DeFi applications: What they can – and can’t – accomplish

DeFi applications – dapps – are generally easy to use and offer an array of benefits that not only enhance the current system, but also repair fissures in it.

Decentralized finance (DeFi) provides wider global access to financial services, including cheap and convenient cross-border payments. It also improves privacy and security, while enabling censorship-resistant transactions. In this regard, it has vast potential for financial inclusion and empowerment.

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But alongside these benefits, DeFi still has imperfections that current and future projects need to bear in mind. These include the following aspects:

  • While the public nature of blockchains like Ethereum may be acceptable to retail investors, their lack of transaction privacy severely limits their usability for enterprise applications.
  • The platforms still act in the cryptocurrency space, which experiences annual volatility of more than 100%. Investors have to hedge market risks using futures, CFDs (contract for difference), cryptocurrency exchanges (using lending facilities) or by simply using a stablecoin.
  • Assets stored in Ethereum are still vulnerable to counterparty risks. If the smart contracts are found to be prone to attacks, this might result in a complete loss of stored funds.
  • There is still a palpable gap between theory and practice. Low liquidity and a lack of price disclosure, non-intuitive user experience (UX), high friction, capital inefficiency, hidden risks and regulation stand in the way of adoption and accessibility.

That said, the potential of DeFi is and remains undeniable. Ethereum’s DeFi landscape is playing out as one of its most profound application environments so far. Let’s look at the types of services DeFi has disrupted using Ethereum or other blockchain protocols so far.

DeFi application issuance platforms

Tokenization has been at the epicenter of discussions since the recent security token offering (STO) wave. Projects around the world have been tokenizing just about anything, from intangible assets (copyrights, trademarks and patents) and fungible assets (gold) to physical assets (real-estate, paintings), marketable securities and cash equivalents. Issuance platforms are venues that create new assets (e.g. tokenized debt), which can then be traded, transferred or used as required. When tokens are issued on Ethereum, they have to follow technical standards like ERC-20 to make them usable by all smart contracts. These platforms have issued assets primarily across three services: debts, stablecoins and securities.

Decentralized lending via DeFi applications

DeFi lending platforms act as peer-to-peer (P2P) lending platforms, where individuals can access a pool of lenders and get a loan without a centralized authority. A simple mechanism ensures that lenders are willing to offer loans without credit history and collateral. Since most of the platforms act in the trustless environment of blockchains, the loans are over-collateralized by locking cryptocurrencies in an account. Decentralized lending offers numerous advantages over traditional credit structures including:

  • Integration with digital asset lending/borrowing
  • Collateralization of digital assets
  • Instant transaction settlement and novel secured lending methods
  • No credit checks, meaning broader access for people who cannot tap into traditional services
  • Standardization and interoperability, which can also reduce costs through automation

DeFi lending users

Number of decentralized lending service users (source: DApp Total)

Total funds in DeFi

Total funds locked in by DeFi users (source: DApp Total)

The DeFi industry started to attract attention in 2018 and expanded rapidly in 2019. The total locked value increased from US$ 302m to US$ 1.49bn. The most borrowed assets are Dai and Weth, with total origination (borrows and loans) increasing from US$ 34m in January to US$ 544m in June – an almost 16-fold expansion. At the same time, the total user base remains small, with only a few thousand monthly active users, although figures have grown dramatically since late 2018.

Stablecoins

Stablecoins are blockchain-issued tokens designed to maintain a stable peg with an outside asset – in most cases to the US dollar, but sometimes gold or another asset or an algorithm. Currently, most stablecoins are issued on the Ethereum blockchain.

Stablecoins primarily fall into three main categories:

  • Crypto-collateralized (Maker’s Dai)
  • Asset-collateralized (backed by fiat, commodities, other alternative assets)
  • Non-collateralized (pegged using an algorithm)

Market cap

Market cap of different stablecoins (source: stablecoinindex.com)

The usage of stablecoins grew fast in the first half of 2019, accelerating in April as crypto prices rebounded. The daily on-chain transaction volume reached US$ 859m at the end of June, with TUSD and USDC being the most popular stablecoins traded. The current market value of all stablecoins stands at US$ 5.24bn. Of top 10 stablecoins, 9 are built on the Ethereum blockchain.

Other securities and tokens issued through DeFi applications

Security issuance platforms encompass a broad range of portals, including several exchanges that double as issuance mediums (e.g. tZERO). Security token issuance platforms are still struggling with the pending regulatory concreteness and the unfulfilled promise of more flexible security standards. Well-known security token issuance platforms like Polymath and Harbor provide the framework, tools and resources for issuers to launch tokenized securities on a blockchain. They prepare their own standardized token contracts for securities (e.g. ST-20 and R-Token) that enable automated compliance and customizable trade parameters and meet regulatory requirements. Changes in governance structures for STOs will combine the advantages of regional regulatory oversight, on-chain governance and decentralized ownership.

This has been a brief overview of DeFi applications. Watch this space for more.

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