Which is Decentralized Finance (DeFi)?

Started by Charlesth, Jul 28, 2022, 11:43 AM

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CharlesthTopic starter

Short story

The first and still the most famous cryptocurrency is bitcoin. You hear about bitcoin from every iron and, probably, you had to spend the last couple of years somewhere in a cave meditating with Buddhist monks in order to know nothing about it. Although who knows, maybe the monks are already mining a little... After bitcoin, the ether blockchain appeared.
He solved one serious issue - extremely expanded the ability to create smart contracts, which in turn expanded the scope for cryptocurrencies. If bitcoin is mainly used either for speculation or for long-term investments (HODL!), then on the ether blockchain, thanks to smart contracts, a whole ecosystem of financial services has grown, which we today call decentralized finance (DeFi).

However, the experimentation did not stop on the ether. Ethereum currently has a significant disadvantage - the throughput of this blockchain is only a few dozen operations per second. Due to the very high popularity of DeFi and NFT, the network is constantly overloaded and this leads to very high transaction costs. Any simple transaction on Ethereum costs hundreds of dollars.

New blockchains have emerged as an answer to this issue - Solana, Tera and Avax are the most popular of the alternative blockchains, they are able to support from several thousand to tens of thousands of operations per second, thereby reducing the cost of transactions by about 1,000 times. For example, on the Terra blockchain, small transactions cost a few cents.

Such a rapid growth of ether and alternative blockchains has led to the fact that over the past 5 years, the share of bitcoin in the total funding of cryptocurrencies has dropped from 90% in 2017 to about 40% today.

The ecosystem of financial applications and services (they are called dApps / decentralized implementations), created on the basis of smart contracts on the ether blockchain and other alternative blockchains, is decentralized finance (DeFi).

The total capitalization of investments in various DeFi applications and services is currently approximately $230 billion and has grown by about 10 times over the past year.

I will talk about DeFi using the example of several implementations that exist on the Terra blockchain - this is the second largest DeFi blockchain after Ethereum by funding. Firstly, my personal experience is mainly limited to the Terra blockchain and I want to talk about what I myself do and understand, and not engage in theoretical discussions about how it works. Secondly, due to the high commissions on Ethereum, most readers will still not be able to try using these applications, it is unlikely that many will want to throw out a couple of hundred dollars just to experiment with DeFi. In turn, on the Terra blockchain, the commissions are very low and everyone can practically try what I will talk about.

I'll make a reservation right away, what I'm talking about below is one very small part of the entire DeFi market.


Without getting too technical, staking is like owning blockchain shares. For example, this is how it works on the Terra blockchain: you buy a LUNA token, give it to the management of the so-called validator, and for this you receive part of the fees paid by blockchain users. This is the first source of income, and secondly, you can earn or lose with the change in the value of this token. You receive part of the commissions for transactions on the blockchain, because with your deposit you help the validator to perform the same function that miners perform for bitcoin, i.e. they confirm transactions and ensure the functioning of the entire blockchain. At the moment, LUNA's staking yield is 7% per annum. This is one of the most conservative forms of returns in DeFi because no matter what happens to the prices, as long as someone is using the blockchain, you will receive returns from their fees.

Of course, the volatility of the token itself remains. The economy of this blockchain (tokenomics) is designed so that the more various implementations on the blockchain are used, the more expensive the LUNA token is.

In addition to the "dividend" yield from staking, you get a say in all matters relating to the governance of the blockchain, which you delegate to your validator. In other words, validators vote on different proposals and the weight of their vote depends on how much capital investors have entrusted to them. This is similar to how voters vote for parliamentary parties, and the parties in turn vote for individual laws. The distinction is that you can change your vote at any time and go to another validator, with decisions that you are more in agreement with.

Generally, it is like a public company that distributes dividends to its investors in the form of staking yields, and is also in a state of permanent meeting of shareholders - voting on certain proposals takes place online at any time.

Here I would like to mention one critical concept, tokens do not have to be "currencies" that perform the functions of a means of payment. A token is a versatile instrument that can be anything like a stock (as described above), bonds, currency, a work of art or a status symbol (NFT), and many other features. This is a universal concept, the implementation of which is not limited to the means of payment.

The Anchor protocol can be called a crypto-bank. It allows you to take loans secured by cryptocurrencies and accepts deposits at interest. The token in which deposits are accepted and loans are issued is the UST stablecoin, which is equal to one dollar. The idea is that if you want to borrow $100, you need to provide a cryptocurrency collateral of at least $200. The protocol has two sources of profitability: firstly, it is the interest on the loan that debtors pay, and secondly, this is the staking yield of this cryptocurrency, since Anchor uses tokens received as collateral for staking, as described above

Example: Someone borrows $100 and provides $200 worth of LUNA token as collateral. Firstly, he pays interest on the loan, about 15% per annum, and secondly, $ 200 of collateral gives a 7% yield.

On the other hand, deposits are paying 19.5% per annum at the moment.

 Criticism and risks:

     recently this protocol attracts extremely more deposits than it gives out loans, respectively, high profitability is likely to decrease very soon, or they will limit the acceptance of deposits;

    at the moment, Anchor is trying to attract new borrowers by offering them cashback, part of the interest paid on the loan in the form of their own ANC token, this can be compared to the fact that Sberbank would give you back half of the interest paid on the loan in the form of its shares. This maintains interest among potential debtors, but the interest in the protocol remains questionable after they terminate this subsidy;

This practice of providing subsidies to early adopters of protocols is a popular practice in DeFi. This can be compared to how Uber lost money on every ride for years, but still focused on growing its customer base and overall turnover.

    there is a risk that the smart contract of this protocol will be hаcked and all your contribution will be lost forever, such hаcks in DeFi happen quite regularly

    there is a risk that the UST token will no longer be worth $1, this has already happened in the past during the general collapse of cryptocurrencies, it dropped to about $0.85 in May last year.

The fact is that this is an algorithmic stablecoin that is not backed by real dollars. Its parity with the dollar is maintained in a different way, more about this here. The very concept of an algorithmic stablecoin is an experiment, a success that is not guaranteed.


    smart contracts of this protocol have been third-party audited three times, which confirmed the absence of vulnerabilities, so far there have been no hаcks;

    it is possible to buy smart contract insurance, which means that if the protocol is hаcked and you lose your funds, another insurance protocol will reimburse you for them, the cost of such insurance is 2% per year at the moment;

    even if the yield on deposits falls by half, it will still give a fairly high yield. It is clear that today's high returns are not forever;

    The most critical plus in my opinion is the very business model of loans secured by cryptocurrency: it is similar to a loan secured by securities from a broker, with the difference that the cryptocurrency market is open 24/7, i.e. in the event that your collateral falls below The minimum level of collateral will be automatically sold on the market at a small discount and the loan will be closed from these funds.

Decentralized Exchange (DEX)

This application is a decentralized exchange, i.e. the place where you can buy and sell various tokens. The main distinction with traditional exchanges is that the liquidity needed to create a market is provided by any private аinvestor who will earn a portion of the commissions received by the exchange for making transactions.

The liquidity provision works like this: you provide $100 in UST token and $100 in LUNA token to the liquidity pool. These tokens will be used by automated market maker algorithms to create liquidity on the decentralized exchange. As a reward, you receive commissions paid by users of the exchange plus an additional reward in the tokens of the exchange itself. For example, for the UST/LUNA pool, the total return is currently around 30% per annum. This yield can vary greatly for different tokens.

Here there is an opportunity to get even higher profitability, however, the level of risks is also higher than in previous protocols. In addition to the risk of volatility in the value of the token for which you provide liquidity, as well as the risk of smart contract hаcking, there is another risk - the risk of impermanent loss. In practical terms, this translates into the fact that if one of the tokens for which you provide liquidity changes extremely in price relative to the other token, you will incur losses, compared to if you did not participate in the liquidity pool.

The high profitability of participation in the liquidity pool is designed, among other things, to compensate for possible impermanent losses. Accordingly, the more volatile the pair of tokens, the higher, as a rule, the reward in the pool will be.

Traditional Applications

From everything described above, you might have noticed that DeFi is like such a closed system, where all is based on the constant active speculation of cryptocurrencies. Speculators make a lot of transactions, the commissions for which are the income of stackers, as well as those who participate in liquidity pools. Speculators take loans secured by cryptocurrencies thus creating demand for deposits in cryptocurrencies. Where is the connection with the real world outside the Internet?

Today, the first serious implementations of DeFi outside of monetary speculation are already beginning to emerge.

Get to know the CHAI payment card: payments made with this card or through a virtual card are processed through the Terra blockchain. What does this mean in practice? In practice, this means that using this card at merchants who are also connected to the Terra blockchain, payments are cheaper and faster than using other traditional payment processing methods. This card is popular in South Korea where they have managed to integrate with a range of popular online and offline merchants.

Merchants are motivated to integrate with the Terra blockchain because it offers a significantly lower cost of payment processing, as well as final payment in 6 seconds, extremely faster than other traditional payment processors in South Korea.

For example, taxi drivers in South Korea accept CHAI cards with great pleasure, because they allow you to receive funds to your account in just a matter of seconds, unlike other cards, when paying with which you need to wait for money for several days. Made a trip, received money on the account in seconds - went to buy gasoline or withdraw money from an ATM.

Technically, it works like this: on the Terra blockchain there is a stablecoin KRT whose value is pegged to one South Korean won, when a user makes a payment for bread and milk in a store connected to the blockchain, this transaction takes place directly on the blockchain, cheaper and faster than their competitors. Thanks to these attractive conditions for the merchant, they offer cashback and discounts to customers who use this card. Today CHAI card is used by more than 5% of the population of South Korea.

Many of the users of this card do not even know that they are using the blockchain. They are not interested - they use the card because it is convenient for them.

How does all of this relate to what we discussed above about DeFi investment opportunities? The fees paid by millions of card users to CHAI in South Korea are the income of LUNA token stackers. Remember the 7% income I mentioned above? Well, part of this income is the payment for the use of the Terra blockchain by the South Koreans, which you can receive as a "shareholder" of this blockchain.

I think this is a very interesting example of how DeFi is starting to make its way into the "real world" and traditional finance: CHAI recently announced an expansion into Thailand and Indonesia and a similar blockchain-linked card has appeared in America.

Who needs decentralization?


Okay, above we briefly discussed some of the real DeFi implementations, as well as the connection between DeFi and traditional finance. In the end, I would like to talk about several reasons why, in my opinion, DeFi may be of interest to many:

 1.Self-Custody. This is both one of the pros and one of the cons of DeFi. On the one hand, no one can block your account, no one can stop the payment, and no one will ask for documents or other explanations to carry out a transaction on the blockchain. You can transfer your funds to whomever you want, when you want and in the amount you want. No one needs to ask permission to make your payment. Your funds in the box are really 100% your funds.

On the other hand, the lack of regulation means that it is possible to become a victim of scammers or hаckers and lose your funds, without any possibility of getting third-party help. There is no call center where you can call with a complaint, if your tokens were stolen, then they are gone forever.

2. Low cost. Blockchain Terra, but not only it, allows you to make almost instant payments from anywhere in the world to anywhere in the world for a very low commission. Moreover, implementations like Anchor can manage tens of billions of dollars with minimal overhead - almost all processes are automated through smart contracts.

A traditional bank would require a huge amount of physical resources and employees in order to attract a significant amount of customers and capital. In turn, the Anchor protocol attracted deposits of $5 billion (in Russia it would be a bank from the top ten) with only 7 (!) employees, most of the processes are automated on the blockchain. This allows you to extremely reduce the cost of financial services for customers.

3. Global market for services and capital. Unlike the traditional monetary business, there are absolutely no geographic restrictions in DeFi. You can start interacting with a financial service created in Korea or Canada without any restrictions. If someone in Vietnam has an interesting idea that will be implemented, they can immediately start attracting customers from all over the world.

4. Composability. Most of the monetary applications on the blockchain are open-source projects, which means that each new application can be easily integrated with existing implementations if desired, thus there are more and more complex products that teams around the world are working on. It can be compared to financial LEGO.

In addition to this, today there are more and more "bridges" between different blockchains, creating one global blockchain ecosystem from many disparate individual ecosystems that existed until recently.

Generally, it must be emphasized once again that the entire DeFi industry, despite significant growth over the past year and a half, remains a great experiment. Each of the practical implementations of DeFi carries very high risks.
The high returns available in DeFi are by no means risk-free returns, even if you use tokens whose value is pegged to traditional currencies (stablecoins). I personally will be very interested to see how this business will look like in 2-3 years. Given the very high pace of innovation and the complete absence of regulatory barriers, significant changes can be expected during this time.


Why would this "someone" provide $250 worth of LUNA token as collateral to get $100? What about paying interest on a loan? Why can't he sell/exchange half (well, a little more, together with commissions) of these tokens on the exchange to get the same $100?

Personally, I have some kind of psychological barrier in front of the crypto. It exists in some parallel universe. And I live here, I buy bread, sausage, milk, pay for bus fare... and there is a crypto: cue ball, ether, terra, some kind of moon +))) Most likely, until these worlds intersect, then for me personally the situation is will not change.


The main idea of DeFi is to create an independent and transparent financial ecosystem that is not influenced by regulators and the human factor.
Simply put, with the help of DeFi, finance becomes available to anyone: users conduct transactions and resolve financial issues directly with each other, and not through intermediaries in the face of banks, courts, brokerage organizations, etc.
Software for a decentralized ecosystem allows buyers, sellers, lenders and borrowers to interact.

The difference between centralized (CeFi) and decentralized financial systems is how their users achieve their goals. At CeFi, users rely on the people behind the business and on regulatory regulations. In the case of DeFi, users rely entirely on technology, program code and encryption algorithms.
Example of use on "Secret"
"The largest theft in the history of decentralized finance occurred on August. The Poly Network inter-network protocol was hаcked as a result of a major hаcker attack. A hаcker under the nickname Mr. White Hat managed to steal $621 million."

The DeFi boom occurred at the height of the coronavirus pandemic. Decentralized finance market grew steadily, adding several billion dollars a month.
"The idea that anyone, anywhere in the world can get access to a system within which you can make transfers and choose financial risks yourself is very powerful. This is something that has been inaccessible to many until now," Vitalik Buterin, the founder of the Ethereum cryptocurrency, said .


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