The decentralized finance (DeFi) industry has grown significantly over the years with many projects aiming to sweep away the users of the centralized finance industry by providing many use cases at low costs. While the year 2021 witnessed an unparalleled expansion of DeFi projects, 2022 drove several such projects out of the industry. The survivors however are committed to providing their services to the average customers.
Reports have suggested that as of Feb 16, 2023, the total value locked (TVL) in decentralized finance (DeFi), is around $51.1 billion around at that time, the TVL of Lido DAO was around $8.78 billion. This means that the Ether (ETH) staking platform held around 17% of the total money in the DeFi industry in February.
What is DeFi?
DeFi, short for “decentralized finance,” refers to a decentralized ecosystem of financial applications and protocols built on blockchain technology, typically utilizing smart contracts. It aims to recreate and enhance traditional financial systems in a transparent, permissionless, and open manner, without the need for intermediaries like banks or financial institutions.
Advantages of DeFi Over CeFi
Here are some of the major benefits of DeFi:
Decentralization: DeFi platforms operate on blockchain networks, usually public networks like Ethereum, where transactions and data are distributed across a network of computers. This decentralized nature ensures transparency, security, and eliminates the need for a central authority.
Smart Contracts: DeFi relies heavily on smart contracts, which are self-executing contracts with the terms of the agreement directly written into code. Smart contracts automate and enforce the rules and conditions of financial transactions without the need for intermediaries.
Open and Permissionless: DeFi aims to be accessible to anyone with an internet connection, allowing users to interact with protocols and applications without the need for intermediaries’ permission or extensive documentation.
Interoperability: DeFi protocols strive to be interoperable, meaning they can seamlessly interact with each other, enabling composability and creating a broader ecosystem of interconnected applications.
Programmability and Innovation: DeFi allows developers to build new financial applications and services using open-source code and existing building blocks. This programmability enables innovation, as developers can combine and extend existing protocols to create new financial products.
Common use cases within DeFi include decentralized lending and borrowing platforms, decentralized exchanges (DEXs), yield farming, liquidity provision, stablecoins, asset management, and insurance, among others.
These applications aim to provide financial services traditionally offered by banks, such as lending, trading, saving, and investing, but in a decentralized and permissionless manner.
Disadvantages of DeFi
While there are some major advantages to using decentralized finance, there are many proven risks that have emerged since the crypto sector explosion of 2021:
Smart contract vulnerabilities: DeFi protocols rely heavily on smart contracts, which are subject to coding errors or vulnerabilities. Exploiting these vulnerabilities can lead to financial losses, as seen in several high-profile hacks and exploits in the DeFi space.
Lack of regulatory framework: DeFi operates in a relatively unregulated environment, which can lead to uncertainty and potential legal and compliance risks. The absence of clear regulations may also hinder mainstream adoption and limit institutional participation.
Volatility and market risks: DeFi platforms often involve volatile and speculative assets, which can result in significant price fluctuations and financial losses. The decentralized nature of these platforms may exacerbate market risks, as they may be more susceptible to manipulation and lack the protective mechanisms seen in traditional finance.
Limited user support and recourse: In traditional finance, users can typically seek customer support or legal recourse through centralized entities. In DeFi, where transactions are conducted directly on the blockchain, there is often limited user support or mechanisms for dispute resolution, making it challenging to address issues or recover funds in case of errors or fraudulent activities.
Complexity and usability challenges: DeFi platforms can be complex to navigate, especially for non-technical users. The user experience and interface design of many DeFi applications may not be as intuitive or user-friendly as traditional financial platforms, creating a barrier to entry for mainstream adoption.
High gas fees and scalability concerns: Many DeFi applications operate on public blockchain networks, such as Ethereum, which can experience congestion during periods of high demand. This congestion leads to increased transaction fees, known as gas fees, making certain DeFi activities expensive and limiting scalability.
Lack of privacy: While blockchain technology provides transparency, it also presents challenges regarding privacy. DeFi transactions are often visible to anyone on the blockchain, potentially compromising user privacy and confidentiality.
Integration with traditional finance: While efforts are being made to bridge the gap between traditional finance and DeFi, there are still challenges in integrating these two ecosystems. Regulatory and compliance requirements, interoperability issues, and trust barriers hinder seamless collaboration between DeFi and centralized financial systems.
10 uses cases of DeFi that overlap with Centralized Finance
Decentralized finance (DeFi) and centralized finance (CeFi) are two distinct financial systems, but there are some areas where their use cases overlap. Here are 10 examples of DeFi use cases that can also be found in CeFi:
Lending and borrowing: Both DeFi and CeFi offer lending and borrowing services, allowing individuals and businesses to borrow funds or earn interest by lending their assets.
Stablecoin usage: Stablecoins, such as USDT or USDC, are widely used in both DeFi and CeFi for stability and ease of use in trading, remittances, and hedging strategies.
Decentralized exchanges: DeFi platforms provide decentralized exchange services, enabling users to trade digital assets directly without intermediaries. CeFi platforms also offer centralized exchanges with similar functionalities.
Yield farming and staking: Both DeFi and CeFi provide opportunities for users to earn additional rewards or interest by participating in yield farming or staking activities.
Asset management: DeFi protocols offer decentralized asset management services, allowing users to pool their funds into smart contracts and earn returns. Similarly, CeFi institutions provide asset management services where professionals manage clients’ investments.
Insurance: DeFi platforms offer decentralized insurance solutions that allow users to protect their funds against smart contract failures or hacks. CeFi also provides insurance products and services to cover traditional financial risks.
Payment solutions: DeFi projects are developing decentralized payment solutions that facilitate peer-to-peer transactions without intermediaries. CeFi institutions also offer payment services, enabling individuals and businesses to send and receive funds globally.
Decentralized identity: DeFi platforms are exploring decentralized identity solutions, allowing users to control their personal data securely. CeFi institutions also implement identity verification processes to comply with regulatory requirements.
Dissolving the Rift Between DeFi and CeFi
Dissolving the rift between traditional finance and decentralized finance (DeFi) requires a combination of understanding, collaboration, and innovation. Here are some steps that can help bridge the gap:
Education and awareness: Both traditional finance and DeFi communities need to understand each other’s strengths, limitations, and objectives. Education initiatives, workshops, conferences, and collaborative events can help foster mutual understanding.
Regulatory clarity: Regulators play a crucial role in bridging the gap. Clear and well-defined regulations that promote innovation while ensuring consumer protection can provide a framework for collaboration between traditional and decentralized financial systems.
Collaboration and partnerships: Traditional financial institutions should actively seek partnerships with DeFi projects and explore ways to integrate decentralized solutions into their existing infrastructure. Collaboration can involve joint research projects, pilot programs, or strategic investments to leverage the benefits of both systems.
Interoperability: Efforts should be made to improve interoperability between traditional financial systems and DeFi platforms. This could involve the development of common standards, protocols, and APIs that enable seamless transfer of assets, data, and liquidity between the two ecosystems.
Risk management and security: DeFi platforms need to address security concerns and establish robust risk management practices. Audits, smart contract testing, insurance mechanisms, and user protection frameworks can help build trust among traditional finance participants.
Regulatory sandbox environments: Regulatory authorities can establish sandbox environments where traditional and decentralized finance can experiment and collaborate within a controlled framework. This allows for innovation while minimizing risks associated with untested technologies.
Innovation in traditional finance: Traditional financial institutions should embrace innovation and explore the potential of blockchain technology, smart contracts, and decentralized applications. This can involve developing their own DeFi solutions or partnering with existing DeFi projects.
User experience improvement: DeFi platforms should focus on improving the user experience to attract a wider audience. This includes simplifying complex processes, enhancing security measures, and providing better customer support.
Standardization and governance: Efforts should be made to establish industry-wide standards and governance frameworks for DeFi. This can help address concerns related to transparency, security, and dispute resolution, making traditional financial participants more comfortable engaging with decentralized systems.
Research and development: Continued research and development are essential to drive innovation and address the challenges faced by both traditional finance and DeFi. This can involve academia, industry consortia, and government-funded initiatives to explore the potential synergies between the two systems.
Overall, dissolving the rift between traditional and decentralized finance requires a collaborative and open-minded approach from all stakeholders, including regulators, financial institutions, technologists, and the broader community.
Top Projects Bringing DeFi and CeFi Closer
Some of the biggest projects in the DeFi space that aim to bring the two industries closer can be spotted using multiple DeFi analytic platforms that provide a closer look at the TVL contained in these projects. Here are some of the top DeFi projects:
Lido
Lido facilitates the staking of Ethereum 2.0 (ETH) tokens and saw a huge inflow of money a few months ago post the Ethereum Network’s Merge which also resulted in the creation of a fork of the main chain called the EthereumPoW Network.
In Ethereum 2.0, staking involves depositing ETH into the network to become an Ethereum validator. Validators are responsible for proposing and validating new blocks, securing the network, and maintaining its consensus.
Lido simplifies the staking process by allowing users to delegate their ETH to a staking pool operated by the protocol. This eliminates the need for users to run their own validator nodes, which can be technically complex and require a significant amount of ETH. Instead, users can stake any amount of ETH, regardless of the minimum requirement, by depositing it into the Lido protocol.
Lido then aggregates these delegated ETH holdings into a larger pool and operates a set of validators on behalf of the users. In return for staking their ETH, users receive stETH (staked Ether) tokens, which represent their share in the total pool of staked ETH. These stETH tokens are liquid and can be freely transferred or used in other DeFi applications while still accruing the benefits of staking rewards.
It is important to note that staking is like investing in a bank’s scheme with some risks as well. CeFi firms provide a portion of their profits from investing your money while Lido also basically does the same.
Aave
Aave is another example of a DeFi firm that works via two components, borrowers and lenders. It allows users to borrow, lend, and earn passive income from their crypto holdings. This is also similar to money deposited in a bank account which provides a return of some percentage over time.
Lenders can deposit their digital assets into liquidity pools on the Aave platform, where they earn interest on their deposits. These deposits are tokenized, creating interest-earning tokens called “aTokens.”
Borrowers can use the deposited assets as collateral to borrow other cryptocurrencies from the Aave platform. The borrowing process is overcollateralized, meaning borrowers must provide more collateral than the borrowed amount. This mitigates the risk of default and ensures the safety of lenders’ funds.
An important fact to note here is that Aave was the first protocol to introduce flash loans, which are uncollateralized loans that allow users to borrow assets instantly as long as the borrowed amount is returned within the same transaction. Flash loans enable arbitrage opportunities and complex trading strategies in the DeFi ecosystem.
MakerDAO
MakerDAO, also known as Maker, is a decentralized autonomous organization (DAO) and protocol built on the Ethereum blockchain. MakerDAO’s primary product is the DAI stablecoin, which aims to maintain a stable value relative to the US dollar.
Just like CeFi firms, MakerDAO also provides financial services using the DAI stablecoin and a lending protocol, allowing users to generate stablecoins by locking up collateral assets. Also, MakerDAO practices risk management policies via risk management strategies. Therefore, just like Aave, users are required to provide additional collateral than the amount they want to borrow.
Additionally, MakerDAO operates through decentralized governance, allowing MKR token holders to participate in the decision-making process. MKR is the governance token of MakerDAO, and holders can vote on proposals, protocol upgrades, changes to stability fees, and other parameters that govern the MakerDAO ecosystem.
Uniswap
UniSwap is a leading decentralized crypto exchange and operates using similar policies as that of centralized exchanges except they provide additional privacy features and access to a wide array of cryptocurrencies.
Interestingly, Uniswap has gone through several iterations. Version 2 (V2) introduced features like flash swaps, which allow users to borrow tokens without upfront collateral. Version 3 (V3) introduced concentrated liquidity, enabling liquidity providers to concentrate their funds within specific price ranges to potentially maximize capital efficiency.
Moreover, Uniswap operates as an AMM, which means it uses smart contracts to facilitate token swaps. Instead of relying on order books and matching buyers with sellers, Uniswap uses liquidity pools that contain token pairs. These liquidity pools are funded by users who deposit tokens into them, allowing for the continuous swapping of tokens at dynamically determined exchange rates.
Uniswap has become one of the most popular and widely used decentralized exchanges in the DeFi ecosystem due to its simplicity, accessibility, and permissionless nature. It enables users to trade tokens directly from their wallets while maintaining control over their funds, and it has fostered liquidity provision and innovation in the decentralized finance space.
Curve Finance
Curve Finance is an automated market maker (AMM) protocol designed specifically for stablecoin trading. It focuses on providing low-slippage and low-fee trading for stablecoins, making it particularly useful for traders, liquidity providers, and stablecoin users. Curve Finance is considered as one of the most underrated DeFi projects despite having more than $3.6 billion in deposits as of July 10, 2023.
Curve Finance stands out for its unique algorithm that allows for efficient stablecoin swaps, resulting in minimal slippage compared to other AMMs. It achieves this by utilizing a bonding curve model that is optimized for stable assets with similar prices, such as different variants of the US dollar (USD).
Despite its innovative design and usefulness within the DeFi ecosystem, it may still be considered underrated by some, as it may not have reached the same level of recognition and popularity as some of the larger DeFi projects like Uniswap or Aave.
Conclusion
All the decentralized finance projects mentioned above provide similar outputs when compared to the banks and their schemes in the traditional finance sector. However, DeFi provides additional privacy with increased yields but it is also crucial to note that the risks here are high. Many DeFi projects were hacked in 2022 which is considered as one of the worst years for crypto and decentralized finance.
DeFi projects like Mango Markets, BNB Chain, Qubit Finance, Horizon Bridge, Maiar Exchange, Wintermute, Beanstalk Farms, Nomad Bridge, Wormhole Bridge, and Ronin Bridge were all hacked in 2022. Hackers specifically targeted the vulnerabilities in cross-chain bridges.
The DeFi industry has yet to catch up to the capital and influence that reside in the CeFi industry mainly due to the security that the latter provides. However, given the innovative side of the DeFi space, that day might not be so far off.
