The advent of decentralised finance (DeFi): which use cases?
In a recent interview with CNBC, Paul Maley, the CEO of Deutsche Bank said that “it is necessary for any bank that wants to be competitive in the future to make sure that it has the ability to interact and interoperate with DeFi systems as they emerge. This will indeed happen, but the question on everyone’s mind is how and in what order. We don’t know the answer to those questions.”
While such a statement demonstrates the interest of the traditional banking industry in decentralised finance (DeFi), it also perfectly illustrates the potential for innovation that this ecosystem represents.
DeFi or open finance is considered an alternative to the traditional banking and financial system developed on open and decentralised blockchain networks (such as Ethereum, Binance Smart Chain, Terra, Solana, Avalanche, etc.). The objective of DeFi is to enable greater access to financial services traditionally offered by banking and financial institutions without a trusted third party. Since the emergence of DeFi, $87 billion of assets under management have been placed in decentralised finance protocols.
Decentralised finance protocols necessarily rely on a decentralised infrastructure. Indeed, programmable blockchain networks provide a support role for the development of these decentralised applications (DApps). Among these, Ethereum is undoubtedly the blockchain most involved in decentralised finance.
The advent of decentralised finance is based on the observation that our access to financial services depends on our social class or geographical location. Yet financial inclusion is synonymous with social inclusion. Indeed, a person who does not have access to basic financial services (right to an account and credit) risks being socially excluded. While in France, the rate of bank penetration has been estimated at 99%, in many countries (particularly in Africa and South America), people face major problems such as monetary inflation, the non-existence of basic services and the obvious lack of financial institutions. In 2017, a Global Findex Database report estimated that 1.7 billion adults worldwide currently lack access to basic financial services.
From this point of view, DeFi appears to some as a financial revolution, a new cycle that is more inclusive and built on new foundations that are, in some aspects, quite different from those of the traditional financial system.
Public and open to all. Anyone with an Internet connection and an address on a compatible blockchain (e.g. Ethereum) can access it.
Interoperable. DeFi represents an ecosystem of protocols that are intended to work together. These are not always in competition with each other: in many cases, they evolve in symbiosis and reinforce each other.
Programmable. The smart contracts on which the DeFi protocols are based can be coded by anyone and can execute themselves.
Resilient. The infrastructure of blockchain technologies, which are immutable and unforgeable, is more resilient in providing these financial services.
A stablecoin is a type of crypto-asset designed to hold a stable value in the crypto-asset and DeFi market. Although the mechanisms vary for each stablecoin, these tokens are meant to be resistant to market volatility, and therefore should not experience significant price fluctuations.
There are currently three main categories of stablecoins:
- Stablecoins backed by fiat currencies (fiat collateralized): this is the case of Tether and USD Coin, both of which are backed by the dollar. Euro-backed stablecoins are also beginning to develop.
- Crypto-collateralized stablecoins: these stablecoins have the particularity of having one or more crypto-assets such as ether as an underlying. Maker DAO’s DAI is one of the most popular crypto collateralized stablecoins. The DAI works through the CDP “Collateralized Debt Position” smart contract which allows the collateral to be locked into the contract in ether. The value of the DAI tracks the value of the dollar.
- Uncollateralised stablecoin: governed by an algorithm that encourages market participants to buy or sell in order to maintain the stability of the asset price. One of the best known algorithmic stablecoins is Anchor, issued by Terraform Labs.
Wrapped tokens allow crypto-assets such as Bitcoin to be sent to the Ethereum network so that they can be used directly in Ethereum’s DeFi system. Wrapped tokens allow their holders to earn interest on their Bitcoins (initially incompatible with the Ethereum network) by making them available on lending platforms (as collateral or in liquidity pools) for example.
Lending and borrowing services
Loan markets are one of the main use cases for decentralised finance. Decentralised lending protocols connect borrowers to lenders of crypto-assets. One popular platform, Compound, allows users to borrow crypto-assets or deposit their own crypto-assets for other users to borrow. Depositors receive interest, paid in the same crypto asset as the one deposited. Most decentralised lending protocols set their interest rates algorithmically, so if there is a higher demand to borrow a crypto asset, interest rates will be pushed higher.
Trading platforms (DEX)
At first glance, decentralised exchange platforms are similar to traditional platforms, such as Coinbase, Coinhouse, Kraken or Paymium. But while the latter are centralised, DEXs are not managed by any central entity for the most part (on the other hand, some important DEXs like Uniswap are managed by a company in parallel). These protocols allow transactions with a wide range of crypto-assets, which are mostly not listed on the centralized exchange platforms.
DEXs operate in particular on the liquidity made available by users of the protocol. Indeed, to ensure transactions without a centralising entity, the various pairs of crypto-assets are pooled in liquidity pools – fed directly by the holders of crypto-assets who wish to benefit from a fraction of the transaction fees.
To date, most of the active DEXs are deployed on the Ethereum network. The best known are Curve, Uniswap, SushiSwap and Balancer.
Derivatives are financial instruments whose value fluctuates according to changes in the rate or price or other variable of another asset called the underlying. Generally speaking, these products are used by sophisticated investors who wish to hedge against a variety of risks – currency, volatility or others.
The main categories of derivatives are :
- Futures ;
- Swaps ;
- Options ;
In recent months, the issuance of derivatives has gradually developed within blockchain technologies and the DeFi ecosystem. They generally require an oracle (i.e. a program that allows information that is not “natively” present in the smart contracts to be sent to the smart contracts) to track these variables and therefore introduce some dependencies and centralised components.
To date, the best known projects specialising in decentralised derivatives are Synthetix, UMA and dYdX.
Decentralized Exchanges aggregators allow DeFi users to trade assets at a lower cost.
These platforms allow to identify most of the decentralised exchange protocols in order to pool the level of liquidity as well as the conversion rates that these platforms offer and to provide the best comparison for users.
To date, one of the best known DEX aggregators is Paraswap.
To cover the risks related to the operation of DeFi protocols – in particular the risks related to a hacking of the smart contract, or the risk of loss of value of a stablecoin – it is possible to subscribe to decentralised “insurance policies” on the Ethereum network. In effect, users make their crypto-assets available on a liquidity pool in return for interest, and in the event of the realisation of the risk (which is by nature random), those who have subscribed to the “insurance policy” are compensated from the funds placed in the liquidity pool.
Several projects such as Unslashed or Nexus Mutual offer this type of service on the Ethereum network.
Dispute resolution platforms
Some decentralised finance protocols use smart contracts for the resolution of different types of disputes: commercial, intellectual property, decentralised governance, etc. This is a form of private arbitration to which users of a smart contract consent by choosing to use it. This is similar to a form of private arbitration to which users of a smart contract consent by choosing to use it.
Kleros is the most widely used decentralised justice protocol to date. Founded in 2017, the platform allows holders of the protocol’s native tokens ($PNK) to become anonymous jurors and participate in dispute resolution. Since its deployment on the Ethereum blockchain, the platform has resolved over 900 disputes.
Finally, there are many fully decentralised marketplaces where assets can be traded or sold on the primary and secondary market – including non-fungible tokens (NFTs) via smart contracts.
Most of these marketplaces are established on the Ethereum network and can even issue their own NFTs.
Opensea, Rarible and Super Rare are the three main decentralised NFT marketplaces deployed on Ethereum.
And a multitude of other use cases…
Finally, there are a variety of other use cases in the DeFi sector such as prediction platforms (with Augur), lossless lotteries (with PoolTogether), real estate investment platforms (with RealT), stabilisation of expected future returns from a DeFi protocol (with APWine), projects related to DeFi protocol governance (with Paladin)
Decentralised finance is tending to reshuffle the deck of the current financial system in many ways. With its inclusiveness, accessibility and decentralisation, its still developing applications provide an interesting alternative to the financial services offered by traditional financial institutions. To date, more than 90 billion assets are under management in the various decentralised finance protocols, and this number is set to grow.
Vertueuse, la DeFi exploite parfaitement les opportunités qu’offrent les réseaux blockchain qui assurent la traçabilité des transactions passées (le registre des transactions étant public), mitigent le risque de contrepartie (un utilisateur ne peut emprunter que s’il a préalablement déposé un collatéral d’un montant supérieur sur le même protocole), et résistent à la censure (les blockchains reposant sur une architecture décentralisée et étant accessible à toute personne dotée d’une connexion à Internet).