Decentralized finance, or DeFi, is one of the most important topics in cryptocurrency. The aim of DeFi is to create an entirely new financial system, completely independent of the traditional financial (TradFi) economy. There are billions of dollars being invested into this goal, along with the efforts of thousands of developers around the world.
This is part one of our series on DeFi. The aim of this series is to provide a deep dive for financial advisors to further our understanding of this space and create a bridge that we can use efficiently to merge the TradFi world we work in with the new and innovative DeFi space that is being created.
The origins of Ethereum and the DeFi ecosystem
In 2013, programmer Vitalik Buterin co-created Ethereum as an additional cryptocurrency project after his work on Bitcoin. Ethereum is different from Bitcoin because it’s designed to be a blockchain with multiple different functions: to be a digital money, to be used for global payments and to have blockchain applications run on top of its code. There’s currently an entire digital economy running on top of Ethereum, one of which is the DeFi ecosystem.
DeFi is a crypto movement that is built on cryptocurrencies like ether, open to anyone in the world (with an internet connection). DeFi is a trustless application, meaning the applications are not controlled or hosted by a central party such as a bank or a government. The aspects of cryptocurrency such as cryptography, smart contracts and blockchain technology allow this system of decentralized finance to exist for the global community to utilize.
Ethereum utilizes a robust smart contract programming language called Solidity, which allows for all of the necessary logic that financial contracts require to be included in the application code. Many other cryptocurrencies now compete with Ethereum to run DeFi applications, such as Avalanche, Terra, Fantom and others, but it is important to note that Ethereum is the largest network and was the first project that was used to create DeFi.
Lending and borrowing in the DeFi ecosystem
Lending and borrowing platforms have become a tremendous part of the DeFi ecosystem. Users are able to lock crypto positions into a smart contract and borrow against their position. Other users are able to lock crypto positions into a smart contract and generate yield by allowing their coins to be lent out to borrowers.
An interesting thing to note is the yields generated by lenders in the DeFi ecosystem are substantially higher than the traditional financial system. Running a smart contract is much more cost-effective than running a traditional bank; therefore, nearly all of the yield generated from lending money is passed directly back to the lender via the smart contract. Many people place their trust in these transparent smart contracts and are able to generate a significant income from their utilization.
Aave and flash loans
Another large lending and borrowing platform in the DeFi ecosystem is Aave. Similarly to Compound, Aave is a decentralized, open-source, non-custodial protocol running on Ethereum. Its native cryptocurrency is AAVE. There is currently $11.8 billion locked in Aave smart contracts. Aave allows users to lend or borrow crypto assets. Lenders are able to earn a yield on their assets that are supplied to the protocol. Like Compound, the earned yield adjusts depending on supply and demand of the market.
Aave also offers a unique service called “flash loans.” Flash loans are “one block borrow transactions,” which are transactions in which a user borrows and repays a loan in the same block. The smart contract only allows the loan to occur if the borrow and repayment of the loan occurs in the same block (transaction). This technology is a new feature that is used in arbitrage and quick trading. This type of loan does not exist in traditional finance and is seen as a major improvement to the TradFi system.
The creation of smart contracts, stablecoins and lending and borrowing platforms, led to another important creation in DeFi: decentralized exchanges (DEX), another incredibly important component of decentralized finance. DEXs saw over $1 trillion in trading volume in 2021. In my next article in this series, we will go through the creation of DEXs, their value to the crypto economy, how they interact with lending and borrowing platforms, and how users benefit from their existence.
Why DeFi is so important
The goal of DeFi is to create an open financial market that is trustless and permissionless. Significant development and investment has been placed into the advancement of DeFi, and as financial advisors, it’s important to understand this space. Much of the technology in the DeFi space builds upon, and improves, the TradFi system, possibly resulting in a better outcome for users – you and your clients. As the space continues to evolve and strengthen, it’s vitally important to have an understanding of decentralized finance and to be prepared to interact with, and rely upon, these applications.