Welcome to the sixth installment of PYMNTS’ eight-part series on decentralized finance (DeFi).
Over the coming days, we’ll be looking at every part of DeFi — the biggest, hottest, most rewarding and risky part of the blockchain revolution.
At the end of it, you’ll know what DeFi is, how it works, and the risks and rewards of investing in it.
See Part 1: What is DeFi?
See Part 2: What Are the Top DeFi Platforms?
See Part 3: What Is a Smart Contract?
See Part 4: What is Yield Farming and Liquidity Mining?
See Part 5: What Is Staking?
The biggest and best-known decentralized finance projects are — no surprise — financial services. The top two being decentralized exchanges, known as DEXs, and lending/borrowing protocols. Stablecoins are a biggie as well. Marketplaces are becoming big thanks to the non-fungible token (NFT) craze, and payments, insurance and prediction markets figure in as well. Then there’s tokenized assets, which is a beast of its own.
But there are more than a few that are non-financial uses, starting with gaming. Personal digital identity credentials are another, as are metaverses, which Mark Zuckerberg just made a lot higher profile.
On the financial side, there are a couple of things to consider:
A) There are no police, and no do-overs. Code is law, as the developers like to say.
B) The actual police (well law enforcement agencies and regulators) aren’t so convinced that DeFi projects are so decentralized there’s no one to pressure.
C) So, expect know-your-customer (KYC) and anti-money-laundering (AML) requirements.
D) Smart contracts are stupid. Meaning if you screw up the design of the agreement, your funds can be lost.
E) Did we mention there are no do-overs?
See also: Sen Warren Calls DeFi the ‘Most Dangerous’ Part of Crypto at Senate Hearing
Here’s a brief look at DeFi’s 10 biggest uses:
1) Decentralized exchanges. Decentralized exchanges generally have lower fees and now the bigger ones have liquidity to rival many centralized exchanges. Many use liquidity pools (see Part 4: Yield Farming) and automatic market makers (AMMs) or use more directly P2P bid/ask mechanisms to match buyers and sellers. What they don’t have is centralized management that will do things like decide to compensate hack victims or respond to problems quickly (we’ll get into this in the next article in this series, about decentralized governance). Nor do they hold your crypto’s private keys.
2) Derivatives. Smart contracts let parties enter derivatives like futures contracts, which are capable of going beyond bitcoin and other crypto assets. Literally anything from pork bellies to securities to market indexes can be tokenized. Leverage of up to 100x on some exchanges can lead to frightening losses.
3) Lending/Borrowing. We went into this in Part 4, but a big, big use of DeFi are the decentralized lending and borrowing platforms that let crypto owners earn passive interest by lending (generally stablecoins) to people who put up crypto collateral, generally at 150% or more to account for volatility. Margin calls can wipe borrowers out by forcing the sale of assets as their prices crash.
4) Stablecoins. Most* stablecoins keep their one-to-one dollar (or euro, yen, whatever) peg by holding a one-to-one basket of cash and highly liquid assets like short term Treasury notes (* tether, the largest stablecoin by far, not so much). But others, like Maker’s Dai, use various algorithmic tools to maintain the peg, such as minting coins to increase supply and (theoretically) lower prices or buying an burning to raise prices.
Read more: Tether Must Pay $41M After Misleading Customers About Stablecoin Backing
5) Marketplaces. Much like DEXs, why pay a centralized company to play middleman, when smart contracts can easily handle listing, buying and selling things. Most notably NFTs, or non-fungible tokens, which contain digital media of some sort and prove its provenance. Say, $69 million collages or CryptoPunks.
See also: NFT Market Hits $2.5B In Six Months
6) Prediction Markets. In a way this is gambling, but there’s more to it. Participants bet on the outcome of anything from an election to whether the Federal Reserve will raise interest rates, with the odds used to predict the outcome. Basically, people tell the truth and indicate the strength of their beliefs, because they are putting their money where their mouth is. So the theory goes.
7) Gaming. Axie Infinity is a DeFi game that uses NFTs, and allows participants to play-to-earn by farming goods that players will buy for real cryptocurrency. Sales and resales of its NFTs has reached $3.7 billion. Complex and immersive MMORPG games can be built on DeFi, and managed by community consensus rather than a developer.
8) Metaverses. Thanks to Mark Zuckerberg, everyone is interested in metaverses. The 3D, VR “worlds” allow people to create and personalize avatars that can interact with others or with things — buy property, build a game people can play, advertise a product on a digital billboard, set up shop in a marketplace. Nike bought a company that makes fashion items for metaverse avatars, and plenty of corporations are getting interested, from Coca Cola to Gucci. You can even sell real-world items from a metaverse store.
9) Payments. Peer-to-peer payments DApps like Flexa and Tornado Cash, have planted flag in payments. Jack Dorsey’s Square, however, is coming for them. P2P payments are really the foundation not just of DeFi, but of blockchain itself. Line one of the Bitcoin Whitepaper: “A purely peer-to-peer version of electronic cash would allow online payments to be sent directly from one party to another without going through a financial institution.”
Read more: Flexa Payment Network Adds Shiba Inu Option
See also: Square Eyes Open Developer Platform For Crypto Products
10) Insurance. While the traditional insurance industry can do a great deal with smart contracts, DeFi insurance projects like Nexus Mutual creates shared risk pools that offer insurance for things like losses from a smart contract bug. Which is more or less exactly the way Lloyds of London works.
Next up: How Is DeFi Governed?
How do you govern something that by its very nature doesn’t have any central control? Well, democratically, by voting. DeFi projects are either governed by a decentralized autonomous organization, best known as a DAO, or are centralized chains under development that are aiming to become DAOs. There are some big benefits of this — notably that it works — but some very big drawbacks, including giving big coinholders — whales — outsize influence. Another is speed: Your DeFi lending platform was just hacked thanks to a bug, a fix is ready, but the voting process that will let you install it takes a week.