What is Decentralized Finance (DeFi)?
Blockchain technology has enabled permissionless networks that can be used by anyone, where built-in economic incentives ensure that network services can be maintained indefinitely without the aid of any individual company or central authority. Similar to how Internet protocols enabled a Cambrian explosion of network applications and services that are still expanding to this day, blockchain networks are enabling a growing number of existing services to be provided in a more decentralized way, without reliance on central authorities or intermediaries. One market segment that is experiencing rapid innovation as a result of blockchain is the financial services industry. Blockchain-based alternatives to traditional financial services have come to be called decentralized finance, or DeFi.
What is DeFi?
The advent of public blockchain networks like Ethereum have enabled peer-to-peer transactions of value to be executed programmatically based on a set of conditions through “smart contracts”, which are simply pieces of code that are deployed and executed on the blockchain. Applications built with smart contracts are colloquially called decentralized applications, or ‘dapps’ for short, and have been a major catalyst for the increasing exploration of cryptocurrency, or digital currency, for its use in industry. In practice, DeFi services are dapps that leverage the power of smart contracts and the decentralized nature of public blockchains in order to provide globally accessible financial services such as:
- Lending & Borrowing
- Spot Trading
- Asset Exchange & Swap
- Savings & Yield Products
- Stablecoins (Fiat-pegged cryptocurrencies)
- Prediction Markets
How does DeFi differ from traditional financial services?
Rather than relying on an institution and its employees to first approve someone to use their service and subsequently validate their transactions, smart contract(s) on a blockchain can be used to facilitate those responsibilities in a decentralized manner. This represents a shift in the fundamental trust model for financial services from trust in an institution to trust in code that is executed on a blockchain network that is secured by economic incentive amongst decentralized participants. These open, decentralized finance applications provide a globally accessible and transparent foundation on which to innovate in the realm of financial services. In general, most DeFi applications follow a set of common characteristics:The advent of public blockchain networks like Ethereum have enabled peer-to-peer transactions of value to be executed programmatically based on a set of conditions through “smart contracts”, which are simply pieces of code that are deployed and executed on the blockchain. Applications built with smart contracts are colloquially called decentralized applications, or ‘dapps’ for short, and have been a major catalyst for the increasing exploration of cryptocurrency, or digital currency, for its use in industry. In practice, DeFi services are dapps that leverage the power of smart contracts and the decentralized nature of public blockchains in order to provide globally accessible financial services such as:
General characteristics of DeFi applications
Rather than centralized institutions, code acts as the only intermediary in the process. Changes to that code are most often made democratically by way of community governance voting.
Open & permissionless
Access is open and borderless; whether you want to create their own DeFi application or simply utlize an existing one, your ticket to entry is an internet-connected device.
The code that controls the operation of the service is transparent to everyone on the blockchain, which enables users to verify and/or audit the service at will.
Incentive models reward the user for participating in the service (e.g. providing liquidity for lending), and users can choose whether they access the service through their own custom interface or a publicly hosted one.
DeFi services are natively interoperable with one another due to the shared blockchain network on which they reside; cross-blockchain interoperability networks will further reinforce this phenomenon as they are adopted.
With broad interoperability, a variety of unique DeFi protocols and services can be used in tandem to enhance the experience or as building blocks to compose net-new applications that offer more value to users.
While at face-value the core characteristics of DeFi may appear utopian, the development and adoption of such services have already begun to accelerate. In a short period of time, the explosive growth of DeFi resulted in over tens of billions of dollars worth of digital assets locked in various on-chain services ranging from lending, exchange liquidity pools, savings yield accounts, and more. As an example, DeFi applications like Uniswap and SushiSwap have revolutionized the way cryptocurrencies are exchanged; both are decentralized exchanges that allow users around the world to swap and exchange a wide variety of digital assets, such ERC20 tokens, an Ethereum token standard for fungible tokens, in the Ethereum ecosystem. Even at first glance, the aforementioned core tenets of DeFi are evident in both projects. Anyone can audit the smart contract code that runs the aforementioned decentralized exchanges (DEX’s), anyone with an internet connected device can use the service, and both incentivize users to provide liquidity to trading pairs by giving them a share of trading fees accrued during operations. On the back of services like these, the programmability of blockchain networks like Ethereum is driving continued innovation in the cryptocurrency / digital assets industry.
DeFi could help reduce the global gap in financial inclusion
While much of the attention and investment in decentralized technologies today is driven by speculation, the underlying value and impact of these technologies are critically important. For example, in many parts of the world, fundamental financial services are either inaccessible or inadequate due to a myriad of challenges such as i) economic underdevelopment, ii) poor infrastructure, iii) regulatory challenges, etc. For perspective, from the global research conducted by the World Bank and Gallup on financial inclusion around the world, studies in 2017 showed that ~1.7 billion adults aged 15+ did not have access to simple bank account services1. Even in well developed economies, both the access to and quality of financial services one has access to is dependent on one’s socioeconomic class. For example, according to a 2019 survey by the FDIC, 22% of the United States are classified as unbanked or underbanked, with large swaths of that population being those with lower income or less education. With this distinct challenge as a backdrop, it is evident that the development and adoption of open, borderless financial services can help bridge the widening gap in financial inclusion and opportunity around the world.
How to get involved in the DeFi ecosystem
Whether by providing savings and lending opportunities to unbanked or underbanked persons around the world, enabling global communities to access a wider variety of asset classes, or offering reliable alternative ways to hold and earn interest on savings, DeFi is evolving at a rapid clip that echoes cycles of growth and subsequent consolidation in the history of technology. With user growth and demand consistently increasing across diverse user groups, virtually every public blockchain network is prioritizing DeFi as a use case by providing tools, features and grants for developers to create the next big DeFi project. Today, the majority of DeFi services and products are being developed and actively utilized on Ethereum, and that trend is likely to continue. AWS supports open-source, public Ethereum networks in its Amazon Managed Blockchain offering, which reduces the overhead required to create and manage full nodes for the public Ethereum mainnet as well as the Ropsten and Rinkeby testnets. Learn more about Ethereum on Amazon Managed Blockchain.
Aave is an Ethereum-based DeFi protocol that offers a variety of decentralized lending services that give users the ability to lend, borrow, and earn interest on a variety of digital assets or cryptocurrencies. Similar to lending transactions in traditional financial services, Aave borrowers must post collateral or have collateral delegated to them in order to take out a loan in cryptocurrency. However, rather than a bank operating as a intermediary in this transaction, smart contract logic handles the execution of the loan. Furthermore, any holder of a cryptocurrency supported on Aave’s platform can become a lender by depositing their cryptocurrency into liquidity pools from which borrowers will subsequently take loans. In return for their provided liquidity, lenders earn a percentage yield on their deposited cryptocurrency. With these two core user personas, the Aave ecosystem achieves an alignment of incentives that makes lending without an intermediary possible. Lenders are rewarded for depositing funds to liquidity pools from which collateralized loans are taken by borrowers.
While this liquidity pool lending environment is innovative in its own right, Aave offers another powerful lending service called a ‘flash loan’. Flash loans allow borrowers to take loans of virtually unlimited size with no collateral as long as they pay back the loan within the average 13 second consensus cycle on the Ethereum blockchain where blocks of transactions are immutably written to the blockchain. If the borrower cannot pay back the loan in that period, the loan is considered null, however, if the borrower does pay back the loan they are assessed a sub-.1% fee for the transaction. Effectively, this rapid form of loan eliminates risk for both the lender and borrower by invalidating the loan transaction if it cannot be paid back in one transaction cycle. Because of this, flash loans are often used in rapid arbitrage trades or swaps for profit, as they give borrowers virtually unlimited capital to leverage.
Similar to Aave, Compound Finance offers users the ability to lend and/or borrow cryptocurrency in a matter of minutes. Borrowers and lenders do not have negotiate terms with one another on the platform, the smart contracts that make up the algorithmic money market protocol behind Compound handle that process for the user to determine collateral requirements and interest rates. When a user deposits cryptocurrency into Compound, the user is given cTokens in return equivalent to the value deposited. For example, if one deposits 1 Ether (ETH) into Compound, they get 1 cETH in return. This cToken entitles the user to the interest earned in the lending market for that deposited asset, which means a holder of cETH will be able to exchange that cETH for more Ether (ETH) than they deposited initially for lending as interest accrues. The value of the cToken representation of the deposited asset is the mechanism of accounting for yield on lending for cryptocurrencies on the platform. Of course, where there are lenders there must be borrowers, and on Compound a borrower must deposit assets as collateral to build up “borrowing power” which entitles the borrower to borrow a certain amount of assets from liquidity pools funded by lenders for a rate of interest.
In the very beginning stages of DeFi adoption, one of the critical ingredients of success was the prevalence of cryptocurrencies pegged to the US Dollar’s value, dubbed stablecoins.
Among the most popular examples of USD-pegged stablecoins is Dai, which is managed by Maker and its decentralized governance community MakerDAO. The Dai stablecoin is pegged to the US dollar’s value by way of collateral deposits by users to generate supply of Dai; more specifically, when a user deposits Ether as collateral into a Maker Vault in order to generate Dai they can use in other DeFi protocols or decentralized applications. The current implementation of Dai is a multi-collateral asset, meaning Maker Vaults can be created for a variety of different cryptocurrencies in order to generate Dai. In this regard, Dai is backed by a variety of cryptocurrency assets as collateral, which in tandem with stability fees and other economic levers is used to stabilize its value and remove the need to rely on algorithmic methods for balancing supply and demand like other stablecoins do.
The promise of Dai is an open, stable, and collateral-backed currency that users can utilize to spend, earn yield on savings, or unlock new opportunities in DeFi. This harkens back to the idea of composability of protocols in DeFi; Dai as a multi-collateral stablecoin is used in a variety of DeFi services as collateral, payment, liquidity and more. For example, Dai is a popular asset within the aforementioned Aave platform, where those who deposit their Dai into the liquidity pool can earn yields of up to 14.2% at the time of publishing. Dai is also often used during the execution of Flash Loans, where it can be used as collateral, liquidity, or part of a trading pair to execute complex arbitrage trades across the wider DeFi ecosystem on Ethereum. This is a clear example of composability; one protocol’s core service or cryptocurrency can be used as a critical component in the implementation of many other unique DeFi protocols.
Another example of a stablecoin that has garnered significant adoption is USDC, which is short for US Dollar Coin. USDC is unique in that it is a regulated, cross-blockchain stablecoin that is ubiquitous across a wide breadth of DeFi applications. The stablecoin was created in a joint effort by Coinbase, a renowned cryptocurrency exchange, and Circle, a crypto payments and infrastructure company. Like other stablecoins, USDC’s value is pegged 1:1 with the US dollar,and offers the frictionless digital exchangeability of cryptocurrency. The regulatory compliant design of USDC is what sets it apart from other stablecoins, as the parent company behind USDC is regulated by the government’s Financial Crimes Enforcement Network (FinCEN) and is a licensed Money Service Business in the United States. Furthermore, the issuance of USDC is backed in full by reserve assets to ensure the 1:1 valuation with the US Dollar, giving users confidence in the value of the stablecoin. Furthermore, USDC is available across multiple rich blockchain ecosystems, making it a composable tool for a wide breadth of applications on the Ethereum, Solana, and Algorand networks.