DeFi has become a trending topic in the blockchain community. In contrast to the decentralization of money through Bitcoin, DeFi aims for a broader approach of generally decentralizing the traditional financial industry. The core of the initiative is to open traditional financial services to everyone and to provide a permissionless financial service ecosystem based on blockchain infrastructure.
This has been enabled by decentralized technologies that have emerged in recent years. Programmable smart contracts, once deployed, automate execution of transactions in the way they were designed. They enable the creation of new financial instruments and digital assets without requiring banks, custodians, brokers or other middlemen. The tamper-proof data on a blockchain’s decentralized architecture increases security and auditability. And, since standards like ERC20 for Tokens (representations of an asset on the blockchain) are well established, all these DeFi protocols and applications are built to integrate and complement one another.
Since Chromia has incubated Hedget, a decentralized options trading platform, the community has been actively discussing the potential of the DeFi sector. Thus, this article aims to clarify what Decentralised Finance essentially is and why it is currently booming.
The roots of Decentralized Finance can be traced back to the earlier days of Ethereum, where much of it stayed under the radar. Projects were only used by few very tech savvy early adopters. Decentralized exchanges like Etherdelta existed in 2017, but they were really hard to use, had a very clunky interface, and due to few users, almost no liquidity. Since then, many improvements were made in all areas. Many stablecoins – Tokens representing a dollar - were created. Most by Custodians, but some are just smart contracts themselves. The DAI stablecoin is overcollateralized by Ethereum and other Digital Assets, with the price of DAI being kept at one Dollar through a system of smart contracts automatically executing themselves.
The current DeFi Ecosystem
There are many decentralized exchanges today where various assets can be traded with good liquidity. Credit and insurance protocols, derivatives, asset management funds based on smart contracts, decentralized prediction markets and other financial services. On the more experimental end of the threshold there are dozens of projects experimenting with fair distribution of an asset, governance for a decentralized application, currencies with elastic supply and funny names. Or even combinations of all of the above that have to be ‘farmed’. Farming here means requiring those interested to get them to lock up capital (in the form of other tokens) in smart contract ‘pools’ to earn their share of the experimental token that is being distributed.
While DeFi products offer very interesting returns, even up to double-digit annual yield on stablecoins, it is important not to lose sight of risks. For one, while smart contracts will always execute the way they designed, they are very complex. They can and do have bugs and vulnerabilities, the most famous one being the 2016 ‘DAO Hack’. To manage and upgrade their DeFi applications, many developers also retain powerful ‘admin access’ that is coded into the smart contract. This is putting in an element of trust into an otherwise ‘trustless’ system: Users have to trust the developer not to behave in a malevolent or careless way. Another major risk is operational security and simple user errors. If a traditional banking user wires funds to the wrong account, there are ways to get them back. In DeFi, if something goes wrong, there is no bank to call, and funds may be permanently lost. Users themselves have to take on the responsibility for securing their private keys and not interacting with fraudulent or harmful contracts. In Decentralized Finance so far one could say ‘code is law’ – but since we all live in a world with existing legal systems, it is important to recognize it is a mostly unregulated grey area so far.
But despite these risks, the amount of protocols, users and liquidity seems to have reached an important threshold in early 2020. To give an example – once a project creating a representation of bitcoin, gold or any other asset on Ethereum exists, other projects can use that as well. It can be traded, placed as collateral to take a loan against, derivatives of it can be created. This means that most DeFi projects complement each other in some way. As the utility, liquidity, value and possibilities of the whole DeFi sector grow, it becomes more appealing to potential new users, creating a positive feedback loop that is still in motion.
Ethereum scaling issues
The total value of digital assets locked in the Decentralized Finance ecosystem has seen a rapid growth in the year 2020 so far DeFi skyrocketed from some 600$ million in January 2020 to well above 6$ billion by August. While this, it has also led to a major issue that could be stalling future growth. Ethereum has built the trust of being secure enough to store and handle assets worth billions of dollars. But the capacity of the Ethereum as a trustless ‘decentralized supercomputer’ is limited, and who gets to use this capacity is decided by how much they are willing to pay. The recent rise in popularity has led to a more then tenfold increase in transaction costs in just a few months. The rapidly growing DeFi sector is not only pricing out other emerging uses of Ethereum, it has already reached a point where even many small to mid-sized DeFi transactions are not worth doing any more due to network fees being higher than profits from those transactions.
While work is in progress on increasing Ethereum’s capacity, solutions are required now. One of them is the use of second layer technologies on top of Ethereum. For example, Crypto Exchange Bitfinex recently migrated USDT stablecoin transfers to the OmiseGO second layer Network to save costs, increase performance and relieve pressure on the root Ethereum network.
Since Chromia recently introduced an ERC20 token gateway, it can effectively take on a role as a second layer for Ethereum as well. Hedget, a decentralized application (dapp) for creating and trading fully collateralized options, will be the first to make use of this interoperability. Hedget Ethereum smart contracts will handle ETH and ERC-20 token deposits and withdrawals and implements physical option settlement. The Chromia-based blockchain handles trades, tracks ownership of contracts and facilitates the required communication to perform settlement through Ethereum smart contracts. You can read more about Hedget in Chromia's recent blog article.
Due to the previously mentioned limitations of scalability, DeFi projects combining Ethereum's high built-up trust, liquidity and user base with Chromia’s performance could be the blueprint for the next generation of DeFi dapps. An improvement is absolutely needed, as despite the rapid growth this year the decentralized finance sector is still in its infancy. It is showing a lot of promise and rapid growth - but is still a niche and mainstream media has barely taken note. Once that changes, it could lead to a massive inflow of new users, requiring a more efficient and scalable approach to DeFi applications. Therefore Hedgets approach might be more complex to build in the short term, but could really pay off in the long run.