DEFI SECTOR IN CRYPTOCURRENCY MARKET
Updated: 5 days ago
Author: Chiara Dal Monte
Publishing date: 9/1/2021
Since 2008, when the first Bitcoin was mined, the cryptocurrency market has been growing exponentially, also thanks to the open-source nature of the blockchain. This means developers from all over the world are able to create new codes to the extent that today there are more than 13.000 cryptocurrencies.
The blockchain system is considered the disruptive technology of the 21st century because it was created to support cryptocurrencies but it has a huge potential not only in the financial sector but also in healthcare, supply chain and IoT.
Blockchain is defined as a decentralized ledger technology, meaning the information is not stored in only one server but is instead shared with all the members of the network. This decentralized approach is one of the main benefits of the blockchain: there is no risk the information gets lost, deleted or manipulated by a single intermediary. Information in the blockchain is stored in blocks, each connected to the previous and the next one through a code called hash, which is specific to the block like a fingerprint. When a miner is able to verify a new block by finding the right alphanumerical code of its hash and connecting it to the chain he receives a new coin as a reward.
Nevertheless, not all cryptocurrencies have their own blockchain:
· Cryptocurrency coins are a medium of exchange and serve as digital cash. They have their own native blockchain, for example, Bitcoin (BTC), Monero (XMR) and Bitcoin Cash (BCH).
· Protocol coins also have their own native blockchain but they retain additional functionalities for the development of decentralized applications (dApps) and the creation of smart contracts.
· Tokens are digital assets that are built on top of another blockchain protocol and do not have their own blockchain. While coins are used to keep the base layer blockchain operational, tokens are generally used to enable the protocols or applications built on top of the Layer 1 chain.
The aim of this article is to understand the difference between the main sectors of cryptocurrencies: Payments cryptocurrencies, Stablecoins, Metaverse, Non-Fungible tokens, IoT cryptocurrencies and Decentralized Finance (DeFi). Since DeFi is able to provide financial services without a third party to act as an intermediary, it is becoming more and more competitive with traditional financial intermediaries. This is why the focus of the article will be on understanding how DeFi works, analysing the services it already provides like borrowing and lending, decentralized insurance and exchange and then having a glance at the problems still affecting the system and the possible solutions to address them.
Cryptocurrencies are divided into categories according to their function. CoinMarketCap counts more than 100 categories, but the search of this article is limited to the most important ones.
The facilitating transaction was the first purpose of cryptocurrencies when they were first created in 2008. Bitcoin was advertised as an alternative payment method that does not need a financial intermediary like a bank but instead uses the internet to connect the
sender and the receiver. This is made possible by blockchain technology, and every transaction is stored as information in a block and verified by miners. The decentralized approach makes this system trustless, meaning there is no need to trust a third party to oversee the transaction, which is instead visible to the whole network. The advantages of payment cryptocurrency are lower fees, the ability to make cross-border payments, no limitations by a centralized authority, increased speed.
One of the main sources of risk for holders of cryptocurrencies is their high volatility. Stablecoins were created to reduce virtual currency volatility by pegging a token to the value of a fiat currency, to material assets, or to another cryptocurrency.
· The most famous Fiat-backed coin is Tether, backed by the U.S. dollar. Investors exchange U.S. dollars for company tokens, called USDT, which can be used like any other cryptocurrency. The company has a reserve that acts as a deposit guarantee. Customers should be able to return their USDT for dollars whenever they want, without being impacted by pricing fluctuations typical of other cryptocurrencies.
Cryptocurrency-backed coins use over-collateralization to avoid volatility by making customers deposit more tokens than necessary to protect them from a possible drop in the cryptocurrency value.
Asset-backed cryptocurrencies are pegged to an external good. In the case of G-coin, each token equates to one gram of physical gold. The gold is supposed to be stored by the company and each token can be redeemed, used as a store of value or used in the digital platform like any other cryptocurrency.
In “non-collateralized” stablecoin the blockchain itself uses algorithms and smart contracts to avoid price fluctuations.
The Metaverse is a virtual reality that allows users to connect with an avatar and interact with each other. Despite gaming platforms already existing, the invention of the blockchain system has made it possible to create more and more sophisticated platforms, where users can live almost every aspect of life virtually. Metaverse cryptocurrency is the medium of exchange used in these platforms, traded by users to buy properties, attend events, gambling and much more.
In economics, fungibility is the property of being interchangeable and indistinguishable, like Fiat Money. As a consequence, the adjective non-fungible refers to tokens which are unique units of data stored in the blockchain and are often associated with a digital file that serves as proof of authenticity. NFT can be traded in the digital markets but they can have only one owner at a time: ownership is managed through the uniqueID and metadata that no other token can replicate and the proof of ownership is public on the blockchain. Anyone can create a new file like a picture, a video, a gif to be sold as an NFT through the creation of a smart contract that is added to the blockchain where the NFT is managed. Their properties are uniqueness, indivisibility and scarcity.
“Internet of things(IoT)” indicates the connection and exchange of data between devices and the internet. IoT has several applications, mostly in the sector of smart homes, which have automated security systems, lighting and home appliances. The main role of cryptocurrency to this domain is the connection of a digital wallet to perform automated payments, for paying bills according to the energy consumption or to buy food automatically when supplies in the smart refrigerator are running out. The next challenge in the future is to build entire smart cities, where cryptocurrencies could be the main form of payment.
The biggest IoT crypto project is IOTA, an open, feeless and scalable distributed ledger, designed to support frictionless data and value transfer and its correspondent cryptocurrency is MIOTA.
The peculiarity of IOTA is the absence of blocks and miners: by sending an IOTA transaction two other transactions are validated. This allows IOTA to overcome the cost and scalability limitations of blockchain.
The fact that transactions in the blockchain are shared in a public ledger makes it impossible sometimes to guarantee full anonymity to the users: some methods exist but they are expensive in terms of higher transaction fees and require advanced skills. The alternative is the use of private cryptocurrencies.
Privacy coins make it possible to obscure the origin and destination of blockchain transactions. This can be achieved by hiding a user’s real wallet balance and address or by mixing different transactions to make it difficult to distinguish them one from the other. As a result, transactions are anonymous because the identity of the parties is hidden, and untraceable because it is virtually impossible for third parties to follow the trail of transactions.
Not all jurisdictions allow the use of privacy coins: in the last months scrutiny from regulators has been increasing and they have in some cases forced platforms to delist some of the privacy cryptocurrencies to avoid regulatory complications.
Decentralized finance is the term used to define a set of financial services carried out through the blockchain instead of using the intermediation of traditional financial institutions. The revolution is the use of a decentralized ledger instead of a centralized system where the third
party plays an extremely important role. It can be risky to consolidate trust into one institution because it creates a single point of failure. The new system is instead defined as trust-less because there is no need to trust a person or an institution to act as an intermediary during the transaction,
which is instead recorded in the blockchain and therefore public to all participants in the network. This makes it impossible to reverse a transaction once occurred.
To carry out transactions, DeFi makes use of smart contracts, computer transaction protocols that automatically execute the terms of a contract when a set of conditions is met. These are a codified series of if-then functions, and when they are fulfilled the contract will execute the established consequence. They are used to digitally facilitate, verify, or enforce the negotiation without any third parties intermediation.
Ethereum was specifically created to provide smart contracts and still is one of the main platforms for DeFi services.
The additional factor with respect to other cryptocurrency platforms
is that Ethereum is able to carry data in the form of arguments: contracts can be programmed to be self-executing and send money as the condition specified in the code are met.
The lender and the borrower are connected by a smart contract that acts as an intermediate since it outlines the condition of the agreement, for example, the interest rate. The transaction is then managed automatically.
“Yield farming” is the name of the practice of staking or lending crypto assets in order to generate high returns or rewards in the form of additional cryptocurrency and it was thanks to this financial innovation that the DeFi sector market cap grew from $500 million to $10 billion in 2020. Through the blockchain, it is also possible to deposit your cryptocurrency as collateral and borrow fiat money against it.
Another application in the borrowing/lending sector is flash loans: a loan of any size can be received, used and paid back in a single transaction. No collateral is required for this type of loan. Should the debtor fail to pay back the loan, the transaction will be reverted, and the sender will only have to pay for transaction fees.
Traditional assets mainly serve as capital backing for companies: virtual assets within the cryptocurrency space have similar purposes. However, as they are created, stored and traded over the blockchain, they are inherently public, and their movements are transparent. Using smart contracts, they can be traded automatically and censorship-less.
v Decentralized exchange (DEXes)
It allows users to buy, sell, and trade cryptocurrencies on the Ethereum platform through a smart contract, without using a central provider that asks for sign-ups or ID verification: trades are executed autonomously. Rules and regulations for trading are predetermined in the smart contract code. Furthermore, exchanging with DEX doesn’t require any initial deposit or fees for withdrawing funds.
A smart contract is signed by two parties, one taking a long position and the other short-position on the underlying entity such as bonds, currencies, or interest rates or any other instrument. One or both sides of the trade lock collateral worth more than their bet into an automated contract. Then the program will transfer collateral to one party or the other according to the price movement of the established asset following the timing and the rule specified in the contract. Tokenized derivatives can be created without third parties and by-design prevent malicious influence.
Through the decentralized system, it is possible to connect with anyone around the world willing to insure your assets, and on the other end, you can insure other people’s assets at a premium, without ever having to go through an insurance company or agent. Everything happens autonomously, with smart contracts ensuring a fair, secure, and trustworthy process.
Despite the high level of security, there is still the possibility of cyber-attacks on crypto exchange platforms or of the hack of smart contracts. To address the problem, some companies are born to provide:
Crypto wallet insurance, against the risk of theft during a cyberattack. One of the most famous is Etherisc - Decentralized Insurance;
Collateral protection for crypto-backed loans, by insuring the collateral provided by the borrower in case of theft or destruction;
Smart contract cover in case the smart contract address is hacked and is used for manipulation or if funds are moved to another address that doesn’t belong to the original investor.
Problems to be addressed
Decentralized finance is still in a growing phase and is facing some problems that developers are trying to address before the system becomes accessible to the mass. Some studies argue if Ethereum itself is viable to handle the growing number of users due to some limitations:
Scalability problem: the technology is dependent on network speed and the blockchain suffers from a limited transaction throughput. As a consequence, the nodes that have to verify transactions need to decide which to validate and the most common criteria are to choose the ones with higher fees. This result in higher average fees for all transactions or confirmation delays.
Centralization risk: if only a limited number of nodes have the technology necessary to deal with big transactions, power could still be concentrated into a small number of hands. As a consequence, there are still risks of corruption, collusion or conspiracy.
Usability: Usability is the degree to which software is easy to use, making sure that the functionalities help a user of the average capability to achieve their intended purpose. Cryptocurrency wallets still suffer from serious usability issues, in particular for general users.
Smart contract vulnerability: the investment could be lost if there are flaws in the contract code. On November 7th, for example, a hacker stole $55 million in various currencies after one of bZx DeFi platform developers fell for a phishing attack.
User error: if the user inputs the wrong address it is very difficult and expensive to reverse the transaction.
Liquidity problems: Liquidity indicates the ability to buy or sell an asset at a stable price and is important to any kind of trading.
Concerns around a lack of liquidity contribute to crypto price volatility, as investors constantly feel the need to sell: a large volume of transactions leads to even more slow validation time, making investors even more worried. Furthermore, during a transaction there could be slippage: the expected price of a trade is different from the execution price. It could occur in periods of high volatility, when it is difficult to maintain the bid-ask spread. The market order price depends on the bid-ask spread so as a result, in periods of high volatility and low liquidity, slippage risk increases and the executed price could far exceed the expected one. This is why providing liquidity could help reduce slippage and uncertainty.
To address the problem of scalability there are two possible alternatives:
Improving the consensus mechanism of blockchain technologies
Applying sharding techniques: this would mean dividing the blockchain into shards, independent nodes. Then only specific shards are responsible for validating a new transaction, with increased speed as a result, since not all the networks need to give their consensus and different shards can simultaneously work on different validation processes.
Another solution to DeFi problems is addressed by Relite Finance, a cross-chain lending project built on Polkadot. Polkadot is a separate blockchain from Ethereum but it has interoperability built-in allowing cross-chain transfers of any data or an asset. The advantages are decreasing the fees for users and lower complexity, in fact, it can be used by the general public without much effort.
Last but not least, it is today possible to overcome liquidity issues with liquidity pools, which are smart contracts where users can pool their assets to provide asset liquidity for traders to swap between currencies. The Smart Contract is usually a DEX smart contract and the investors putting assets on the pool receive a share of transaction fees or crypto rewards. The more assets in a pool and the more liquidity the pool has, the easier trading becomes on decentralized exchanges.
The world of cryptocurrency is developing at a very fast pace and boundaries between the uses of the blockchain are not yet clearly defined. The huge potential of this technology will not only influence the financial world but all the sectors characterized by data storage, like data protection or healthcare.
Since it was born the main use of cryptocurrencies is as a payment method, which later developed in different branches like payments through the IoT systems or payments in the gaming platform and the metaverse. With non-fungible-tokens instead, cryptocurrency is exchanged for a unique item, to be kept as a store of value or to be traded when its value increases. Critics of cryptocurrencies point to the fact that they do not have a real value, in fact, they are not like gold or fiat money. Stablecoins try to overcome this problem by pegging the digital coin to another asset, to limit their volatility and make the investment less risky. Instead, to overcome the problem of traceability, developers have created privacy coins, which make transactions in the blockchain completely anonymous.
Among the different sectors, decentralized finance is the one with more potential and application: through the use of smart contracts, many kinds of financial services are offered all possible without the use of a financial intermediary. Nevertheless, DeFi sector is still facing some problems like scalability, usability, and liquidity which in any case do not prevent investors to get more and more involved in this new technology.
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