Explore the different components of the DeFi ecosystem
As discussed in our previous article covering the workings of the decentralized finance sector there are many benefits and advantages for potential users.
The various products and services involved in the DeFi ecosystem are sometimes collectively referred to as ‘open finance’. This term broadly relates to the number of layers within an ecosystem where blockchains, digital assets, and open protocols are integrated with traditional financial structures.
One of the most important areas of the DeFi sector right now are the dapps running on the Ethereum blockchain. As the first blockchain to prioritize smart contracts and the deployment of dapps activity in the DeFi and DEX categories is mostly focussed there.
Recently though, other protocols such as TRON, WAX, and EOS have started to build their own respective decentralized finance ecosystems. A quick glance at the DeFi top ten reveals Ethereum’s dominance in the category.
It is not an understatement to say that the number of layers contained within the space can appear very overwhelming. The image below does a great visual job of showing the true size and scale of the Ethereum DeFi ecosystem.
As you can see, although young the ecosystem is already bulging. Let’s look at some of the most important components that make up the decentralized finance space.
Exchanges & Marketplaces
Another extremely important area of the DeFi ecosystem are Exchanges and Marketplaces. Unlike centralized exchanges such as Coinbase, decentralized exchanges allow peer-to-peer transactions of digital assets between two parties on the blockchain with no third-parties involved.
The advantage of this approach is that there are no sign-ups, no identity verification, no middlemen taking a commission and no withdrawal fees. Over the last few years, a couple of decentralized exchanges (DEXs) have been created. It is also important to note that whilst DEXs look to change the way the system works they still draw on methods and practices used in the traditional finance world.
Recently, exchanges have witnessed a surge in activity due to the yield farming craze. Users looked to trade tokens such as ETH into stable coins such as USDC and then invest that USDC and start earning a healthy % return. These topics have been covered extensively on our blog and we would suggest you continue here and then go further into exploring yield farming.
Arguably the Uniswap protocol has become the go-to location for token swaps and has recently released a more user-focused and friendly version 2.
Though many DEXs claims to be decentralized and non-custodial, that may not be the case. So it’s always better to look into each protocol before using them. IDEX is one of the most popular DEXs and runs on the Ethereum blockchain. Other DEXs include Kyber Network and 0x.
Other types of open marketplaces focus on offering users a place to exchange non-fungible tokens (NFTs). These tokens are can also be referred to as crypto-collectibles. OpenSea and Rarebit are two such platforms that help with the discovery, buying, or selling of such crypto-assets.
The marketplace category has been expanding in 2020 as more and more people look to own digital assets rather than physical. The rise of dapps such as Niftex which not only offer NFT trading but also offer the opportunity to shard the NFT into smaller pieces for redistribution and sale are causing quite a stir in the sector.
Whilst Ethereum is clearly the home of DeFi and exchange products. Other, perhaps lesser-known chains are fast becoming the home of collectibles on the blockchain. Following two successful Garbage Pail Kids digital card sales – and Blockchain Heroes due on 8 August – the WAX blockchain is also quickly becoming a go-to location for collectibles.
What’s interesting about this momentum isn’t the initial success of the releases. Instead, what’s been more significant is how the entire marketplace ecosystem on WAX is evolving. The Blockchain Heroes set due out on 8 August is a collection from the Bad Crypto Podcast team that’s already building a strong audience. Other planned releases include Street Fighter collectibles and memorabilia from William Shatner.
There are other marketplaces like District0X which let you create your own marketplaces and vote on governance procedures. It is clear from recent activity that Ethereum-based P2P marketplaces have outstanding long-term potential.
Open Lending platforms
Open lending protocols are digital money lending platforms built on the blockchain and have become the most popular among other open finance sectors. This can be in part attribute to the introduction and extensive use of MakereDao’s Dai. Other peer-to-peer protocols such as Dharma and Compound Finance have also become very popular over the last 12 months.
Just like when using a traditional bank, users deposit their money, and when another customer borrows the digital assets they earn interest. However, instead of intermediaries, here the smart contracts dictate the loan terms, connect lenders and borrowers, and are in charge of distributing the interest. Due to the inherent transparency of the blockchain and no middleman, the lender earns higher returns and can clearly understand the risks.
The success of an open lending protocol means it must be based on a public blockchain like Ethereum and thanks to its capability to lend digital assets it is feasible that open lending protocols can be widely adopted. They offer several advantages over the traditional lending/crediting services:
- Integration with digital asset lending or borrowing
- Collateralization of digital assets in case of defaulting on the loan
- Instantaneous settlement of transactions and new secured lending methods
- Standardization and interoperability which can reduce costs through automation
- No credit checks, meaning access to people that previously had no access
In the sector’s infancy, MakerDAO was perhaps the most important component here and has become the most prevalent decentralized lending protocol.
Although in 2020 MakerDao has certainly been rocked by competitors and new offers as other protocols such as Dharma, JUST, Aave and Curve have entered the space.
One of the major concerns in the early days of cryptocurrencies was their volatile value. In order to remedy this situation and provide the foundations of the DeFi ecosystem Stablecoins were introduced.
Stablecoins are blockchain-issued tokens designed to hold on to a specific value. Usually, this is achieved by pegging the stable coin with fiat currencies like the US dollar. Other assets such as gold can also provide the same stability. Stablecoins incorporate collateral to accommodate for the price variation.
Stablecoins can be primarily categorized into 3 types: Fiat-Collateralized, Non-Collateralized, and Crypto-collateralized. Let’s explore each of these.
These coins store value in fiat currencies like the US dollar or British Pound and are usually supposed to be redeemable at a 1:1 ratio with the pegged currency. These types of stablecoins are the most popular as they are regulatory-compliant. Furthermore, audited coins have a great opportunity to reach mass adoption since active measures are taken to maintain the peg. A fiat currency reserve is kept in a bank to back the current circulating supply of the token. Some examples of these stable coins are Tether, Gemini Dollars, and USDC.
However, this makes it centralized, thus creating a risk. These stablecoins need trust in a centralized entity and are therefore vulnerable to loss of peg and destabilization from external geopolitical factors. Whilst it is true that the prices rarely fluctuate wildly, anything can happen.
It is important to understand that the protocols and organizations creating these stablecoins get their revenue from the interest earned on the deposited funds (in fiat) from users and that they store that in a bank account.
These types of stablecoins are neither centralized nor over-collateralized with crypto assets. Based on an algorithm, the system supplies more tokens with increased demand while the price of each token is lowered and vice versa in order to maintain a stable peg.
The risk here is that it is difficult to maintain stability while constantly contracting the money supply. Also, it requires that participants believe that the demand will increase in the future. In case demand stops growing, the stablecoin will not be able to maintain its peg.
These decentralized stablecoins are backed by crypto assets as collateral. They rely on trustless issuance and maintain a 1:1 peg against assets through various methods including over-collateralization and incentives.
The trustless issuance makes this type of coin wholly transparent and the reserve auditable. Maker’s Dai is one such stablecoin. In essence, the underlying asset Ethereum is over-collateralized against the loaned Dai based on the current collateralization ratio.
For example, the DAI stablecoin is pegged to USD and backed by ETH. For every DAI, there is $1.50 worth of ETH coins locked into the MakerDAO smart contract as collateral.
The collateral is held in a smart contract which is accessible only when stablecoin debt is cleared. If excess collateral falls below a certain predetermined level, the stablecoin system can close the smart contract and sell the collateral.
The volatility of the underlying cryptocurrency collateral is the biggest disadvantage of this operating model. If the collateral losses too much value, the system becomes under-collateralized and recovery procedures like stablecoin liquidation could be enabled.
One of the latest innovations in the cryptocurrency ecosystem and something expected to launch the entry of institutional capital into the industry are custodial solutions. Furthermore, these solutions are vital to the success of the DeFi ecosystem.
Cryptocurrency custody solutions are independent storage and security systems used to hold large quantities of tokens and are obviously a vital component of the ecosystem.
Simply stated, cryptocurrency custody solutions are third party providers of storage and security services for cryptocurrencies. Their services are mainly aimed at institutional investors, such as hedge funds, who hold large amounts of bitcoin or other cryptocurrencies. The main function of cryptocurrency custody solutions is to safeguard cryptocurrency assets.
Private keys, which are used to conduct transactions or access crypto holdings, are a complex combination of alphanumerics that are extremely difficult to remember and can be stolen or hacked. Online wallets and exchanges are two potential solutions but they have also proven susceptible to hacks.
The other main reason for the need of cryptocurrency custody solutions is regulation. According to SEC regulation institutional investors that have customer assets worth more $150,000 are required to store the holdings with a “qualified custodian.”
One big player in the cryptocurrency custody space is the popular digital currency exchange Coinbase. Coinbase entered the institutional-grade custody solutions area relatively quickly by buying up companies like the registered broker California Keystone Capital. In August of 2019, Coinbase acquired the institutional business of storage provider Xapo as well.
It can be argued that Coinbase is the most widely recognized and used custodial service as a by-product of attracting so many retail users since its launch in 2012.
As stated previously it is worth considering that the entire DeFi space is currently operating at Beta level. As with any high return product, there is always some risk involved.
Securely handling cryptocurrencies and finance tools require specialized knowledge, so of course, there’s a risk factor involved. It’s the user’s responsibility to keep their private key and holdings secret, use a hardware wallet and multi-factor authentication.
One such case to highlight would be the infamous digital decentralized autonomous (DAO) hack that occurred in June 2016. A hacker managed to transfer one-third of DAO funds to another account by exploiting a vulnerability in its coding. This activity left the Ethereum community with no choice but to hard-fork the blockchain to restore the funds.
Dapp and Smart contract security has since become much tighter in recent years but it would be highly irresponsible to think it was bulletproof.
As a user, you must keep yourself constantly updated and aware of the changing terms of services between various DeFi ecosystem products, wallets, exchanges, and crypto projects. Some DeFi products can suddenly add new dimensions that are paired with DAOs that govern the protocol or platform.
As with traditional currency analysis, investors usually use historical data and benchmarks such as annual inflation of a currency and the risk-free rate of return to evaluate investment opportunities. But in the case of DeFi, the lack of extensive historical data and benchmarks makes it hard to assess the risk of investments in DeFi.
To mitigate these risks, tokens like Compound Dai (cDai) have been introduced. cDai automatically gains variable interest using the compound lending protocol. This will allow users to invest in DeFi products relatively risk-free.
Comparing to the traditional finance markets the DeFi ecosystem represents a drop in the ocean. But, notable is the speed at which it has developed and gathered pace.
With more and more projects arriving into the DeFi ecosystem, we expect to see the decentralized financial future arrive quite quickly and see a reality where the traditional finance market is interoperating with digital assets and blockchain.