Decentralized Finance – The Emergence Of DeFi

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Disclaimer: Crypto is a fast-paced economy and things change quickly. Information on this post might be outdated even if written today. Do your own due diligence and stay safe. I might get affiliate commissions for purchases made through links in this post. Read the disclosure.

Alpha Gained:

DeFi as in Decentralized Finance. For us to understand defi we have to understand centralized finance. Centralized finance is all your banks, middlemen, brokers, etc. Every financial institution and centralized exchange that is maintained by corporations is all inside the umbrella called centralized finance.

Centralized finance

In centralized finance, you as a person do not own the keys to your bank account, you do not own your money and assets. It is ultimately the corporation, exchange, bank, or other entities that own the assets and money you have.

While you do have account usernames, passwords, and other account-related keys. The bank for example can seize your money the moment they wish to do so. While you might feel like this can’t be true or this can’t actually happen. It truly does happen and people do lose money this way. It’s unfortunate, but the reality is that when you use services from centralized finance, you are running a risk of assets being locked away by some unfortunate event.

The Money Flow In The Centralized Exchanges

Usually, trading is executed on centralized exchanges (CEX’s) using a limit order book mechanism. When you make a sell order, you are matched with a buyer to make the trade. When you want to for example trade ETH to BTC through a CEX, the platform first transfers your ETH to the CEX operator, waits for a buyer to show up, and then withdraw the incoming BTC from the market operators after the execution of their orders. So in a nutshell the funds are CEX’s to use and things can go wrong.

Examples Of Centralized Exchanges

Decentralized Finance

In decentralized finance, there is no government, bank, middleman, or any one entity that controls the flow of money. DeFi blockchains can operate through staking which we covered before and thus no single user, corporation or anyone can lock up your assets. That is because you own your private keys, you own your digital currency and asset wallet. Only you have access to your wallet and only you can mess up your finances.

Yes, it is true that this puts more responsibility on an individual and some individuals are more prone to accidents and misuse of private keys thus centralized finance might suit them better.

However, if you are one that likes to have total control over your money and wealth, then it’s a good time to look into decentralized finance and what it can offer you.

Decentralized finance is most prominent on blockchains and handling crypto assets and cryptocurrency. That is because centralized finance is usually physically located in one or multiple places.

Decentralized finance lives on thousands of systems running validator nodes. Nodes that validate the money flow inside the blockchain network. A network that is formed by thousands of individuals and persons like you and me.

What Are Decentralized Exchanges (DEX’s)

Decentralized exchanges are platforms to trade tokens from one token to another. However, when talking about dex’s one should note that you can’t trade anything and everything in a dex. 

So for example, you cannot currently trade ADA token to ETH token inside the Uniswap dex. Also trading as it is understood in centralized exchanges is not yet fully available in dex’s. Uniswap which is the biggest dex in the crypto space (at the time of writing) is only supporting ERC20 tokens, meaning tokens built for and on the Ethereum blockchain.

For this very reason when thinking about dex’s, one must notice that the world is missing a dex platform that combines every blockchain out there and bring token exchange into one place.

Currently, if you want to trade tokens in a decentralized manner, you need to exchange tokens inside either Ethereum, Algorand, Solana, Polkadot, etc. blockchain, but you can’t trade ETH tokens with DOT tokens for example.

Developers are hard at work, building a dex that supports every blockchain in the crypto space, Solanax for example is one aiming to create cross-chain dex, DFYN being another one. The challenge lies in the way the cryptographic encryption is made, in the different hash algorithms. For example, Bitcoin uses SHA-256d and Ethereum uses Ethash. 

Because the hashing algorithm and the way the blockchain was developed differ from one another, it makes it pretty challenging (not impossible) to connect different blockchains together.

How Tokens Work Inside A DEX?

DEX’s are based on smart contracts running on a blockchain. So instead of pairing your sell or buy order with another person, the trades are completed immediately when the orders are recorded to the blockchain. 

For example, when you trade BTC and ETH, the DEX you use offers a smart contract (liquidity pool) with locked-in funds for these two cryptocurrencies. So when you want to trade BTC to ETH, you will just send your ETH to the smart contract and the contract will return BTC to you. 

The exchange rate is primarily determined by the ratio of BTC to ETH locked in the smart contract. So in a sense, you are getting someone else’s BTC from the smart contract, directly from the liquidity provider.

Uniswap

Uniswap is currently the biggest Ethereum based dex in the crypto space. With a whopping 24% market share of all dex’s, it sits at the very top of the list. You can swap ERC20 tokens in uniswap and even though you see BTC there, it is wrapped in the ETH (WETH) version of the token and thus you should do your own research before trading/swapping anything in Uniswap. Other notable dex’s in Ethereum are SushiSwap which also accepts BSC, Avalanche, Fantom, Arbitrum, Polygon, etc. blockchain tokens. However, you have to switch between different blockchains when you want to trade certain coins or tokens.

While there are dex’s that support other blockchains, the token trading still takes place in their own blockchain, not inside one blockchain and while you might be able to trade BNB (Binance coin in Binance Smart Chain) for ADA (Cardano) for example, the price impact makes the whole process not worthy.

PancakeSwap

PancakeSwap is developed on the Binance Smart Chain (BSC) blockchain. CAKE gives you fast transactions and an easy-to-use interface to do trading, staking, etc. The only problem with BSC is that it’s not fully decentralized, making CAKE not fully decentralized either. So when you are looking for a decentralized blockchain and experience you would have to know the underlying blockchain and how it is maintained.

Liquidity In Decentralized Finance

Liquidity is the one single important thing that runs a dex successfully and makes decentralized finance a challenge to build efficiently. In traditional centralized exchanges, you transfer funds to example Binance or Kucoin and by trading on their platform you pay a small 0.5% to 1% trading fee.

After multiple attempts to make dex work for the user (limit order books), dex developers settled on liquidity pools. As dex’s wasn’t used too much, and there were not so many people involved in the crypto space, liquidity pools were the one thing that started to make sense. Creating a limit order book to a dex requires deep liquidity and a fast chain to execute the transactions fast enough.

AVAX-SUSHI Liquidity Pool, you can swap AVAX for SUSHI

In liquidity pools, users add their assets to a pool to increase market liquidity. The assets are frozen on a special smart contract that conducts the trades/swaps and protects the funds in the pool.

Initially, the pool only had two assets that could be changed among themselves. When a pool is created, the pool creator sets the starting exchange rate, and after that, anyone can add assets to the pool to increase the liquidity.

Each exchange in the liquidity pool results in a movement in the exchange rate. This process is called an automatic market maker (AMM). When making a swap/trade, the volume of the coins of the first asset increases, and the volume of the second asset (trading-pair) decreases, this results in a change of course. When a trade is made, the liquidity providers will get a commission.

However, the thing is that trading in dex’s is not yet (at the time of writing, but things move fast in crypto) at the level that centralized exchanges offer. Where you can set the price you are willing to pay and trade any token easily and effortlessly.

Total Value Locked As Health Metric In DeFi

TVL as in Total Value Locked in a given blockchain. The reason why TVL is so important is that TVL somewhat represents a fundamental metric of how much value/tokens/coins/money is locked/staked inside a blockchain. This value gives you an idea of what chain is trusted and also what chain is most used.

Mcap/TVL ratio tells you how much value is locked into a chain in contrast to the market cap of the chain. When TVL is growing, it means people are “trusting” the chain and moving funds inside the chain to make it more secure and usable. The more funds staked to a chain, the healthier the chain is and will be.

If you want to know whether a chain is over or undervalued, the simple way to do that is that the bigger the number the worse the situation from an ROI perspective. The more assets are staked the lower the return fee is. This is a good thing but also a bad thing. Good thing is that the chain is trusted and used, the bad thing is there are fewer rewards to be distributed because there are so many users collecting them.

However, values like 1 or 10 do not always tell the whole truth, as you need to take into consideration the utility of the token. What the token can and cannot do. This also makes a huge difference whether something is over or undervalued. However, if you see a quality chain with a low number like 1-3, it’s more than likely undervalued.

Digital Wallets In Crypto

For you to be able to trade inside dex’s you need a digital wallet or software for your cryptocurrency wallet. You can also opt for a hardware wallet like Ledger when you seek an extra layer of security. One of the most used software wallets is MetaMask and TrustWallet. Both are available for mobile phones, but MetaMask is also available for Chrome as a browser extension.

This extension makes dex’s pretty easy to use when trading at Uniswap or in PancakeSwap. At first, it feels like you are doing super alien stuff when creating your own wallet and getting it to work in Uniswap, but after a while, you get used to it and see the benefits of owning your assets 100%.

What should be noted here is that the wallet address that you will get when creating your own wallet is not private in the sense that only you know it. In a way, it is universally always visible to others and other users can see the transactions you make with your wallet, and that in a sense creates security to the network. That is because the transactions in the crypto space are open and trusted by the way the information is shown openly between participants.

However, for someone to actually know your public address is very unlikely as it’s very unique and not easy to figure out by any means, other than publicly sharing it with someone.

Fees In Decentralized Exchanges

DEX’s usually charge a percentage transaction fee for each trade/swap. Now, when this fee is charged, it’s redistributed among the liquidity providers. So when you lock up your funds into a trading pair and someone comes to use that DEX and swap a token inside the liquidity pool that you have chosen, you will earn tokens a.k.a rewards.

The Future Of DEX’s

If we think Ethereum blockchain, we must acknowledge Uniswap, when we think Binance Smart Chain, we must think PancakeSwap. Even though it is pretty convenient to swap tokens to another inside the mentioned dex’s. The issue of trading comes from the fact of not being able to trade efficiently and with multiple native trading pairs.

In 1inch DEX you can use a classic trading view based model to trade/swap your tokens, but for example trading ETH to BTC isn’t possible without trading ETH to Wrapped BTC, native tokens (BTC for example) are not available when talking about different blockchains. This makes the user experience confusing and not easy to trust.

In one sense wrapped BTC is the same as BTC, but the wording Wrapped will more than likely confuse users and thus the adoption for DeFi based money management and usage slows down.

For you to profit inside a dex is questionable. The ease of use is also questionable (when you are first starting, that is). For some reason, I can not see a future where dex’s are siloed into one blockchain technology.

So what we can see today is the rise of cross-chain dex’s. Dex’s that work with multiple blockchains and combine them together to create one massive dex. Polkadot is one of those blockchains that has introduced a technology to create parachains, which create a massive network of blockchains.

So creating a dex for Polkadot would potentially become the largest dex overnight. As of right now, Acala took the spot as the Polkadot’s main DEX. However, we have to acknowledge that Polkadot is kind of creating the same thing that Ethereum, Solana, Avalanche, Fantom, and all other chains are creating collaboratively. Making Polkadot a bit useless?

But the big change will come when there will be only one DEX. After that things will get very interesting. That would mean only one liquidity pool for every token pair, one central place to trade and swap tokens. Something that has been seen already is Curve and SolidSwap (Solidly) creating a DEX that offers deep liquidity for stablecoin swaps, but in the future for volatile assets too. 

Aggregators In DEX’s

Aggregated DEX’s like 1inch DEX enables you to get the best price from multiple DEX’s in the given blockchain ecosystem. So rather than using just one DEX, you are kind of using all of them at the same time. If anything the best DEX’s are not reliant only on one source of liquidity, hence aggregated DEX is a promising feature to have inside a DEX.

Cross-chain

Another feature that should be incorporated inside a DEX is a cross-chain feature. Cross-chain means that the DEX is compatible with other blockchains, so the DEX wouldn’t only work inside e.g. Ethereum blockchain. While cross-chain is somewhat already enabled feature, I still see it lacking that one interface, one network, one wallet mechanism that CEX’s have. Metamask is far in the game, but we still need Solana, Cosmos, and Cardano to be integrated into one wallet like Metamask.

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Written By Juha Ekman

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