The crypto markets have survived some of the roughest economic conditions in a generation, with a global pandemic and record inflation crammed into three years. However, while 2021 saw new all-time highs for cryptocurrencies, as of June 2022, Bitcoin and the broader cryptocurrency market have been hammered.
As a result, despite the growing adoption surrounding decentralized finance (DeFi), current market conditions and a lousy overall performance in 2021 are causing people to question if DeFi is dead. The following article will explore the health of the DeFi sector and see what’s in store next for this new financial movement.
What Is DeFi?
DeFi is short for decentralized finance, an umbrella term for a variety of financial applications in blockchain positioned to disrupt financial intermediaries.
In today’s financial world, financial institutions act as guarantors of transactions. This setup gives these institutions immense power because your money flows through them. The purpose of DeFi is to remove the control banks and institutions have over society’s money, financial services and financial products and make financial services more accessible regardless of who or where people are. DeFi has the potential to create more free, open and fair financial markets that are accessible to anyone with an internet connection.
How Does DeFi Work?
DeFi uses cryptocurrencies and smart contracts (programs stored on a blockchain that run when predetermined conditions are met) to provide services that don’t need intermediaries. These smart contracts are programmed to perform various functions in a permissionless manner. Transactions are executed after specific conditions are met, making these transactions easy to use and more efficient but also more susceptible to errors that can’t be fixed.
Users from anywhere in the world with an internet connection can lend, borrow and trade using peer-to-peer networks that verify and record financial actions in distributed financial databases. A distributed database is accessible across multiple locations, collecting and aggregating data from all users and using a consensus mechanism to verify it.
Use Cases for DeFi
- Obtaining a loan: Get a loan instantly without filling in paperwork, including extremely short-term flash loans that traditional institutions can’t provide.
- Trading: Make peer-to-peer trades on certain crypto assets, eliminating the need for any kind of brokerage.
- Lending: Lend out your crypto and earn interest and rewards every minute, not just once a month.
- Saving: Put some of your crypto into savings accounts alternatives to earn superior interest rates to that which you’d typically get from a centralized bank.
- Buying derivatives: Make long or short bets on crypto assets.
- Stablecoins: Buy stablecoins that peg cryptocurrencies to an supposedly stable underlying asset such as the U.S. dollar, potentially providing a safe haven from the inherently volatile cryptocurrency market.
DeFi Performance in 2021
- Despite sound fundamentals, DeFi blue chips underperformed Ethereum by over 110%.
- The DeFi Pulse Index, a benchmark tracking the performance of 18 DeFi blue chips, retraced over 55% from the all-time high it made in 2021.
- No blue-chip protocols outperformed Ethereum in 2021.
Best DeFi Crypto Projects
The DeFi sector of the global cryptocurrency market has thousands of coins. To allow you to navigate this vast space easily, a few of the best DeFi projects have been listed below:
Chainlink connects blockchains with the real world through a decentralized oracle service that can provide external data to smart contracts on Ethereum. By nature, blockchains don’t have an effective way to access external data – it’s difficult to connect off-chain data with on-chain data when using smart contracts. As a result, Chainlink plays an important role in enabling the majority of DeFi to leverage external data and operate correctly.
An oracle is a piece of software that translates external data to a language that smart contracts can comprehend (and vice versa). The services Chainlink currently provides include price feeds, which are used by DeFi projects to secure billions in value; APIs to connect blockchains to off-chain resources (such as weather data for insurance); and smart contracts to perform audits verifying proof of reserves for stablecoins.
LINK (the native token of the Chainlink network) is an ERC-20 token and is used to pay for the oracle service on the network.
In mid-2021, the whitepaper for Chainlink 2.0 was launched, which delineates how Chainlink is positioned to capture the growing demand for decentralized oracles. Chainlink 2.0 will increase the services available to projects and allow stakeholders to build more advanced smart contracts that will enable DeFi to grow.
Uniswap is a DEX protocol built on Ethereum. To be more precise, it is an automated liquidity protocol. No order book or centralized entity is needed to make trades. Instead, Uniswap enables users to buy and sell cryptocurrencies among themselves in a trustless, highly decentralized and censorship-resistant manner.
This goal is achieved through the use of a collection of liquidity pools. Liquidity providers contribute to Uniswap pools by locking assets into a smart contract, For example, Uniswap’s DAI/ETH liquidity pool consists of equal values of DAI and ETH deposits.
In exchange for maintaining liquidity, providers are rewarded with a portion of the trading fees, along with newly minted UNI cryptocurrency. Liquidity is essential to Uniswap’s operations, as users sell and buy cryptocurrencies from the liquidity, swapping out one token for another.
UNI is the native token of the Uniswap protocol, and it entitles holders to governance rights, which means that UNI holders can vote on changes or propose changes to the protocol.
The technology behind Uniswap has seen multiple iterations so far. The most recent update for the protocol was Uniswap v3. One of the most significant changes with Uniswap v3 is related to capital efficiency.
Like most automated market makers (AMMs), Uniswap was capital inefficient in the sense that most of the funds sitting in liquidity pools are not being used at a given moment. To combat this, liquidity providers can now set custom price ranges for which they want to provide liquidity. This change should lead to more concentrated liquidity in the price range that most trading activity happens.
Aave is an Ethereum-based money market where users can lend and borrow a variety of digital assets, from stablecoins to altcoins. The Aave protocol is governed by AAVE (the native governance token of the Aave protocol) holders.
To be more precise, Aave is an algorithmic money market, meaning loans are obtained from pools instead of being individually matched to a lender. The interest rate fluctuates depending on the utilization rate of the assets in a pool. If almost all the assets in a pool are used, the interest rate will increase to entice liquidity providers to deposit more capital. Conversely, if few assets are used, the interest rate charged will crease to entice borrowing.
Aave also enables users to take loans out in a different cryptocurrency. Because of the inherent volatility of cryptocurrencies, Aave includes a liquidation process. If the collateral you provide falls under the collateralization ratio specified by the Aave protocol, your collateral may be liquidated. As a result, you need to understand the risks of depositing funds into Aave before using the protocol.
Looking ahead, Aave plans to expand beyond money markets by allowing users to obtain flash loans. There is often much more liquidity in Aave’s money-market than loans required by borrowers. The underutilized capital can be used by those that take flash loans. Flash loans allow users to borrow a large amount of money without posting collateral, then return the loan within the same transaction.
Pros and Cons of DeFi
Benefits of DeFi
- Flexible: Users can move their assets anywhere at any time without asking for permission, paying expensive fees or waiting for long transfers to finish.
- Pseudonymous: You don’t need to provide your legal name, email address or any personal information.
- Open: DeFi is accessible; you don’t need to apply or open an account. You get access by creating a wallet.
- Transparent: Everyone involved can see the full set of transactions.
Drawbacks of DeFi
- Scalability: DeFi projects encounter formidable difficulties in the scalability of the host blockchain.
- Uncertainty: In the event of instability in a blockchain hosting a DeFi project, the project could automatically inherit instability from the host blockchain.
- Concerns of liquidity: DeFi has far less liquidity than traditional financial systems.
- Shared responsibility: DeFi projects do not take responsibility for your mistakes; without intermediaries, users have to take responsibility for their funds and assets.
What Is the Future of DeFi?
With Web3 on the horizon and sidechain and Layer 2 scaling solutions like Arbitrum, Optimism and ZK-Sync growing, DeFi projects on Ethereum should have ample opportunity to showcase their utility and make a strong comeback. Moreover, many blue chip DeFi projects such as Chainlink have proven to be oscillators in terms of their ETH trading pairs, meaning that as long as investors can weather the storm, a reversal should happen sometime in the future.
The potential of DeFi is boundless, limited only by the imagination and execution of blockchain developers. A few growing trends to watch include: algorithmic stablecoins, synetic securities, self-repaying loans, the monetization of blockchain gaming, surging DEX and AMM volume and improved cross-chain technology.
Overall, while more people are using DeFi applications, it’s difficult to say whether DeFi will go mainstream any time soon. DeFi technology is experimental, new and isn’t without serious problems such as scalability. If developers can continue to rectify these problems, as exemplified by the impending Ethereum Merge, the potential behind this expansive financial ecosystem is boundless. If you want to take part, be sure to understand not only the rewards but the risks before getting started.