DeFi: how ready-to-wear blockchain-based finance works

Cryptocurrencies have created a virtual “clone” of traditional financial markets.

The year 2022 could be a decisive year for DeFi, decentralized finance that allows users to directly conduct financial transactions without the need for intermediaries. Operationally, this is possible thanks to the distributed ledger technology of blockchain, the special kind of shared and immutable database on which cryptocurrencies were born. Thanks to blockchain, multiple parties can keep track of a transaction, preventing it from being controlled by a single central entity.

On DeFi platforms, financial transactions are carried out through the tool of smart contracts, which are programs or protocols that automatically execute, or control events or actions based on predetermined conditions. To date, the most widely used blockchain for executing smart contracts is still that of Ethereum (the world’s second-largest cryptocurrency by market capitalization), the first to have been specially refined to support smart protocol programming.

DeFi: Decentralized finance ready to change the rules of the game?

Impressive growth

From the users’ perspective, DeFi offers multiple advantages over traditional finance: few barriers to entry, anonymity, faster execution of contracts, reduced transaction costs, extreme variety of available applications. Although still a niche market, the prospects for development are enormous. This is confirmed by the impressive growth rates of the last two years, certified by the boom in Total Value Locked or TVL, i.e., the total value of assets deposited in DeFi’s protocols. From early 2020 to the present, TVL has jumped from less than $1 billion to about $230 billion. Two major expansive phases can be distinguished: the first began in the spring/summer of 2020 and stopped in the first half of May 2021 (in sync with the correction in the prices of major cryptocurrencies), while the second started last July and continued until early December 2021.

Decentralized Finance: What is its role on the road to financial liberation?

Stable coins and “tokenization”: to the origins of DeFi

Decentralized finance represents the natural evolution of cryptocurrencies. Exactly as in classical finance, first the currency is developed, then the payment systems, and then the broader financial services. In particular, the origins of DeFi are intertwined with those of stable coins, digital coins that aim to minimize price volatility by pegging their value to that of fiat currencies such as the dollar, or commodities or even other cryptocurrencies. Early applications of DeFi allowed these stable coins to be lent (lending) against payment of interest and commitment of collateral, often in the form of other digital currencies.

In their essence, stable coins embody the promise of always holding the same value expressed in terms of a predetermined exchange ratio with the underlying asset. It is easy to see, then, how in a short time on the blockchain so many other types of financial promises have proliferated, the digital formalization of which is called tokenization. A token is the set of digital information that identifies on the blockchain the owner of a particular asset. The most basic example are “native” cryptocurrencies such as Bitcoin and Ethereum, that is, those that have their own blockchain on which they are minted, but there are now several stable coins and many other tokens that represent as many promises as possible, extravagant.

What is DeFi? All you need to know about decentralized finance

Derivatives, decentralized exchanges, and liquidity mining

In a short time, smart contracts have made financial transactions of increasing complexity possible. Thus, alongside lending platforms such as the famous Aave and Compound, platforms are now operational that allow users to enter derivatives, insurance, or asset management contracts, but also to trade digital currencies or other tokens (so-called crypto trading) on DEX, the decentralized exchanges. DeFi also provides users with numerous passive strategies to enable them to put their tokens to income by temporarily selling them to specialized platforms (liquidity pools). In jargon, these strategies are known by the term liquidity mining, as those who temporarily give up their crypto assets by making them available to a liquidity pool receive additional liquidity in return in the form of new tokens.

Even in the digital world, liquidity is the brick that holds everything else together: liquidity pools need liquidity to lend it to other users, or to allow other users to exchange pairs of crypto-assets at an exchange rate determined at any given time by an algorithm (so-called automated market-makers). An advanced version of this operation is yield farming, which allows the user to maximize returns by shifting liquidity between different pools based on algorithms capable of selecting the most profitable one from time to time. It is possible to examine the relative importance of different decentralized finance services over the past year by considering the top ten most successful protocols for each macro-typology: lending, decentralized exchanges, and other services (including liquidity mining).

A year ago, 43 percent of the total value of assets deposited in smart contracts was related to lending of cryptocurrencies and other tokens; decentralized exchanges followed with a 32 percent share and, finally, other services contributed about 25 percent. During 2021, changes took place that saw a gradual decline in the weight of lending protocols essentially in favor of an increasing share of contracts encoding other types of services. The result is, by early 2022, a more even distribution of LTV among the macro-types analyzed.

DEFI: The path to decentralized finance under blockchain technology

A ready-to-wear finance

The rapid escalation of the different types of transactions possible with DeFi is realizing a genuine digital clone of the entire world of traditional finance. The intermingling of the two ecosystems is already numerous. In May 2020, Société Générale issued its first bond on the Ethereum blockchain and recently announced a new project to carry out digital repo transactions. Other global financial bigwigs have also launched initiatives in the DeFi field, but they must compete with the many startups rising rapidly to colonize a still new and very promising universe.

After all, the enormous flexibility of decentralized finance allows it to adapt extremely quickly to new and complex operations that enable users to mobilize resources in relation to the pursuit of a wide variety of purposes. The phenomenon is traced back to the concept of Internet-of-Value, that is – according to the creators of the Ripple cryptocurrency – a use of the network to transfer value between individuals or companies as quickly as information. We are in a context in which economic and financial aspects are intertwined with deep socio-cultural dynamics and with the means offered by digital technologies. In the non-financial sphere, these enable people to make phone and video calls, scan their retinas or fingerprints, order a pizza, listen to a song.

But now “datafication” is increasingly pervasively affecting even the financial aspects of our social action. The euphoria of the last couple of years has been fueled by very low interest rates and the peculiar situation created by the pandemic, which, by locking everyone in their homes, has prompted many people to spend more time on electronic devices and thus also to discover DeFi. However, it is likely that, perhaps a few years late, the phenomenon was destined for an exploit even without Covid-19. Disintermediation, the scarcity of barriers to entry, anonymity, and the absence of a central authority are all factors that have created in many users the feeling of ready-to-wear finance.

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