To some people, DeFi is a complicated mystery. But it doesn’t need to be. In fact, it’s pretty simple. Decentralized Finance, at its most basic, is simply the recreation of commonly used financial products, services, and tools in an environment that isn’t controlled by a central authority, like a bank or brokerage firm, or insurance company. That environment is a blockchain (or various blockchains).
What does this mean, in practical terms?
It means that you can make the same types of purchases or execute the same types of transactions without a central entity collecting and selling your personal and transaction data. Or adding onerous fees on top. Or treating people differently based on their personal characteristics or beliefs. Or using your data and activity to grow behemoth-like and crowd out all competitors that might offer better service at a better price. Your financial activities are conducted peer-to-peer, without the need for intermediaries.
Without getting into the nuts and bolts of how blockchain tech works, that’s it.
Here are a few more significant differences between DeFi and traditional finance, or TradFi.
In TradFi, control and ownership of financial assets, such as bank accounts or investment portfolios, are typically held by centralized institutions on behalf of individuals or organizations. In DeFi, individuals have direct control and ownership of their assets through the use of cryptographic keys and smart contracts.
DeFi is more accessible and inclusive. TradFi often requires that consumers meet certain criteria, such as a minimum account balance or credit score, to access financial services. With DeFi, if you have a smartphone and internet connection, you’re good to go. This is particularly important to the huge numbers of global citizens who don’t have access to TradFi services. This population, commonly referred to as the “unbanked,” is estimated to be over 1 billion globally and 60 million U.S. citizens.
DeFi is transparent. It operates on public blockchains, which all users can see. All transactions and activities are recorded on-chain, allowing for easy verification and auditing. In TradFi, transparency levels vary—in fact, a lack of transparency is often part of the business model.
DeFi enables the creation of programmable financial applications through the use of smart contracts. This programmability allows for the automation of most financial activities, like lending, borrowing, and trading. TradFi generally relies more on human intervention for most operations. The principal DeFi advantage here is that the user knows how the smart contract is supposed to behave, and there are no surprises. Humans, on the other hand, are full of surprises.
And then there’s size. DeFi is novel, interesting, and innovative, but TradFi is still far bigger in terms of transaction volume. For now.
So what are a few TradFi capabilities/products that you can access in DeFi? DeFi lending and derivatives are two common ones, while interest in tokenized real-world assets (RWAs) is continuing to grow.
DeFi lending is a fundamental and very popular DeFi product. It enables users to lend and borrow digital assets directly from one another (peer-to-peer) without intermediaries. Smart contracts automate all the activity. By eliminating intermediaries, DeFi lending offers improved accessibility, potentially higher interest rates for lenders, and opportunities for borrowers to access loans very quickly.
How does DeFi Lending work?
Users who own digital assets—crypto or stablecoins—can choose to lend them to others on a DeFi lending platform. By supplying assets into the lending pool, they earn interest on their holdings. On the other side, users who wish to borrow from the lending pool do so by providing other digital assets as collateral. The collateral secures the loan in case of default, just as in the TradFi world.
DeFi lending interest rates are determined dynamically by supply and demand metrics within the lending platform, such as asset availability, lending pool utilization, and overall market conditions. Interest rates are generally more competitive than in TradFi since there are no intermediaries who must be paid.
Smart contracts coded into the protocol automate the entire process. This includes dynamic interest calculations, collateral management, and repayment schedules. These contracts ensure the transparency, security, and enforceability of the lending agreements. An important aspect here is dynamic collateral management. Most DeFi platforms require borrowers to provide collateral that exceeds the value of the borrowed assets. This over-collateralization helps protect lenders in case the value of the collateral coin drops significantly.
Over time, as the collateral increases or decreases in value, the protocol automatically monitors whether the borrower can withdraw some of his collateral or must provide more. This lessens risk to the entire process and protocol. If the value of the collateral falls below a certain threshold (known as the liquidation ratio), lenders have the right to liquidate the collateral in order to recover their funds. If you’re a borrower, you want to avoid this.
Three major lending protocols are AAVE, Compound, and MakerDAO. We compare each in greater detail here, but for now, here are the broad strokes.
AAVE is an open-source, decentralized, non-custodial liquidity protocol with, at the moment, $8.7 billion of liquidity locked across five networks and 11 markets, including Ethereum, Avalanche, and Polygon. Users can be either depositors or borrowers. Depositors provide liquidity to the market to earn a passive income, while borrowers are able to borrow in an overcollateralized (perpetually) or undercollateralized (one-block liquidity) fashion.
Compound is a decentralized protocol running on Ethereum that currently has nearly $1 billion of borrowing backed by $2.5 billion across five markets. It's one of the oldest lending/borrowing apps in DeFi. Users like Compound’s easy-to-use dashboard. Compound dynamically maintains the interest rates in its coin pools, based on the supply and demand metrics for the particular cryptocurrency.
MakerDAO is a bit different from AAVE and Compound. It isn't a lending protocol per se, but rather is a decentralized autonomous organization (“DAO”) that uses staking to create an algorithmic stablecoin. The stablecoin is called DAI, and it's created by users depositing some form of crypto collateral and then borrowing against that collateral; the borrowing is done in DAI and it accrues interest.
Amberdata’s DEX and Lending Protocol Data provides a window into all the relevant data you need to understand the current state of the large lending protocols. It enables you to generate visualizations of critical protocol actions, including borrows, deposits, supplies, repayments, withdrawals, reserves as collateral, liquidations, and flash loans.
Crypto derivatives are financial instruments that derive their value from cryptos or crypto assets. They enable you to capture the price movements of a crypto without owning the underlying asset. They're also more cash efficient, enabling serious leverage if that’s what you want. They can also help you hedge risk in your overall portfolio.
Crypto futures: Crypto futures contracts are agreements to buy or sell an underlying crypto at a predetermined price and date in the future. These contracts enable traders to speculate on the future price of a cryptocurrency and potentially profit from both upward and downward price movements. Purchasing a contract costs far less than purchasing the underlying crypto.
Crypto options: Crypto options give you the right, but not the obligation, to buy or sell an underlying cryptocurrency at a specified price within a specific time frame. Call options give you the right to buy the asset; put options, the right to sell. Options can be used for various trading strategies, including hedging and speculation. Amberdata’s institutional options analytics deliver comprehensive spot, vol, and derivatives data history, together with a robust set of analytics and tools that help traders identify opportunities, manage risk, and build better strategies.
Crypto perpetual swaps: Perps are essentially futures with no expiration date that track the spot price of the underlying crypto. You can go long or short.
Crypto swaps and swaptions: Crypto swaps involve the exchange of cash flows or returns based on the price movement of crypto or interest rates. They're used to hedge against price volatility or to gain exposure to different cryptos. Swaptions are options contracts on swaps, giving the holder the right to enter into a swap contract at a later date.
Crypto Contracts for Difference (CFDs): Crypto CFDs are derivative contracts between traders and brokers, where the parties agree to exchange the difference between the opening and closing prices of an underlying crypto. CFDs let traders speculate on price movements without owning the actual crypto.
Crypto binary options: Crypto binary options are derivative contracts with a fixed payout determined by the price movement of an underlying crypto. Traders predict whether the price of the crypto will be above or below a certain level at a specific time. If the prediction is correct, the trader receives the predetermined payout; otherwise, the investment is lost.
Tokenized real-world assets (RWAs) refer to the representation of physical or tangible assets in a digital format using blockchain technology. By leveraging the properties of blockchain—such as decentralization, transparency, and immutability—previously illiquid assets can be fractionalized. This makes tokenized assets more accessible to investors, ultimately increasing their liquidity.
As a result, a range of sectors, including real estate, art, and finance, have begun exploring tokenization as a means to democratize investment and streamline operations, marking a significant shift towards the integration of traditional finance instruments into the DeFi space.
Tokenized assets can be broadly classified into two categories: fungible tokens and non-fungible tokens (NFTs). Fungible tokens are digital assets that are interchangeable with others of the same type, maintaining uniformity and divisibility. They are often used to represent assets that do not require unique identification, such as stablecoins or commodities.
In contrast, NFTs are unique digital representations of assets and cannot be exchanged on a one-to-one basis with another token. RWA NFTs are suited for assets that require specific identification, such as individual artworks, collectable items, or real estate properties.
Amberdata's AmberLens Ethereum Treasury-Backed RWA dashboard provides insights into the RWA market. With AmberLens, institutions can track the market capitalization and unique wallet holders of various RWA protocols including BlackRock $BUIDL, Ondo $OUSG, and Superstate USTB. In addition to expanding features, our roadmap for this dashboard includes coverage for real estate, private credit, and luxury goods RWA sectors.
DeFi is simply a new way to purchase the financial products or services you're already accustomed to in TradFi. By stripping out middlemen, it offers a host of benefits, cost savings, and other efficiencies. Every day brings new innovators as well as new entrants from the TradFi world, all of which, at the end of the day, are good for consumers.
TradFi rests on reach, reputation, branding, and bigness, whereas, DeFi has been built with code and data. Enormous amounts of data. Much of which is unfamiliar to TradFi users. Amberdata can provide that data to you and your customers, and help make sense of it all.
Our unified API and data services provide a single integration point for obtaining a complete view of the entire crypto economy. Our defi-lens endpoints provide in-depth views of DEXs/protocols and the way they operate. Depending on the protocol, there are multiple lenses available: Protocol, Asset/Pool, Wallet, Governance, and Portfolio.
To learn more about the surge of RWAs, download our Real-World Asset (RWA) Primer.