Research | What is DeFi? What does DeFi mean to the world?

Table of contents

1. What is DeFi?

• Why did DeFi appear on the blockchain? Why did it appear now?

• What is the difference compared to traditional finance?

• What are the characteristics of DeFi? What are its advantages and disadvantages?

2. What is the DeFi ecosystem like?

• What categories of applications does DeFi have?

• How do these programs work?

3. What does DeFi mean to blockchain?

4. What does DeFi mean to the world?

1. What is DeFi?

DeFi, one of the hottest concepts in the blockchain industry, has soared from a total locked-in amount of US$700 million at the beginning of 2020 to the current US$121.66 billion. In less than a year and a half, the total locked-in amount has expanded by more than 170 times. It has now exceeded the total assets of Deutsche Bank.

What is DeFi? It allows users to complete a series of financial services through decentralized applications (Dapps) deployed on smart contract platforms without relying on centralized institutions.

1.1 Why did DeFi appear on the blockchain? Why did it appear now?

Despite the earlier exploration of BTS (BitShares), the history of true DeFi is actually very short. It has been less than 4 years since the birth of the first official DeFi application MakerDAO.

The reasons and timing of the emergence of DeFi are related to the development of blockchain technology

• Before DeFi, blockchain technology experienced two major breakthroughs, both of which laid the technical foundation for the emergence of DeFi.

• The first time: the Big Bang period - Satoshi Nakamoto published the Bitcoin white paper, introducing a secure, decentralized, anonymous payment system to the world

• The second time: The birth of Ethereum, an open source public blockchain platform with smart contract functions, solved the problem of insufficient scalability of the Bitcoin protocol and laid the foundation for innovation on the blockchain

When the birth of Ethereum laid the technical foundation for blockchain innovation, DeFi naturally emerged.

• In 2017, ICO was at its peak and became Ethereum’s first “hit product”. New projects no longer used traditional methods to raise funds, but instead began to offer their own tokens to raise ETH.

• The prevalence of ICOs created a new “user-to-contract” model, with the main breakthrough being to have users interact with smart contracts that contain the collective funds of multiple users, rather than interacting directly with other users.

• In the ICO projects of that year, although air coins were rampant and banned by policies, a number of DeFi projects were born overseas.

• In the bear market, DeFi projects are quietly polishing their products; at the same time, on-chain financial demand is gradually emerging.

1.2 What is the difference compared with traditional finance?

There are different roles in the traditional financial system, including currency, central bank, commercial bank, investment bank, exchange, brokerage, insurance, payment and asset management. Defi achieves similar functions through different applications.

The significant difference between the two is that DeFi does not need to rely on intermediaries to engage in financial activities.

• Intermediaries are often managed by people and regulated by the government, which can easily lead to risks related to people. For example: the 2008 global financial crisis

• DeFi optimizes three key parts of traditional finance through blockchain technology: payment and settlement systems, accessibility, centralization, and transparency.

1.3 What are the characteristics of DeFi? What are its advantages and disadvantages?

Features of DeFi:

• Eliminate trusted third parties: Rely on the characteristics of blockchain to create trust, transforming the trust in credit institutions such as governments and banks in traditional transactions into trust in machines.

• Smart contracts: automatic and autonomous, reducing costs, improving speed and accuracy, ensuring contract execution without being affected by external forces

• Security, privacy, and transparency—the essential advantages of blockchain

Advantages of DeFi

• Immutability: Once information is saved on the blockchain, no one can change it

• Transparency: A transparent and auditable financial ecosystem

• Availability: As long as you have an internet-connected smartphone, you can freely access Defi applications without worrying about differences in nationality, geographical location, etc.

• Convenience: Cryptocurrency can be transferred to any account in the world without going through an intermediary, saving a lot of time and fees

Disadvantages of DeFi

• Risk of being hacked

• Some basic functions of Dapp are developed by some companies, making it difficult to achieve true decentralization

• The scalability of Dapp is limited by the public chain where it is located. When the transaction volume increases but the basic performance of the public chain cannot support it, congestion may occur.

2. What is the DeFi ecosystem like?

DeFi is a decentralized replication of a code-based financial world on the blockchain world.

• In this world, there are institutions that issue currency, as well as applications that provide a series of financial services such as lending, trading, derivatives, fund management, lottery, payment, insurance, etc.

• Dapps can be combined with each other like Lego to achieve various functions

2.1 What categories of applications does DeFi have?

• Applications on Defi can be roughly divided into stablecoins, lending, exchanges, derivatives, fund management, lottery, payment, and insurance.

• In reality, many Dapps have functions far beyond the above nine categories, mainly because they can be combined with each other, called Money Lego

2.2 How do these projects work? — Stablecoin

Used to hedge against cryptocurrency price fluctuations, with prices anchored to stable assets such as the U.S. dollar

• Fiat currency collateral anchor: USDT, Tether will put one dollar in reserve for every dollar of USDT minted

• Cryptocurrency Collateral Anchor: Dai, backed by ETH and BAT as collateral, is algorithmically anchored to one dollar

• Algorithmic stablecoins under exploration

Medium of exchange

2.2 How do these projects work? - Lending

As long as they have enough collateral, anyone can get a loan in the Defi ecosystem, while in the traditional financial environment, they often need to go through layers of approval from banks.

Anyone can lend money simply by injecting capital into a decentralized liquidity pool, whereas in the traditional financial environment, the benefits of low-risk, high-return lending are often enjoyed exclusively by the rich.

• Interest (APY): The interest rate for lending or borrowing different assets is often determined by a specific algorithm based on the supply and demand of the asset.

• Liquidation: When the value of the collateral is lower than the loan, the system will automatically liquidate

2.2 How do these projects work? — Decentralized Exchanges

The risk of centralized exchanges is that users do not own their assets on the exchange, and there is a risk of cryptocurrency theft or information leakage.

Decentralized exchanges (DEX) reduce or eliminate intermediaries through smart contracts and on-chain transactions, and users can keep their assets in their own wallets.

2.2 How do these projects work? — Decentralized derivatives

Derivatives are mainly used to hedge against the volatility of the underlying asset, speculate on the directional movement of the underlying asset, or increase the asset holdings.

The total value of locked assets in Defi derivatives Dapps is $3.2 billion, accounting for 7% of the entire Defi ecosystem

Although the proportion is small, it is growing rapidly

Taking the largest DeFi derivatives protocol Synthetix (83% market share) as an example, it consists of two parts: synthetic assets (Synths) and exchanges (Synthetix Exchange)

Synthetic Asset: An asset or combination of assets that has the same value or function as another asset

• Two categories: synthetic assets & reverse synthetic assets

• Advantages:

• Helps traders gain price exposure to assets without actually holding the underlying assets, lowering the barrier to entry

• Synthetic assets can be freely converted into each other

• Currently supported assets include:

• Cryptocurrencies: Ethereum, Bitcoin, Binance Coin, Tezos, Maker, TRON, Litecoin, Chainlink

• Commodities: Gold and Silver

• Index: CEX Index Fiat currencies: USD, AUD, CHF, JPY, EUR, GBP

• and Defi Index

Synthetix Exchange: Users can trade directly with contracts that maintain constant and ample liquidity, reducing the risk of price volatility and lack of liquidity

2.2 How do these projects work? — Decentralized Fund Management

Decentralized fund management does not require investment managers, but users can choose the appropriate asset management strategy by themselves

• Reduced service fees

• How to participate: Purchase tokens with strategy functions on the trading platform Dapps. These tokens have automatic trading strategies and are automatically executed without users having to monitor the market all day.

2.2 How do these projects work? — Decentralized Lottery

Taking PoolTogether as an example, at the beginning of each round, PoolTogether will deposit the purchased funds into Compound to obtain interest as a bonus. When the prize is drawn, a player is randomly selected to win all the interest, and the rest of the principal is returned to all players.

2.2 How do these projects work? — Decentralized Payment

Although cryptocurrencies can realize payment functions through peer-to-peer remittances, they have problems such as slow speed, congestion, and high fees.

Decentralized payment Dapps enable cheaper, faster, scheduled transfers, conditional transfers, and standardized invoice format payments, which is an important step for cryptocurrencies to participate in daily life consumption.

2.2 How do these projects work? — Decentralized Insurance

Risks faced by DeFi users:

• Technical risks: Smart contracts have vulnerabilities and are subject to security attacks

• Liquidity risk: Liquidity exhaustion on platforms like Compound

• Key management risk: the platform’s master private key may be stolen

Risk reduction insurance through decentralized insurance Dapps

In the above bZx incident, some users received compensation through Nexus Mutual

Mainstream Insurance Dapps — Nexus Mutual, Opyn

3. What does DeFi mean to blockchain?

DeFi is an important milestone in the development of blockchain, showing the world the possibility and huge space for blockchain technology to be effectively integrated into economic activities.

The catalyst for this round of Bitcoin bull market. The last round of Bitcoin bull market was mainly driven by the popularity of ICO, and this round benefited from DeFi. The development of DeFi not only proves the huge potential of blockchain technology in on-chain economic activities, but also verifies the view that Bitcoin is a store of value. Moreover, this wave of bull market is more extensive, and large institutions and companies have participated in it. For example: Tesla, Micro Strategy

4. What does Defi mean to the world?

The emergence of Defi has far-reaching significance for the world

• Full control over all financial activities of your own on-chain assets

• A financial system for everyone, regardless of geography, economic level, or trust

• Machine intelligence, automatic and autonomous execution, avoiding black box operations

• Combining with NFT in the future - expanding to games, intellectual property, physical assets, records and identity proof, financial documents, ticketing, etc.

Through its characteristics, DeFi has created a transparent, autonomous, borderless financial system that can accommodate more diversified assets and more complex transactions. This is a major breakthrough both in blockchain and in financial history.

What does Defi mean to the world? ——Resist inflation and have full control over your assets

Mariano Conti, head of the Maker Foundation, shared his personal experience

• As one of the top five countries with the highest inflation rates in the world, residents are reluctant to hold Argentine pesos and prefer to convert their assets into US dollars.

• The government's strict restrictions on dollar exchange have greatly increased the possibility of residents exchanging dollars.

• Mariano solves inflation and currency conversion issues by settling salaries in DAI

• Situations like Argentina are common, and residents have an urgent need for Defi.

• Not only stablecoins, but also Dapps in other fields, such as payment, lending, etc., will become tools to help such users to consume in a normal life.

What does Defi mean to the world? ——Everyone

• Nearly 1.7 billion people in the world do not have financial accounts due to poverty, geographic location, trust,

• Due to geographical location and censorship, residents of some regions cannot access some networks, such as North Korea, Belarus, Iraq, etc.

• Under DeFi, anyone with internet and mobile phone can get financial services

What does DeFi mean to the world? ——Eliminate risks and turn the possibility into a certainty

No intermediary means avoiding risks such as black box operations

Machine intelligence avoids risks such as user default.

• Flash Loan: If the user does not return enough tokens, the entire transaction can be automatically rolled back. This is something that traditional finance cannot do.

What does Defi mean to the world? ——NFT

• Non-fungible tokens, each token represents an indivisible, unique asset

• Ownership does not prevent others from inspecting it or reading it. It does not capture information and hide it, but only captures information and then discovers its relationship and value to all other information on the chain.

• With its natural collection properties and ease of trading, crypto artists can use NFT to create unique digital artworks for exhibition and trading around the world.

• The diverse forms make Defi more imaginative than traditional finance