryptocurrencies whose stability is ensured by the fact that it is based on another asset). Generally, stablecoins are cryptocurrencies pegged to fiat currency like the US dollar. For example, DAI is a stablecoin backed by the US dollar and guaranteed by Ether (ETH). 1 DAI = $ 1. Note that in the world of DeFi, tokens are also used for the governance of a project and give users who have decision-making power.

While for many the volatility of cryptocurrencies is an opportunity, it is not for many use cases. Indeed, taking out a loan whose value fluctuates with such intensity as can be seen in the markets does not seem like a very good idea. This is why a special type of cryptocurrency arose, stablecoins. These are tokens whose value is as fixed as possible, and tending towards the price of a fiat currency. The most common scenario is indexation to the US dollar. There are two main methods to stabilize the price of these tokens: insurance with fiat currencies or other cryptocurrencies

The first scenario is the most common, we find in this category Tether or the USDC for example. These are tokens whose stability is guaranteed by the latter's distributors. Indeed, it is the funds of these companies which, in theory, allow the exchange of their tokens with a ratio of 1/1 towards the US dollar. Different audits are implemented to verify that they have enough dollars in cash for the number of tokens in circulation. These audits are sometimes the subject of much controversy and it is difficult to determine whether the issuers really have the announced funds.

The second (main) type of stablecoin works differently. They are guaranteed directly by cryptocurrency funds, or rather over-guaranteed due to the volatility of cryptos. The best known being the Dai stablecoin, deployed by MakerDAO. Everyone is free to be able to create new tokens by providing a guarantee equivalent to 150% of the creation of tokens.

The last example of DeFi projects is decentralized exchanges, also called DEX (Uniswap, Curve Finance). These are crypto exchanges that do not have central operators. Trading, transactions are done in a fully decentralized way, again thanks to smart contracts. To use this type of trading platform, it is not necessary to verify your identity (KYC). There are a lot of more DeFi related projects launched every day since several months, but we can quote some serious ones that are well-reputed in the crypto sphere :

  • MakerDAO is the protocol for creating units of the DAI stablecoin, whose value hovers around the US dollar. By pledging ethers as well as BATs, the user can claim to borrow Dai. Once the DAIs are obtained, they can be used on other Ethereum applications such as Compound for example. The necessary collateral must be kept above 150% in order to ensure price stability, despite the decline in the ether.

 

  • Compound is a public protocol for lending and borrowing Ethereum tokens through its interfaces. In exchange for adding funds to the protocol, users get an intermediary token, the cToken. This intermediary token allows you to obtain interest or borrow funds. This is because the value of cTokens increases over time and interest will therefore be collected when exchanged for the original token. Each token has different interest rates which vary depending on supply and demand. Since it is necessary to pledge more tokens than the borrowing capacity, some liquidity is guaranteed within the protocol.

 

  • BinanceDEX is a decentralized exchange platform based on Binance's blockchain. There is much controversy when it comes to the real decentralization of the system. Indeed, the system is based on a relatively small number of nodes, although theoretically this is sufficient to speak of decentralization. The black point of the project is above all its functioning in relation to the tokens of the chain. If you want to trade bitcoins on the platform, you will need to send your bitcoins to Binance which will exchange them for "bitcoins.d".

 

  • Yearn.Finance , Curve Finance and many more. Some other DeFi projects require to fully understand the term of « Yield Farming » and this field will be the subject of our next article explaining the features of Decentralized Finance projects.

 

Today we are still at the beginning of DeFi, and things are moving very quickly in this field. Many projects appear, and existing projects gain momentum quicker than ever seen in this space. More and more users and therefore cash as well as volumes are arriving on the various DeFi applications. User experience, one of the main barriers to adoption by the general public, is improving everyday and decentralized finance is coming to our smartphones quickly.

Possible risks and issues

Possible risks in DeFi

However, a number of issues and risks must be considered. It is indeed important to keep in mind that using DeFi involves risks and that it is necessary to be particularly informed before participating.

  • A lack of insurance mechanisms: the main risk is the non-repayment. This implies the mobilization of strong guarantees and entails other drawbacks for the customers/users.

 

  • No direct connections with classic fiat currencies: in fact, to use DeFi's functionalities, you must leave your euros at the entrance and obtain ethers or other Ethereum tokens. A real potential synergy with traditional financial mechanisms is still at the stage of reflection.

 

  • The use of overvalued guarantees: While there are currently no other effective methods of ensuring the stability of protocols, this situation is not without its drawbacks. As it stands, this does not provide the ability to bring borrowing capacity to users outside the banking system. Why and how to apply for a loan on this kind of platform when you must already hold 150% of this loan in cryptocurrency beforehand? It also limits the use of DeFi for leveraging.

 

  • The security of smart-contracts: while the security of smart-contracts is a priority for projects, the danger is always present and can never be totally ruled out.

 

  • Mechanisms of decentralized rates : To set up the different rates linked to decentralized loans, the protocols use data. These are not always accessible and the mechanisms are currently based on Oracles. The report therefore highlights the various risks involved. If the data is manipulated, this could lead to rate changes and endanger guarantees, for example.