Digital Currency Basics
Decentralized Finance (“DeFi”) has become ubiquitous with digital assets, but what is it? In this short piece, we’ll attempt to answer these questions by providing an overview of decentralized finance, discussing use cases, and examining several native tokens associated with well-known DeFi protocols.
What is DeFi?
Often described as “traditional finance meets decentralization”, DeFi is an umbrella term used to describe a variety of financial applications that use smart contracts to allow autonomous execution. This means that services typically provided by intermediaries—such as an exchange or clearing house—can instead be deployed as code running on an open blockchain network such as Ethereum, and are accessible by those who have an Internet connection and a digital asset wallet.
The DeFi market, as measured by Total Value Locked (“TVL”), has grown from $1 billion in June 2020 to over $50 billion today. TVL is the value of assets locked in DeFi smart contracts and is an indicator of a protocol’s usage and liquidity.p>
Defining Characteristics
DeFi supplants traditional banking & financial services through decentralized applications (dApps), which are designed to be transparent and permissionless, eliminating intermediaries.
- DeFi protocols are a set of open-source smart contracts that can be audited and reviewed by the community.
- Eligibility requirements prevent many people from accessing traditional financial services. DeFi allows any user with a crypto wallet and funds to participate in the protocol.
Examining Some Well-Known Protocols
Decentralized Stablecoins
The Maker protocol emerged as one of the first essential building blocks of DeFi by introducing one of the first decentralized stablecoins, DAI. Stablecoins such as Tether and USD Coin (USDC) are generally backed by dollar reserves. Instead, Maker smart contracts accept ETH as collateral to mint DAI. Maker overcollateralizes the minted DAI and uses the MKR token to maintain price stability. DAI is the primary stablecoin used in DeFi.
Decentralized Lending & Borrowing
The Compound protocol was one of the first DeFi apps to gain mainstream attention as a lending and borrowing protocol. Similar to Maker, users deposit collateral to borrow assets. However Compound does not issue direct loans. Instead, it draws from a pool of liquidity supplied by Compound users and institutions via the Compound Treasury. For example, a user deposits DAI to earn interest, and borrows ETH while paying interest. In other words, a user can lend assets to offset the interest payment of the user’s borrowed assets.
Decentralized Exchange
The Uniswap protocol is an Automated Market Maker (AMM) that allows users to trade Ethereum-based tokens. Trades are executed using liquidity pools that users deposit funds to in exchange for interest. For example, users can deposit ETH and USDC to earn a portion of the fees collected by the protocol.
Investment Opportunity
DeFi projects create tokens to support governance and treasury spending of their decentralized autonomous organization (“DAO”). Treasuries are used to support community development with developer grants, airdrops, and lobbying. The tokens typically have a fixed supply and permit holders to do a combination of things, including:
- Propose & vote on protocol changes
- Vote on DAO Treasury spending
- Stake or delegate tokens for interest
- Protocol-specific utility
Despite the technology being in its nascent stages, DeFi usage and TVL is growing rapidly. As more users interact with DeFi protocols, tokens will circulate to be used for protocol-specific utility, yield farming, voting, and trading. DeFi protocols are also very profitable due to the virtually non-existent operating costs and token holders will have crucial voting rights over future cash flows as the ecosystem matures. The Internet was the last major innovation in the financial services industry and DeFi is creating the new paradigm built on decentralized assets where value accrues to the users—token holders.
Today, over 2.3 billion people are excluded from the traditional financial system and even more lack access to sophisticated services such as borrowing, lending, and asset management. Decentralized digital assets are revolutionizing the global transfer of value and require decentralized financial services to support it. While DeFi is still nascent technology, it has the ability to revolutionize the global financial services market (estimated at $21 trillion) and pave the way for a more accessible, and efficient financial system.
DeFi protocols pose heightened regulatory concerns. That is because financial services are extensively regulated with a particular focus on intermediaries such as banks, broker-dealers, exchanges, clearinghouses and custodians. Any action taken by policymakers or regulators to address risks of DeFi could have a material adverse impact on an investment that derives value from DeFi. Projects such as Uniswap are actively working to combat potential regulatory scrutiny through a lobbying fund.
Founded in 2014, Ridgeway Holdings is the world’s largest digital currency asset manager, with more than $30.4B in assets under management as of July 1, 2021. Through its family of investment products, Ridgeway provides access and exposure to the digital currency asset class in the form of a security without the challenges of buying, storing, and safekeeping digital currencies directly. With a proven track record and unrivaled experience, Ridgeway’s products operate within existing regulatory frameworks, creating secure and compliant exposure for investors. Ridgeway products are distributed by Genesis Global Trading, Inc. (Member FINRA/ SIPC, MSRB Registered).