Much of the headlines surrounding cryptocurrency at the moment seem to focus on the latest meme coin or big NFT sale. However, there are other interesting new crypto projects finding popularity, and many of these are in the world of DeFi.
being the first and most well-known, allow us to transfer digital money without the need for a central entity overseeing the transaction. The Financial Conduct Authority (FCA)
estimates 2.3 million UK consumers hold crypto assets.
DeFi takes the ideas and technology behind cryptocurrency to produce higher-level applications than transferring currency from one person to another. DeFi crypto has seen an explosion of use in the last two years, with more new and exciting applications finding use within the cryptocurrency community.
So is DeFi the future of cryptocurrency? Are decentralized applications (dApps) built using blockchain technology going to find greater use and offer a real alternative to traditional financial services?
What is DeFi in crypto?
First, let’s define the phrase itself.
DeFi, or “decentralized finance,” refers to financial services that utilise blockchain technology to remove intermediaries like banks and other financial institutions. With DeFi, users can move away from traditional centralised financial systems and establish peer-to-peer finance with automated, enforceable agreements, or smart contracts, using the same online blockchain technology
cryptocurrency is built on.
How does DeFi work?
DeFi requires open-source cryptocurrency platforms, with the majority of dApps running on the Ethereum blockchain network.
Ethereum is open-source, meaning its code is available for everyone to read, share, and run themselves. In the modern world, you can also interact with computers that are guaranteed to be running that specific code. And this is what allows for the creation of new crypto projects within DeFi.
Users write their own programs to interact with the Ethereum network. Because the Ethereum code is open-source, these programs generate predictable results. By writing complex code that predictably interacts with blockchain platforms, you can produce sophisticated dApps such as a decentralised currency exchange or a crypto lending platform.
The so-called “smart contracts” that execute DeFi in practice are programs stored on a blockchain. These programs execute transactions automatically upon specific criteria being met or receiving certain real-world data. Smart contracts allow for the creation of anonymous, peer-to-peer financial services through enforceable agreements that are baked into the code itself.
All this without a central authority, DeFi transactions are validated using the same consensus mechanisms as cryptocurrencies.
DeFi protocols and tokens
Many terms within DeFi can seem confusing from the outside. For example, specific examples of these autonomous programs are also referred to as DeFi protocols. These protocols typically incorporate DeFi tokens, a type of asset or utility used within the protocol.
DeFi tokens have similar properties to cryptocurrencies. They can be transferred seamlessly and offer the same levels of transparency. However, while cryptocurrencies are very much an asset, DeFi tokens can also be considered financial tools. The tokens are embedded within the protocol by the financial logic that governs the specific application.
With the explosion of DeFi crypto over the last couple of years, there are now a considerable number of DeFi protocols available performing different applications. Some of the better known DeFi protocols are:
- Aave – one of the most popular DeFi crypto lending protocols. Users can lodge their tokens and receive interest.
- yEarn – an automated liquidity aggregator, yEarn also offers a wide range of opportunities within yield farming.
- Chainlink – an oracle network providing real-world data for smart contracts.
- Uniswap (UNI) – one of the most prominent decentralised exchanges within DeFi.
- Compound – a lending platform similar to Aave. The compound also offers yield payments in the form of its own token.
- DAI – A stable coin that uses an automated system of smart contracts to try and maintain its value as close to that of the United States dollar.
Potential benefits of DeFi
There are many potential benefits to DeFi crypto that people are excited about. These include:
- Permissionless – through decentralisation, DeFi financial systems remove the need for intermediary actors within financial transactions.
- Accessibility – DeFi offers simple and effective access to financial services to anyone with an internet connection.
- Security – by effectively utilising cryptography, DeFi offers the potential for greater security compared to traditional financial systems.
- Programmability – with DeFi’s programmable smart contracts, it is possible to build new financial instruments rapidly.
- Combining dApps - existing DeFi products can be built on top of, modified or combined to produce new services.
- Speed – without intermediaries checking and approving transactions, DeFi offers real speed advantages compared to traditional platforms.
- New investment opportunities – DeFi crypto transforms financial systems and allows for entirely new investment opportunities.
Is DeFi the future of cryptocurrency?
DeFi crypto has seen a dramatic rise since early 2020. CoinGecko
tracks the Defi crypto market cap. In January 2020, it was hovering around $2 billion. Now it is almost $160 billion (£117 billion). With so much more activity, it is easy to see why many believe DeFi is the future of cryptocurrency.
But there are still many things that need to happen to ensure further adoption of DeFi crypto. Including further clarity on any potential regulations, improving consumer confidence, and greater investments to develop DeFi infrastructures.
One of the biggest factors coming for DeFi is the full merge of Ethereum 2.0, expected in the first quarter of 2022. Ethereum 2.0 is an upgrade aiming to improve the speed and scalability of the blockchain by changing the consensus mechanism from proof-of-work to proof-of-stake as well as incorporating sharding.
Proof-of-stake is a far less energy-intense process and requires less technical knowledge to participate. Plus, breaking up blocks through sharding offers much greater efficiency. With Ethereum 2.0, DeFi crypto will be faster, more accessible, and scalable.
Decentralised Exchanges (DEXs)
DEXs are online exchanges that allow participants to exchange currencies directly with one another. This could be both fiat currencies or cryptocurrencies.
Lending and borrowing DeFi protocols have already found widespread use. They use smart contacts to remove the need for intermediaries. Borrowers get liquidity without selling their assets, typically using tokens as collateral, and lenders can earn interest on their crypto assets.
These marketplaces allow users to vote, trade or bet on future events, with smart contracts setting the payouts.
Stablecoins are cryptocurrencies whose value is connected to the value of another asset such as:
- Fiat currencies
- Other cryptocurrencies
Stablecoins reduce the dramatic fluctuations often seen in the value of cryptocurrencies. Stablecoins offer a “risk-off” instrument with some of the advantages of cryptocurrencies, such as fast transactions and access to cryptocurrency exchanges/marketplaces.
Users who lend crypto assets receive interest. However, they also often receive rewards in the form of additional cryptocurrencies. Yield farming is the practice of lending to receive assets of new cryptocurrencies that have the potential to skyrocket in value.
Risks of DeFi Investments
DeFi crypto is still in its infancy, and not all DeFi is created equal. Many of the tools are experimental, and while some offer ingenious new approaches to finance, others offer very little except disappointed investors.
There are real security risks present in smart contracts. Their open-source nature allows them to interact with one another seamlessly. But any potential flaws or exploits are there for anyone smart enough to spot.
If you want to understand the risks of DeFi crypto, look no further than the “flash loan” incidents on the lending platform bZx in February 2020. Anonymous traders took advantage of the ability to take out extremely short term loans without putting up capital. They then used some of the funds to open long or short positions and the rest to pump up the prices in illiquid markets to benefit their position.
Two separate incidents occurred, with each taking less than 15 seconds. The traders got away with a combined Ether (cryptocurrency of the Ethereum network) worth over $900k. You could consider these traders hackers who put up zero collateral and made off vast sums of money. Or you could argue they spent the time to understand the DeFi protocols and spotted an exploit no one else had.
Other potential risks occur in the third-party services for external information. For example, if this information feed contains corrupted information, it has the potential to disrupt DeFi protocols.
UK crypto regulation
There is also the possibility of new crypto regulations putting an end to the DeFi crypto party or at least turning the music down. Comments by the FCA’s chief executive, Nikhil Rathi, suggest there is the potential for new UK crypto regulations in the future. Plus, in June 2021, the FCA stated Binance, a significant cryptocurrency exchange, could not conduct any regulated activity and issued a warning to the platform’s customers.
With exciting new applications and approaches to financing, DeFi crypto may well become the future of cryptocurrency. It has the potential to transform financial services for a significant portion of the UK that already hold crypto assets as well as draw more people to the technology.
However, in a field this new, it is important to be wary of the risks involved and learn as much as possible before jumping into any new investment.