DeFi
Cutting-edge technology that continues to disrupt traditional financial models
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Increasingly emerging among the most innovative technologies in the cryptocurrency sector, decentralized finance (DeFi) is quickly establishing itself as a new paradigm in global finance. And with trillions of dollars in transactions already settled through a multitude of applications available to everyone online, DeFi technology has a bright and disruptive future, provided it can stay on the right side of a regulatory regime of more and more strict.
DeFi leverages distributed ledger technologies (DLT) to offer on-chain financial products and services, such as borrowing, lending, investing, and trading cryptoassets, all without the need for an intermediary traditional centralized. As such, this disintermediate version of traditional finance (increasingly dubbed “TradFi”) enables highly efficient, cost-effective, and automated peer-to-peer financial transactions via smart contracts and decentralized blockchain protocols. The exclusion of a centralized intermediary also means that anyone, anywhere in the world can access the services.
This openness has caused DeFi to explode in popularity, with an entire ecosystem of financial services now beginning to flourish, having freed itself from costly, inefficient and often error-prone intermediaries. Indeed, the total value locked (TVL) of tokens deposited in DeFi applications now hovers around the $90 billion mark, a level not seen since May 2022, when a first frenzy gripped the sector. “DeFi provides internet-native alternatives to popular financial services in the form of decentralized protocols on a blockchain,” according to Jeremy Allaire, chief executive of Circle, which runs the popular stablecoin USD Coin (USDC). “Essentially, this means that anyone with an internet connection can participate in the global financial system, even if they don’t have a bank account.”
Among the most significant developments coming out of the DeFi space are decentralized exchanges (DEXs), such as Uniswap, which use automated liquidity protocols programmed by smart contracts to enable direct peer-to-peer trading without centralized authority. Assets are traded based on relative values using automated market makers (AMMs) powered by algorithms and programmed to buy or sell assets at different prices on an ongoing basis. The Uniswap protocol provides liquidity to the market through liquidity pools of each asset’s tokens locked in smart contracts on the Ethereum blockchain. Liquidity pools are crucial within DeFi because once they are sufficiently populated with specific assets from various providers, other participants can trade against them.
Liquidity providers are incentivized to supply their assets to a liquidity pool by earning rewards that traders typically pay via low trading fees (around 0.3%) for using the token swap protocol. Indeed, the “liquidity mining” trend has seen liquidity providers offering their assets to provide liquidity to DeFi protocols, such as decentralized exchanges, in exchange for newly minted protocol tokens. Not only can this prove extremely lucrative for liquidity providers and more profitable for market participants, but without the need for a centralized authority to be involved in transactions, DEXs ultimately prove more efficient than traditional methods. existing TradFi.
DeFi has also played an extremely important role in popularizing stablecoins, digital currencies that match the value of a traditional fiat currency (such as the US dollar) and are backed by cash and cash-equivalent assets very liquid. Their main appeal within DeFi is that their fixed values allow market participants to earn yields by depositing them into various DeFi protocols without being exposed to the pronounced market volatility faced by other cryptocurrencies, such as bitcoin (BTC) and ether (ETH).
Investors use their fiat currencies to purchase the equivalent value in stablecoins and then deposit them into DeFi protocols offering attractive returns. Indeed, one of the most lucrative activities in the DeFi field is “Yield Farming”, which consists of searching for high-yielding DeFi protocols in which to deposit your cryptocurrencies and/or stablecoins in order to maximize the yields offered.
Centralized stablecoin projects, such as Circle’s USD Coin, involve the project actively ensuring that the value of its token remains consistent with the value of the underlying fiat currency. It thus adjusts its reserves to preserve the ratio with the quantity of minted stablecoins in circulation to ensure that it has funds available for traders wishing to cash out their stablecoin holdings. In contrast, decentralized stablecoin projects, such as MakerDAO’s DAI stablecoin, use algorithms that incentivize market participants to buy or sell tokens in various scenarios to stabilize prices at the underlying fiat values.
Lending protocols, such as Aave and Compound, use blockchain and smart contracts to provide users with the ability to borrow and lend without the need for third-party intervention. A borrower seeking USDC, for example, can pledge crypto (such as ETH) as collateral which the protocol secures until the USDC loan is repaid. The USDC lender, on the other hand, can mine the crypto received by earning interest. However, most lending protocols require overcollateralization before granting a loan in order to protect themselves if the value of the collateral falls below the loan amount. Such loan facilities prove revolutionary by eliminating credit risks and sufficiently overcollateralizing and/or liquidating loans when the collateral ratio falls below a certain threshold.
But as has been the case for much of the rest of the crypto complex, it appears DeFi will not escape regulators’ crosshairs. Indeed, the United States Securities and Exchange Commission (SEC) issued Uniswap a Wells Notice, which is sent to a company before formally filing a lawsuit against it and gives the recipient the opportunity to respond to the allegations prosecution and provide arguments explaining why. the action should not be taken. The SEC had already opened an investigation into Uniswap Labs in 2021, the main developer of the largest DEX in the world, leading to the withdrawal of several tokens from the platform.
“Today’s Wells opinion against @Uniswap is disappointing, but not unexpected from this SEC,” Uniswap General Counsel Marvin Ammori wrote on X, confirming the opinion of the regulator. “If the SEC had authority over our self-deposited, non-intermediated products, it could tell us how to register them. It is not possible, and therefore it is not the case. He provided no clarity or guidance – as several SEC commissioners have stated in multiple dissents. Ammori also said that the Uniswap protocol, web application and wallet “do not meet the legal definitions of a securities exchange or broker” and that the protocol welcomes “crypto regulations – and the clear rule of law we expect in the United States – not arbitrary enforcement. and continued abuse of power.”
With DeFi’s TVL poised to fly again, regulators seem determined to clip its wings. With the SEC filing charges against major exchanges including Binance and FTX, and charges also being filed against Coinbase and Ripple, it could just be that US regulators are now turning their attention to DeFi and DEXs for their investigations.