What is it?
Decentralised Finance or DeFi as it has become popularly known is a term used to describe a host of applications that leverage blockchain and cryptocurrency technology to complete transactions in a manner that removes the need for an intermediary or centralised control. As you probably already know, this is why it comes from the words ‘decentralised finance’.
I’ve sketched out the high-level view of DeFi and some of the core applications that sit within it on a simple diagram below:
In this article, I’m going to cover two of the main DeFi applications: lending platforms and exchanges. With DeFi applications, transactions are able to occur through the establishment of a protocol which is essentially an encoded set of conditions that if met by both parties will deliver the specified outcome i.e. a transaction taking place.
Who cares? (Lending Platforms and Lenders)
Potentially you one day, and a whole host of businesses that sit in between these transactions. Take the example of buying a house. Currently, this would mean going to a mortgage broker, finding a suitable bank with an affordable rate, attending an auction / bidding on a property through an estate agency, finding a property lawyer to draw up the purchase agreement, and ultimately exchanging the ownership title of the house once the funds have been cleared by the bank. Not only is this a gruellingly inefficient transaction with multiple intermediaries, it is also quite expensive as everyone in the middle needs to take a cut to run their business.
While DeFi is still in the nascent stages of development, there is already functionality to provide loans to those who are able to provide a source of collateral (similar to a deposit) and agree to pay a specified interest rate. Once both parties have agreed on the parameters of the contract and conditions are met, the title of the property can be handed from seller to buyer.
In the case of defaults on payments, collateral can be seized, and the contract revoked. This can all done through what you may have heard as 'smart contracts'. Overall, this shift in the way we take out loans has still some way to go before it becomes mainstream, and it may well be that we'll still need some form of intermediaries to inform these contracts being created. However, it may also be possible to envision a world in which these contracts are created once, with a change in the variables e.g. price of the house or the rate of interest on the loan. The net impact could be a significant reduction in the overall cost to borrow.
Decentralised Exchanges (DEXs)
Another example for the use of DeFi is through decentralised exchanges (DEXs), these are platforms which have been set up to facilitate automated exchanges of cryptocurrencies at an agreed rate.
Exchanges take place in what are known as liquidity pools where cryptocurrency holders deposit their crypto and earn interest or ‘liquidity tokens’. These pools are regularly used as markets for exchanges across cryptocurrencies e.g. buying Ethereum using bitcoin. An extremely popular example where this occurs today is UniSwap.
Each liquidity pool uses a smart contract and formula to determine the prices at which currencies are exchanged in an automated manner. For example (x * y = k) where x and y are the supply amounts of two different cryptocurrencies, also known as pairs, and k is the constant: a predetermined value by the creator of the liquidity pool. This ensures that if someone made a large transaction to buy Ethereum using bitcoin, the supply of bitcoin would increase (driving its price down) and the supply of Ethereum would decrease (driving its price up).
The larger the liquidity pool is, the less impact a transaction of similar size will have on the overall price, and thus for reasons of price stability, a larger liquidity pool is preferred. Further, the larger the liquidity pool is, the greater the reward for the liquidity providers who earn up to 0.3% of the value of transactions that take place within it. There is of course more to it than this which I don't yet have the time or expertise to delve deeply into (I've provided a couple of links below if you'd like to read more deeply on how liquidity pools work).
Exchanges using these liquidity pools differ from traditional exchanges and marketplaces because they do not rely on an order book to guarantee a transaction. So long as there are tokens or cryptocurrencies in the liquidity pool, there is always a market which is determined by the aforementioned mathematical formula. In a traditional market, if the bid and ask price don’t match then it can create illiquidity and may require intermediary market makers to step in and create a price match (again this is significantly slower as manual human intervention is required).
Part 2 to be continued where I will be covering Stablecoins and wrapped BTC (bitcoin).