The Ultimate Guide to DeFi: Everything You Need to Know

Have you ever been charged fees for financial services like record-keeping, ATM usage, overdrafts, excessive transactions, or account closures? It can be costly to keep your money in a bank account. Following the 2008 financial crisis, many people lost faith in the traditional financial system and sought a new way to deal with money that was independent of existing financial services, government control, and middlemen. This provided the perfect environment for decentralised finance (DeFi) to disrupt the industry. In this blog, we will explore what DeFi is, DeFi and Ethereum, DeFi applications, DeFi vs traditional finance, and the challenges of DeFi.

Due to its ease of deployment, Ethereum remains a preferred choice among developers in 2024. However, it still faces high transaction fees, which have been fluctuating significantly, averaging around $15 to $45 AUD per transaction. Despite these issues, Ethereum 2.0 has been progressively rolled out, with significant milestones reached since the initial phase 0 launch in December 2020. This upgrade transitioned from Proof of Work to Proof of Stake, making the network more energy-efficient and secure. The continued enhancements from Ethereum 2.0, including the recent implementation of danksharding in early 2024, are aimed at further reducing transaction costs and improving transaction speed. These developments of course also influence ETH’s prices. 

DeFi Usage

Decentralised finance (DeFi) is a broad term encompassing various business models. As a relatively new term in the cryptocurrency world, many businesses have begun using the DeFi label to capitalise on the trend. Let’s explore some of the DeFi business models:

DeFi Lending and Borrowing through Smart Contracts

DeFi allows users to lend their assets as tokens through smart contracts, which then issue interest in the native coins. Smart contracts serve as encrypted and automated agreements between lenders and borrowers, stored in a DeFi blockchain space. By removing middlemen like banks, everyone has access to the public ledger, blockchain. For instance, in the DeFi application Compound, lenders deposit their assets, creating a pool or value locked, where borrowers can issue loans. Lenders must guarantee they have enough cryptocurrency to cover the loan from the pool. The cryptocurrency’s collateral factor determines how much a lender can borrow. For example, ETH has a collateral factor of 75% on the DeFi lending platform Compound, allowing lenders to borrow up to 75% of their supplied cryptocurrency. To mint, redeem, borrow, repay, or liquidate a borrow on Compound, cTokens are used.

Decentralised Exchanges, or DEX for short, are cryptocurrency exchanges that allow users to trade cryptocurrencies without the need for intermediaries like banks or stockbrokers. Uniswap is a notable example of a DEX DeFi application that operates on the Ethereum blockchain. Utilising the Automated Market Maker (AMM) model, Uniswap requires liquidity providers to deposit two tokens to the liquidity pool, which traders pay a fee to access. Liquidity providers receive payment according to their contributions to the pool, while Uniswap itself does not earn any profit from the traders. However, Uniswap charges a protocol fee of 0.03% that will reduce the amount received by liquidity providers but is necessary for the platform’s growth and improvement.

DeFi Staking involves holding coins in a dedicated cryptocurrency wallet or node to help secure the blockchain network. Proof of Stake chains use staking to create and validate new blocks. Validators keep coins in their wallets and are randomly selected by the protocol to create a block. The higher the amount of coins held in the wallet, the greater the chance of being chosen as the next validator. By staking, users can earn passive income. Some DeFi protocols use a lottery system to choose validators, while others have reward pools that are distributed to all stakers on a pro-rated basis.

DeFi Stablecoins refer to cryptocurrencies that are pegged to a reserve asset, such as the US dollar or gold, to minimise the volatility of their market value. Stablecoins have become increasingly popular, particularly for stablecoin loans, which are in high demand from institutional traders and cryptocurrency payment processors. USDC is one of the most famous stablecoins. Institutional traders often use stablecoins for speculative purposes, using the capital to increase their leverage on specific cryptocurrencies or to engage in arbitrage trading between different exchanges. Cryptocurrency payment processors, on the other hand, use stablecoin loans to quickly reimburse businesses within a specific time frame. 

DeFi and traditional finance differ in four main ways:

Firstly, DeFi operates on a public digital ledger known as blockchain, using smart contracts without the need for intermediaries. In contrast, traditional finance relies on centralised administration.

Secondly, DeFi has low barriers to entry, making it more accessible to anyone. In contrast, traditional finance is less open and transparent.

Thirdly, DeFi is more democratic than traditional finance as decision-making is less influenced by senior management.

Finally, DeFi’s use of blockchain technology makes it self-reconciling and generally immutable through decentralisation, leading to significant cost savings compared to traditional finance, which still relies on manual reconciliation and is generally more costly.

An Overview of Challenges and Issues in DeFi

In 2014, the People’s Bank of China (PBoC) established a group to investigate digital currencies and their potential applications. In 2017, the PBoC launched the Digital Currency Research Institute, which filed over 63 patent applications relating to blockchain and cryptocurrency that year. This suggests that the bank may seek to impose regulatory restrictions on blockchain and crypto. In March 2021, the Bank of Communications and China Construction Bank conducted digital yuan trials at two department stores in Shanghai, according to Cointelegraph. If China creates its own digital currency and suppresses other blockchain and crypto, it would cease to be decentralised and instead become a tool to support the central bank’s agenda.

I see DeFi as being like Winston Smith, the protagonist of George Orwell’s novel 1984, who fought against totalitarianism and mass surveillance. If the government uses cryptocurrency data for surveillance purposes, it could lead to less privacy for individuals than if they used traditional fiat currency.

Another issue is network security. In February 2021, the bZx protocol was hacked twice through a contract that allowed the hacker to execute a flash loan attack that cost approximately 1,200 ETH. Despite the risk of potential government abuse and lobbying by traditional financial institutions, DeFi has the potential to be a more democratic financial institution, providing financial inclusion, transparency, and security to empower individuals worldwide. Rafael Cosman, CEO and co-founder of TrustToken, has stated that “Decentralised finance is an unbundling of traditional finance. Defi takes the key elements of the work done by banks, exchanges and insurers today -like lending, borrowing and trading-and puts it in the hands of regular people.”