As mentioned in our previous article about asset classes, digital assets and decentralized finance (DeFi) represent an emerging asset class consisting of decentralized alternatives to traditional financial products and services.
DeFi has captured the imagination of blockchain developers, investors, and users and spawned a thriving ecosystem of cutting-edge financial products and services. This segment will cover what is DeFi, how did the movement get started, and what are the applications and projects that define the space.
Curious about the adoption of decentralized finance solutions?
The DeFi analytics tool from DeFi Pulse shows that the total amount of value locked in the smart contracts of DeFi solutions has skyrocketed since the movement began in mid-to-late 2017 to a high of $1.25B in February 2020. Worth understanding
What is decentralized finance?
In contrast with “centralized” or “traditional” finance, decentralized finance (DeFi) is a movement that aims to develop censorship-resistant software applications.
What does censorship-resistant mean?
A good litmus test for whether or not a product is “decentralized” is whether or not it can remain accessible without regard for entities like governments, Internet infrastructure providers, and even the creators of the software itself.
Using smart contracts hosted on a distributed ledger enables software to remain available to anyone with the resources and know-how to interact with a smart contract.
The DeFi Movement
Arguably one of the most successful marketing campaigns to come out of the Ethereum ecosystem, the DeFi movement began as a collaboration organized by a number of projects developing DeFi applications during late 2017 into early 2018.
Early participants in the DeFi movement include MakerDAO, dy/dx, Compound, Kyber Network, bZx, Dharma, and more.
The website launched to announce the movement defines the principles of DeFi as:
Interoperability and Open Source
Accessibility and Financial Inclusion
The explanation provided in the section on “Financial Transparency” effectively describes the goal of DeFi in stating: “market-level information should be transparent to all participants while still preserving individual privacy.”
DeFi Asset Classes
In the same way, we divide traditional investments into asset classes, we can also classify the different types of investments a person can make using various DeFi products and services.
The framework we outlined in our previous article on asset classes can also be applied to decentralized investment opportunities.
Using that framework, the four decentralized asset classes include:
Security Tokens and Derivatives
While the DeFi movement has only been around since 2017, in some ways, DeFi has been around for as long as cryptocurrency!
In our article on Cryptocurrency, we note that some of the earliest applications of Bitcoin, blockchain, and distributed ledger technology include a “pseudo-anonymous” poker tournament and the (in)famous pizza purchase.
As a form of currency, many of the earliest applications of decentralized cryptocurrencies include decentralized forms of common uses for fiat currency; in this case, gambling and commerce.
For individuals engaged in casual gambling or making small purchases over long distances, cryptocurrencies like Bitcoin provide a fast, pseudo-anonymous way to exchange value.
For things like large-scale gambling and ongoing commerce, however, extreme volatility in the value of cryptocurrencies makes it difficult to sustain their use when settling payments. Why use Bitcoin for purchases when it might have 30% more value in a week?
To solve this problem, people introduced stablecoins. Stablecoins are digital assets whose value is tied to that of an underlying asset, the most common example being the USD-pegged DAI stablecoin from MakerDAO.
Fiat- and commodity-backed stablecoins have been circulated as well but their status as “decentralized” currencies tends to be hotly debated since there tends to be a single organization responsible for minting and destroying the assets.
Trading and investing remain two of the primary uses of cryptocurrency and digital assets, which has led to the development of a variety of financial instruments.
Decentralized lending protocols enable lenders to earn interest by depositing digital assets into smart contracts.
When a trader wants to engage in margin trading or an investor wants to build a leveraged position, the smart contract enables them to borrow assets by depositing collateral to cover the interest paid out to lenders for making the assets available.
Security Tokens and Derivatives
Tokenized equities have been widely discussed since the ICO craze of 2017 but remain rare since they offer little if any advantage over regular equities.
The ongoing legal battles faced by companies like Kik and Ripple demonstrate that issuing tokens does not enable organizations to avoid compliance with regulations on securities and storing tokenized equities can be an unnecessary complication for many founders.
Decentralized derivatives, however, have become wildly popular.
The invention of decentralized prediction markets like Gnosis and Augur and synthetic derivatives platforms like Set Protocol and Synthetix has made it possible to make markets and invest in virtually anything that can be interpreted by an oracle.
Non-Fungible Tokens (NFTs)
Most cryptocurrencies are programmed to be divisible. For example, a single Ether can be divided using up to 18 decimals and many of the tokens created using the ERC20 standard follow the same pattern.
Non-fungible tokens (NFTs) are digital assets programmed to be indivisible. This enables them to be used as digital collectibles. If we wanted to create some kind of “limited edition” of some digital assets, issuing them as NFTs would be an effective way to do so.
Digital collectibles are already popular on certain gaming and social networking sites but NFTs are unique in that once they have been issued, their ownership depends on whoever controls the digital wallet containing the asset.
The digital cards purchased or earned through a game like Hearthstone can always be seized or destroyed by the manufacturer. If the cards were issued as NFTs, however, players could retain ownership of the cards and develop other games that make use of their properties.
Follow along as we add to our Binance.US Education 101 Series: Your Guide to Crypto Literacy
#1 Demystifying Digital Dollars
#2 Evolution of the Internet
#3 Finance, Rhymes with …
#4 Back that Asset Class Up
#5 What are Cryptocurrencies?
#6 Defining Decentralized Finance
#7 Cryptoeconomics Explained
#8 Intro to Consensus Algorithms
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