One of the fastest growing sectors in the crypto industry – and often dubbed the future of finance – DeFi is definitely a word to know if you are interested in blockchain and cryptocurrencies.

Fundamentals

The term DeFi stands for ‘decentralized finance’ and is usually used to describe the cluster of applications and companies offering financial services based on decentralized blockchain technology. It is also sometimes referred to as ‘open finance.’

The concept of decentralization stands in contrast with the traditional financial services that are generally centralized, i.e. controlled by a single entity such as a central bank, or a financial institution. DeFi is expected to address many of the common drawbacks of centralization as single points of failure and control, monopolizing power and bureaucratic blockage.

Decentralization of financial services can be achieved through smart contracts where rules are embedded in a computer code and enforced automatically, and all the data about transactions is stored in a distributed ledger. This way, no actor has complete control over transactions, thus preventing censorship or corruption.

For example, when a traditional bank lends money to customers, it has full decision power on who, how much and on what conditions must be met in order to receive a loan. In a decentralized network, anyone with a smartphone and internet access can potentially get a loan based on the rules embedded in a smart contract. The conditions are made transparent and available for everyone to review. This way, according to the proponents of DeFi, financial services become more accessible and inclusive.

Some of the main services offered by DeFi companies include stablecoin issuance, lending/borrowing, trading, peer-to-peer payments, insurance, among others. The users can get access to these services through decentralized applications (DApps), the majority of which are currently built on Ethereum.

State of affairs

The DeFi is a newly born and rapidly growing sector, which makes it difficult to access reliable data for the market analysis. There are several metrics used to estimate the size and dynamics of the DeFi market. One is the total value locked (TVL) which shows how much assets are locked in the sector, in USD or ETH. According to DeFiPulse, at the time of writing the TVL is estimated at $5.2B, with the value showing exponential growth during the recent months. Just a year ago, the TVL was under $500M.

The market capitalization of the DeFi coins at the time of writing is estimated at $9.1B. The biggest projects by market cap currently are MakerDAO (the decentralized protocol issuing the USD-pegged stablecoin DAI) and Compound (a money market protocol for lending and borrowing). The market cap growth in the recent months has been dramatic, crossing the threshold of $2B in the beginning of June 2020, and $1B just a few weeks earlier.

However, since TVL may be skewed to the upside due to the use of leverage within the system (such as in many yield farming strategies), the total number of users can be a better metric for DeFi adoption. According to Dune Analytics, the number of DeFi users in August 2020 is following an exponential trend and has surpassed 250 000, which is a five-fold increase compared to a year ago.

Lending/borrowing represents a big share of the DeFi market to date. Companies like Compound offer crypto owners the opportunity to borrow money with crypto assets as collateral, or to lend their crypto assets to other network users to earn interest. Most platforms automatically match lenders and borrowers, and the interest rates are adjusted based on supply and demand.

Another significant area of the DeFi is so-called ‘stablecoins’. Stablecoins, like DAI or USD Coin, are cryptocurrencies backed by a set reserve asset which is designed to reduce their price volatility. Stablecoins can be pegged to a fiat currency, or a commodity price, or be managed algorithmically. The general purpose of stablecoins is to provide users with a more stable asset, similar to a fiat currency.

Outlook

DeFi is without doubt an extremely hot topic in the crypto industry and it has been one of the fastest growing sectors over the past year. The exponential growth and the general buzz around DeFi have attracted many new crypto investors and developers to the space and has piqued interest of traditional financial players. However, the road to mainstream adoption is still long. The future prospects of the DeFi will depend on the creation of actual value for its users, and if the space can keep its promises of accessible and open services.

At the time of writing, DeFi offers very competitive returns compared to traditional financial markets, and other crypto opportunities. For example, the lending interest rates are much higher than most traditional banks’ saving rates. Within the crypto industry, the competing opportunities come from staking, which also allows crypto users to earn regular rewards.

At the same time, the DeFi industry is still very novel and investing in it bears corresponding risks. Stiff competition in the DeFi sector may push the developers to offer new services and more user-friendly products, reduce the transaction fees (e.g. through second layer solutions), and improve security.

Is DeFi the future of finance? While many crypto enthusiasts are convinced it is, it will ultimately depend on the value that it adds (such as lower costs, faster settlement, and innovations such as flash loans) as well as overall crypto adoption by people around the globe.