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Understanding DeFi

Future of Finance? This is it.

If you’ve been in the cryptocurrency industry for at least a couple months, chances are you’ve heard of DeFi already. What is it?

DeFi stands for Decentralised Finance. You can think of it as Wall Street on-chain, with a lot less corruption.

In the following report we:

  • Explain DeFi

  • Breakdown the infrastructure

  • Lay down the different sectors of DeFi

DeFi Explained

Financial institutions such as banks, funds and brokerage firms all offer us different products; ones most use everyday. Given that these products are all issued by centralised entities, they all have a single point of failure. They also reduce innovation by promoting post-success complacency and accessibility is often limited to the wealthier individuals.

DeFi is offering the exact same base products but in a decentralised manner where self-custody and censorship-resistance reign. Additionally, since most protocols are open-source anyone can contribute or create their own version which promotes constant innovation. The key benefit of DeFi comes from composability which allows developers to create products that would simply be impossible in TradFi (traditional finance). One example of such product is a loan that repays itself.

TradFi is governed by humans whereas DeFi is governed by code.

Disclaimer: THIS IS NOT FINANCIAL NOR INVESTMENT ADVICE. Only you are responsible for any capital-related decisions you make and only you are accountable for the results.

The Infrastructure

This report will delve into the different sectors/verticals found within the DeFi ecosystem. However, before we go there we’ll need to talk about where DeFi is housed.

DeFi applications need somewhere to live, somewhere where users can come in and interact with it. Think of iPhone applications, they need be housed somewhere to operate: iOS. In the case of dApps, it’s a blockchain that supports smart contracts – the most popular of which is Ethereum.

There are many blockchains offering a home for DeFi:

  • Ethereum has the major market share and has been around the longest.

  • Solana is slowly seeing an increase in products available on top of it.

  • Binance Smart Chain also has DeFi apps but is highly centralised which is controversial so far.

  • Other chains promise smart contract capabilities but don’t deliver – truly a wild west out here.

These chains all have tokens that secure the network. They’re not DeFi tokens per se but rather the mothership where all DeFi tokens live.

The question to always ask is: where do these tokens’ value accrue from? In most cases, these chains operate on a Proof-of-Stake (PoS) consensus mechanism which follows the rule of “the higher the price per unit, the more secure the network” – because it becomes very expensive to 51% attack it.

The Verticals

Today, we call it decentralised finance, tomorrow it’ll just be Finance. As you know there are multiple sectors, types of applications or verticals within finance which we’ll break down right here:

Vertical 1: Exchanges

Decentralised Exchanges (DEXs) are the decentralised versions of FTX, Binance and Coinbase where users can exchange one token for another. There are two types of DEXs evolving:

  • Chain-specific: Allows trading/swapping between tokens that live on a single blockchain; such as Uniswap on Ethereum.

  • Chain-agnostic: Allows trading/swapping between assets across different blockchains; such as THORChain.

Vertical 2: Lending Markets

Lending and borrowing are one of the most popular financial products on the planet, think of taking a bank loan or using a savings account. This vertical is a crucial part of the financial system and one decentralised example is Aave.

Vertical 3: Derivatives Markets

Products that derive their price from spot are called derivatives. The two most popular products are: futures and options. In traditional finance, the derivatives market is said to be in the quadrillions, but this include leverage. In reality, the actual value stood at $12 Trillion in 2019. For comparison, the lending market had a size of roughly $7 Trillion that same year.

There is a clear discrepancy within DeFi between lending and derivatives markets as the latter is 10X smaller than the former in terms of TVL, when it clearly is larger in a more mature markets.

Examples of derivative markets are dYdX, Perpetual Protocol and Synthetix (once futures are introduced).

Vertical 4: Fixed Income

When you lend out your funds in DeFi you earn interest but it’s variable, what may start as 200% APR on one day may become 5% on the other.

This is the next frontier for DeFi: fixed income where users can earn fixed pre-determined yield. There are multiple ways to structure such a product, the most popular two being:

  • Fixed Rate Lending: This is the simpler product within fixed income markets and a protocol offering it is: Yield Protocol.

  • Interest Rate Swaps: While this product is a derivative, it does fall in line with fixed income as it helps users achieve the same outcome: fixed rate lending. It is difficult to explain IRS in a couple sentences but we’ll give you a simplified preview: the basic premise is swapping a variable (or floating) interest rate for a fixed one – a type of hedge that locks in a fixed interest rate. A DeFi protocol working on such a product is: Horizon Finance.

Vertical 5: Insurance

We all hear of hacks and protocol attacks all too often. This is a major obstacle for DeFi and one of the reasons why many people still prefer interacting with TradFi institutions. Imagine having your funds on a certain protocol as you provide liquidity only to see your assets drained due to a smart contract bug or vulnerability. This is where the insurance industry comes into DeFi.

The two most popular protocols offering DeFi insurance products are Nexus Mutual and Insurace.

Vertical 6: Asset Management

Last but not least, asset management. The world of funds is a very complex one that includes a high barrier of entry. Hedge funds can be extremely expensive to set up and run which makes it that unless you are raising tens of millions, you’re unlikely to meet large success or even longevity. DeFi takes care of this by reducing the set up and running costs – they become integrated in the code rather than completed by humans. There are a few DeFi protocols offering this, such as dHedge, Enzyme Finance (formerly known as Melonport) and Set Protocol.

Important Note

The only two verticals that have caught significant traction are chain-specific exchanges and lending markets. The remaining sectors remain in their very early infancy within DeFi which means they offer high potential returns (not financial advice) but that also means they may not see any traction for a few years.

We speculate that the next two biggest use cases will be fixed income market and derivatives, the latter would be boosted further by the introduction layer-2 solutions.

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