Decentralized finance, or DeFi for short, is an emerging phenomenon in the crypto world that aims to end the reliance on financial intermediaries by replacing them with open-source smart contracts that operate on a blockchain and are self-governing. According to the proponents of DeFi, the resultant system is more transparent, democratic, efficient, inclusive and ethical than the traditional financial system or, as the DeFi movement likes to call it, the legacy financial system.
We at Blockchain Intelligence Group (BIG) gathered trends and insights on DeFi in 2020 into a primer for our audience in law enforcement and finance. Some highlights include:
- Ethereum’s blockchain was the most popular choice for smart contracts as it hosted all of the 75 most popular DeFi protocols barring Lightning Network, which was based on Bitcoin’s blockchain. This was largely due to the fact that the Ethereum blockchain’s programming language Solidity allows for creating complex smart contracts. Even though other blockchains have also developed their infrastructures to host smart contracts, Ethereum’s early lead meant that it already had an ecosystem of DeFi apps on it. As many smart contracts interact with each other, this ecosystem makes Ethereum the primary choice for most smart contract developers.
- Automated market makers (AMM) emerged as a solution to illiquidity faced by order-book based DEXs. AMMs do away with the peer-to-peer trading model and instead use the peer-to-contract model wherein crypto owners (liquidity providers) deposit their cryptocurrency in ‘liquidity pools’. These pools are then used to honor any exchange order. AMMs became popular after the runaway success of Uniswap.
- Yield farming was another trend that started last year. It refers to generating rewards by moving cryptocurrencies across different smart contracts. Many smart contracts give incentives to their users, like AMMs rewarding liquidity providers with a return whenever that liquidity pool is used. Yield farming became popular in June 2020 when Compound started distributing its governance token COMP to lenders and borrowers on its platform. This encouraged people to use the platform, thereby aiding in customer acquisition as well as token distribution. After Compound’s success with this strategy, other smart contracts used similar strategies to increase their user base quickly. On the other hand, Yield farmers took advantage of this by coming up with complex strategies that often involved multiple smart contracts to maximize their yields from such rewards.
- Stablecoins were also a popular offering as they provide stability by deriving their value from a particular asset or a basket of assets. Currently, DAI and Tether (USDT) are the most prominent stablecoins. Both of these tokens are pegged to the US Dollar but in different ways. USDT is issued by Tether Limited who claim to have a Dollar reserve backing the token in a 1:1 ratio. Dai, on the other hand, operates through smart contracts and is maintained by MakerDAO. Rather than having a Dollar reserve, DAI relies on its users making Crypto deposits as collateral. Users can then generate the amount of DAI they wish to borrow against the Dollar value of the collateral. Due to the volatility of cryptocurrencies, MakerDao requires the debt position to be overcollateralized. Through this mechanism, they ensure the value of each DAI token to be $1.
- Finally, lending protocols like Compound and Aave gained a lot of traction for allowing users to lend and borrow a variety of tokens on a simple and user-friendly interface.
