Have you ever played Lego as a kid? If you like to piece things together, there is a good chance you’ll like Defi, the eight-billion-dollar ecosystem of interconnecting, strangely alike projects where big boys and girls lock their assets via smart contracts, provide liquidity, lend and borrow Crypto assets, risk a lot of crypto – to earn a lot of crypto… or lose it. Let’s play.
What’s DeFi?
Decentralized Finance (DeFi for short) is a lot of things but one simple definition. First of all, it’s a community of liberterian-minded developers and startupers who aim to replace traditional banking with new distributed algorithms.
Why? This will help eliminate the problem of trust, excessive fees as well as single points of failure and control – issues common for the long-established financial niche.
Second, DeFi is a nickname for a wide ecosystem of dApps for borrowing/lending, monetary banking, staking, trading and so much more – built mostly on top of Ethereum and sometimes on other blockchains such as TRON.
And last but not least, it’s a movement with its leaders, crystal-clear logic and philosophy. Here it goes.
Crypto DeFi projects are interoperable for all dApps to be woven together on a technical level. They are accessible to anyone with an Internet connection: every developer can fork your code, every person on Earth can sign up with your app. All the market-level information, say, the history of your crypto transactions, is transparent to all participants, although nobody knows (except for forensics maybe) that this history is yours.
At the end of this summer, for the first time ever, DEXes (decentralized exchanges) built on Ethereum set three consecutive records, aggregating a volume of $11.6 billion in a matter of just one month, up from $4.5 billion in July. But this game has not always been that big. Have a look at where crypto DeFi has begun.
Brief History of DeFi
Everything started with Satoshi in 2008 when he pitched his whitepaper to the cypherpunks on the mailing list he was subscribed to. Bitcoin was the very first DeFi project. Still not convinced? OK.
Everything started with Vitalik in 2013. In the very first version of the Ethereum whitepaper he described three categories of possible applications on his blockchain: financial, semi-financial and non-financial. Buterin envisioned much of what we see playing out right now: derivatives, prediction markets, lending… Still not convinced?
In May 2018, Polychain offices in San Francisco hosted a meetup where 150 visitors proclaimed their projects to be DeFi projects – they represented Maker Foundation, Compound Labs, 0x, dYdX, Wyre, early dApps focused on monetary economics. But not everybody has attended.
EtherDelta – the first decentralized exchange
The very first decentralized crypto exchange in the DeFi niche was EtherDelta, the trading platform that relies on smart contracts to automatically execute trades. No middlemen, no centralized governance – just smart contracts executing orders.
If you buy and sell on top of this exchange, you don’t need an account with it, just MetaMask in order to send and receive ERC-20 tokens.
However, in 2020, EtherDelta’s order book processing, such as executing, modifying and canceling the order, looks slow. Because everything happens on Ethereum’s mainchain you have to spend gas every time when creating, modifying and cancelling orders.
That being said, the era of EtherDelta is rumored to have come to an end due to low trading volume and market liquidity. However, such DeFi platforms as 0x have tried to address the above issues.
0x – when a DEX meets a centralized exchange
One of the first DEXes out there, with its $61-million 24h trading volume, 0x these days is not among top dogs in DeFi. However, the founders of this exchange described a very interesting AMM model in their whitepaper.
These days, Automated Market Makers effectively replace a traditional order book with a system where assets can be automatically swapped against the pool’s latest price.
Whenever you add liquidity to a pool, you earn fees for any trade facilitated by that pool. Thus, people earn fees for providing pool liquidity, and seemingly they like it a lot, since it has created these surreal monthly volumes on top of not only Uniswap but also Curve and Balancer. But everything started on 0x.
Back in time, the engine under the hood of this exchange looked very impressive not only because it offered the AMM functionality but also because it offered off-chain transactions, which significantly lowered trading fees, processing time and generally could compete with such market players as Coinbase.
Binance DEX – not that decentralized
But wait, you should say right now. Wait a minute – all those DEXes are great, but what about the whale of the industry, Binance? Its $7-billion 24h trading volume covers all the records set by other exchanges over months.
While talking about exchanges, it’s really hard to ignore a pink elephant in the room – the original Binance platform with its centralized governance. Tied in first place in terms of trading volume, does it have anything to do with DeFi?
Due to the cosmic number of the total value locked in the DeFi built on Ethereum the niche has started to differentiate itself from other crypto market players. Cool crypto projects these days are DeFi apps built on top of Ethereum. And here is why this is important.
Although Binance created a new blockchain for its decentralized exchange, Binance DEX, which now boasts low latency, high throughput, low fees and the ability to control private keys, the fact that their DEX is not a part of the Ethereum ecosystem tells a story.
Binance DEX started with a $1.2-million trading volume in February 2019, for now, however, its volume is slightly more than $380K, as of this writing.
Maker Protocol – a collateral-backed stablecoin
Interestingly, the whole DeFi ecosystem has brought to life not only decentralized exchanges but newer forms of earning crypto.
Maker Foundation, today you might know it as MakerDAO, came into existence 6 years ago.
As of now, it has bottled up some dark algorithmic magic inside of its stablecoin, Dai, for it always to be equal to $1. But it’s not everything the protocol can do.
Put your Ether into a smart contract, generate some Dai, borrow it, repay 0,5% per-year interest and get your Ether back. Lost in translation? What sounds too complicated didn’t stop DeFi kids from locking $1.26 billion in the protocol’s smart contracts, as of this writing.
In such a competitive ecosystem as DeFi is, it’s no wonder that after Maker had emerged, other akin projects started to pop up, too.
Lending, being a fundamental part of traditional finance, has seen a DeFi frenzy this year, with the record inflow of almost $10 billion. That being said, in the crypto niche, there was seemingly a pressing demand to migrate the elements of well-established banking to blockchain, and DeFi has successfully done it.
Aave – DeFi lending platform
In 2017, Stani Kulechov founded ETHLend, a peer-to-peer exchange now rebranded as Aave, where you can lend and borrow a wide range of crypto, including DAI, USDC, TUSD, USDT, sUSD, BUSD, ETH, BAT, etc.
With Aave, lenders deposit their funds into a pool from which users borrow. While borrowing, you will need to pledge collateral that is larger than your loan (very typical for DeFi) and pay either stable or algorithmically based variable interest fees. While lending or depositing collateral, you’d be given aTokens that will allow you to earn interest.
The Aave pools also reserve a small percentage of the assets to hedge against volatility within the protocol and allow lenders to withdraw at any time.
Along with other DeFi lending platforms, this protocol grew tremendously by the end of the summer 2020, and even gained first place in DeFi-protocol rankings surpassing Compound and MakerDAO in terms of total value locked (TVL). It currently leads with $1,5 billion TVL.
Compound – DeFi lending platform
Being initially a centralized crypto lending platform, Compound has played a very important role in the strengthening of a new trend in DeFi, yield farming.
In mid-June 2020, the team released their COMP token, turning into a community-driven dApp, which later brought them a 450% growth in terms of TVL.
Borrowers and lenders on Compound are obtaining COMP tokens on a daily basis for using the platform, thus “farming yield”.
Interestingly, Compound’s growth didn’t bring many new users into DeFi, but many DeFi users who may not have been using the protocol in the past chose to do so because of the new financial mechanisms allowed by yield farming.
Just like with Aave, Compound users can deposit cryptocurrency as lenders and withdraw cryptocurrency as borrowers obtaining tokens, cTokens, for participating.
However, this protocol doesn’t offer stable interest rates and has only 9 assets whereas Aave offers 17.
Also Aave allows users to borrow a higher percentage of the underlying collateral, 75%, compared to Compound’s 66.6%. Yet, as of writing, the Compound lending platform has $608.6 mln locked in value securing the place in the ranking of DeFi top dogs.
Decentralized vs Centralized
While this DeFi guide throws at you atomic amounts of American dollars and such a jive talk as yield farming, liquidity pools, AMM, etc, you must be wondering more and more if the carefree times of centralized services in crypto are done for good.
Is it true that the DeFi niche, futuristic, exotic and bizarre on the face of it, is actually something that crypto has always tried to grow into? Is the existence of functioning crypto economics truly possible without middle men now, and what consequences does it have?
Centralized crypto exchanges, wallets and stablecoins have brought a lot to the table, too: convenience, ease and even some conservatism – will the challenger called DeFi be able to cover that and even add something to the existing value?
Here are pros and cons of both concepts, centralized and decentralized crypto niches – so, back to your corners and let’s have a clean fight.
Exchanges
A centralized crypto exchange is an online platform to trade cryptocurrencies 24/7. Not only is it a middle man between traders, but also a sitting target for hackers and a large-scale authority to watch over every trading operation on the platform.
Such an exchange has access to the users’ funds and, importantly, stores these funds in the way the exchange’s team thinks is secure.
For example, 95% of all Kraken’s funds are stored offline, air-gapped, and geographically distributed. This exchange’s servers are also claimed to be in “secure cages” that are under 24/7 surveillance by armed guards and video monitors.
The other centralized crypto exchanges that take care of your money include but not limited to Coinbase, Binance, Bitfinex, Bittrex etc.
Compared to them, decentralized crypto exchanges (DEXes) are online platforms that operate in a decentralized way allowing peer-to-peer trading, which brings the concepts of decentralization and anonymity pretty close to each other.
Basically, they are instant exchanges for ERC20 tokens where you don’t have to worry about KYC, custody or fishing. Your money is your money – well, at least, on paper.
The swaps are leveraged by chain transactions, atomic swaps and smart contracts that have unfortunately proved to be vulnerable to hackers already. However, core features of DEXes might include positive aspects, too.
These exchanges are non-custodial, they require no identification and, in theory, should operate across multiple blockchains and cryptocurrencies. They have a decentralized order book instead of a service for matching sellers and buyers and are accessed via some decentralized service instead of a website – but, of course, in practice the most famous DEXes don’t always live up to all these standards.
This is the list of DEXes that includes but not limited to such platforms as Balancer, Bancor, Bisq, Matcha, etc. There you can find all the characteristics needed to define the level of each platform’s decentralization.
Liquidity
For an accurate comparison of asset liquidity on both centralized and decentralized exchanges, it’s important to compare similar assets. But despite that the case in hand is crypto markets, the traded assets in focus are different.
To illustrate the difference, let’s compare three top exchanges of the centralized and the decentralized niches in terms of 24h trading volume.
As of writing, Binance occupies the first place with $6,6 billion, Huobi Global holds second place demonstrating $1,6 billion in trading volume, and Coinbase Pro is ranked third with $351,7 million. The total trading volume for these three leading centralized exchanges makes around $8,5 billion.
Now let’s look at three top DEXes with Uniswap showing $351,5 million in 24h trading volume, Curve Finance $40 million and Compound $22,3 million.
Even without adding those numbers, we can see already how the trading volume on top of DEXes is much lower, $413,8.
So, should you buy and sell crypto only on top of centralized exchanges? Not exactly. On top of centralized exchanges, the liquidity is better for traditional tokens, on DeFi exchanges, the liquidity is better for obscure, exotic crypto, such as Chainlink, Wrapped Bitcoin, Dai, etc.
In fact, because Ethereum is seeing a large volume of transactions now, DEXes are less efficient than centralized exchanges in terms of transaction speed, so you might experience long delays.
Types of Trading
An important difference between centralized and decentralized exchanges is of course the types of trading you can do on top of them.
With such giants as Binance, Bifinex, UPbit, etc, not only can you go for spot trading but also margin trading, futures trading and even CFDs, which is a logical next step in your crypto education after spot trading. Especially if you come from the world of traditional markets.
On top of BitMEX, you can leverage up to 100X, with Bitfinex, you can borrow assets to later margin trade, Kraken offers you Bitcoin futures, and these are by no means all of the options.
As for DEXes, they are not designed for trading, rather for swaps. These platforms might be slow, there are no traditional tools on top of them and no established prices since the bandwidth of blockchains may change as a result of high or low latency.
It’s not quite clear if decentralized exchanges will ever be close to the point where they replace traditional exchanges. That being said, only centralized exchanges are good for trading because of tight spreads, good liquidity, different trading tools and various order types you’re so used to.
Fees
As you probably know the fees on top of centralized crypto exchanges might be of a few types: market maker/market taker fees, deposit and withdrawal fees (which is a rare case for crypto) and the fees that payment services might ask you to pay when you transfer fiat.
With DEXes, the situation is slightly different.
One type of a fee is a smart-contract fee for a transaction on the Ethereum chain. Say, you have to pay 43 Gwei for a transaction, as of writing.
Also, DEXes could charge you for transacting fiat into a multisig escrow, which protects you.
Also, there might be a fee if you’re doing an atomic swap between different chains, and a fee for market takers. Anytime a swap is made, the fees go straight to people who provide pool liquidity.
On the flip side of the coin, if you have coins sitting around in your wallet and you’re not ready to use them for a while, why not provide liquidity and earn fees?
Ease of Using
All it takes for you to purchase an asset on a big centralized exchange, such as Coinbase, is your pretty boring debt/credit card. With such a card, you can buy almost any crypto coin for fiat in a few clicks. There are also other payment methods available: wire transfer and bank account, for example.
So do the other major centralized crypto exchanges offer you a relatively easy way to dip your toes into the wild world of cryptocurrency.
With DeFi exchanges, such as Uniswap, DODO, Bancor, Kyber, Curve Finance, etc, the situation’s a little bit different than with centralized exchanges. You should be prepared in order to start using them.
Say, in order to swap on Uniswap, you already have to know something about crypto and specifically, about Ethereum and ERC20 tokens.
For a swap to take place, you input a token to sell and the output token to purchase instead – but for that, you need to have those tokens and an ERC20 wallet, such as MetaMask, right?
Not rocket science, of course, and yet, it’s still more complicated than Coinbase where everything happens in a few clicks literally,
Privacy
What you should keep in mind is that the thorough KYC/AML procedure that you have to go through on top of every major centralized exchange will make you totally visible to the government.
However, decentralized exchanges are considered more private since they don’t require you to complete KYC/AML, and it’s only up to you if you want the government to see you and track you in every possible way.
How so? The ERC20 wallets you use to swap tokens, such as MetaMask, are anonymously stored on your machine, and your transactions written in the blockchain look like long strings that are hard to decrypt if you’re a non-professional.
Security
While storing your funds in centralized crypto exchanges’ accounts, you arrange a sort of a backup for yourself in case of losing valuable information such as passwords. But remember that all of the online platforms are very vulnerable to hackers.
Well, everything that touches the Internet is basically vulnerable to hackers.
Take for instance the very latest breach (as of writing) that happened in September, 2020, when a Slovak centralized cryptocurrency exchange Eterbase was hacked for $5.4 million. According to the statement made by the exchange, the cyber criminals stole Bitcoin, Ripple, Litecoin and other top-dog coins. The exchange is now ready to reimburse their clients from their reserved funds, of course, but it’s not always the case.
Generally, in terms of the hacks attempted, the number of DEX breaches is of course much lower than the number of centralized exchanges’ breaches since the DeFi niche is very young.
But 2020 saw at least a few disconcerting hacks on top of major DeFi exchanges. Why disconcerting? Because they were facilitated through flash loans that are so popular on top of Aave, Compound and Uniswap and happening in one click only.
In June, 2020, an attacker stole over $500k in WETH, STA, WBTC, SNX, LINK from Balancer through the flash-loan scheme. The hacker used a smart contract to automate multiple actions in a single transaction. February this year, through a flash-loan attack, the bZx protocol lost 1193 ETH and then $645k – in a matter of just a few days. The hack, in fact, was a clever arbitrage execution, which did exploit a bug in bZx smart contract implementation.
Wallets
Just as with crypto exchanges, there are two main wallet types in the niche, custodial crypto wallets and non-custodial crypto wallets.
A non-custodial wallet allows you to maintain your private keys in the form of mnemonic seed or just a raw alphanumeric string. Take a look at the list of these wallets!
On the other hand, the custodial wallets don’t let you have complete control over your money.
Just like in the centralized crypto niche, in DeFi, there are several wallet categories: web wallets, hardware wallets, mobile light wallets, desktop wallets and paper wallets.
What type of a wallet you should choose for yourself is totally up to you. We’re saying that not because it’s always scary to give any sort of advice, but because you have to decide what’s important for you personally.
Here are a few aspects you might want to consider while picking a custodial or a non-custodial wallet:
Security
Generally, with custodial wallets, the sensitive data is being stored in hot and cold storages. Say, Coinbase keeps 98% of customer funds offline distributing them geographically in safe deposit boxes and vaults around the world.
As for non-custodial wallets, such as Blockchain.com, you’re solely responsible for your funds since you store them on your machine. That’s why before using such a wallet, you should take precautionary measures: write down your mnemonic phrase, keep it in a safe place and set up 2FA.
Sometimes wallet providers ask you to add your ID to the list of clean IDs, too.
Ease of Using
Often custodial wallet providers make it very easy on the end user to interact with their services.
The fees they might charge – not for transactions but rather for some other services – basically cover your comfort when you lose your password, start learning about crypto or seek for bright well-thought interfaces.
With non-custodial wallets, the situation is a little bit different. Yes, most modern DeFi wallets are very easy, but some of them might be slightly geeky.
So once running across a pretty raw interface to store your Dai, don’t be surprised: early users of these apps, programmers, don’t always care about looks.
Lagging behind while transacting ERC20? Welcome to the chain transactions: increase your gas fee, and you will most likely increase the speed of your transaction – a difficulty you probably don’t even have to know about while using a custodial wallet.
Stablecoins
As you probably know, stablecoins are cryptocurrency coins that display stability over time as their main feature. They maintain a peg to another asset from commodities, to a price index, to a fiat asset and more.
Just like with other Lego bricks, exchanges and wallets, there are more and less centralized stablecoins in the crypto niche.
Centralized Stablecoins
The most popular centralized stablecoin you probably know about is Tether (USDT).
It claims to have one dollar in their bank account for every one Tether they’ve put out in the market. The drawback? Because the project is not transparent enough this fact has been disputed over the years.
The coin is rumored to not have 100% traditional currency backing, but presumably other cryptocurrencies and reserves held as loans.
That might be also true for other stablecoin projects that are considered centralized since it’s totally up for an issuing authority how to maintain the peg.
Decentralized Stablecoins
Now, wouldn’t it be great if the decentralized stablecoins turned out to be the answer to our prayers and solved these problems?
Unfortunately, real life doesn’t work this way, and one famous decentralized stablecoin protocol MakerDAO is a striking example of that.
The victims of March’s “Black Thursday” will not be compensated according to the MakerDAO community’s vote, although the investors have lost $8.33 million as a result of the mid-March crash.
The smart-contract based protocol automatically liquidated collateralized positions once the price of Ether started experiencing a huge drop – now take it or leave it. Such an approach plays directly into the hands of the protocol developers: because the community has voted against refunding sunken investors, no-one is held responsible, and they don’t need to do it.
The obscure and overcomplicated nature of the decentralized stablecoin protocol has proved to be vulnerable just like any other crypto project to the fluctuations of the niche.
