The Rise of Decentralized Finance (DeFi): What Are the Use Cases?

In arecent interviewwith CNBC, Paul Maley, CEO of Deutsche Bank, stated that “any bank that wants to remain competitive in the future must ensure it has the ability to interact and interoperate with DeFi systems as they emerge. “This will indeed happen, but the question everyone is asking is how and in what order. We don’t know the answer to those questions.”

While such a statement demonstrates the traditional banking industry’s interest in decentralized finance (DeFi), it also perfectly illustrates the innovative potential of this ecosystem. 

DeFi, or open finance, is seen as analternative to the traditional banking and financial system, built on open and decentralized blockchain networks (such as Ethereum, Binance Smart Chain, Terra, Solana, Avalanche, etc.). The goal of DeFi is to provide greater access to financial services traditionally offered by banks and financial institutions, without the need for a trusted third party. Since the emergence of DeFi,approximately $106 billion in assets have been invested in decentralized finance protocols. 

 

Decentralized finance protocols necessarily rely on a decentralized infrastructure. Indeed, programmable blockchain networks serve as the foundation for the development of these decentralized applications (DApps). Among them,Ethereum is undoubtedly the blockchain most deeply involved in decentralized finance. 

Why DeFi? 

The rise of decentralized finance stems from a simple observation: our access to financial services often depends on our social class or geographic location. Yet financial inclusion goes hand in hand with social inclusion. Indeed, a person who lacks access to basic financial services (such as the right to a bank account and credit) risks becoming socially excluded. While in France therate of bank account ownership is estimated at 99%, in many countries (particularly in Africa and South America), populations face significant challenges such as inflation, the absence of basic services, and a clear lack of financial institutions. In 2017, areport from the Global Findex Database estimatedthat 1.7 billion adults worldwide currently lack access to basic financial services.

From this perspective, DeFi is seen by some as a financial revolution—a new, more inclusive cycle built on new foundations that, in some respects, differ significantly from those of the traditional financial system.

The Characteristics of DeFi

Public and open to everyone. Anyone with an internet connection and an address on a compatible blockchain (e.g., Ethereum) can access it. 

Interoperable.DeFi is an ecosystem of protocols designed to work together. These protocols are not always in competition with one another; in many cases, they evolve in harmony and reinforce one another.

Programmable. The smart contracts that underpin DeFi protocols can be coded by anyone and can execute themselves.

Resilient. The infrastructure of blockchain technologies—which are immutable and tamper-proof—is more resilient when it comes to providing these financial services. 

Use cases

Lending and borrowing services 

Lending markets are one of the main use cases of decentralized finance. Decentralized lending protocols connect borrowers with lenders of crypto assets. A popular platform, Compound, allows users to borrow crypto assets or deposit their own crypto assets so that other users can borrow them. Depositors earn interest, paid out in the same crypto-asset as the one deposited. Most decentralized lending protocols set their interest rates algorithmically, so if there is higher demand to borrow a crypto-asset, interest rates will be pushed higher.

Decentralized exchanges (DEXs) 

At first glance, decentralized exchanges are similar to traditional platforms, such as Coinbase, Coinhouse, Kraken, or Paymium, for example. But while the latter are centralized, most DEXs are not managed by any central entity (however, some major DEXs like Uniswap are managed by a company in parallel). These protocols allow users to trade a wide range of crypto-assets, most of which are not listed on centralized exchanges. 

DEXs operate primarily using liquidity provided by users of the protocol. In fact, to facilitate transactions without a central authority, different crypto-asset pairs are pooled together in liquidity pools—which are directly funded by crypto-asset holders who wish to earn a portion of the transaction fees. 

To date, most active DEXs are deployed on the Ethereum network. The best-known ones are Curve, Uniswap, SushiSwap, and Balancer. 

Staking protocols 

Participating in the validation of transactions on a blockchain is often complex and costly, requiring technical expertise and financial resources. Liquid staking revolutionizes this process by allowing anyone, even without technical expertise, to contribute indirectly to validation by staking their assets.

While staking requires running a full network node—which creates a financial barrier to entry—some protocols allow anyone holding a certain amount of a protocol’s token to participate in validating transactions on the network. Liquid staking therefore offers a more accessible alternative for investing in transaction validation, thereby broadening participation in this crucial blockchain function. By simplifying the process while lowering the financial barrier, liquid staking makes transaction validation more inclusive, allowing more people to contribute to the security of blockchain networks.

To date, the most widely recognized staking protocols are Lido and Rocket Pool. 

Merchandise 

Derivatives are financial instruments whose value fluctuates based on changes in the rate, price, or any other variable associated with another asset known as the underlying asset. Generally speaking, these products are used by savvy investors who wish to hedge against a variety of risks—such as currency risk, volatility risk, or other risks. 

The main categories of derivatives are:

• The future;
• Swaps;
• Options; and
• The forwards. 

In recent months, the issuance of derivatives has gradually grown within blockchain technologies and the DeFi ecosystem. They generally require an oracle (i.e., a program that sends information to smart contracts that is not “natively” contained within them) to track these variables, and thus introduce certain dependencies and centralized components.

To date, the best-known projects specializing in decentralized derivatives are Synthetix, UMA, and dYdX.

Aggregators

Decentralized exchange aggregators allow DeFi users to trade assets at lower costs.

These platforms compile information on most decentralized exchange protocols to aggregate the liquidity levels and exchange rates offered by these platforms and provide users with the best comparison. 

To date, one of the best-known DEX aggregators is Paraswap. 

Insurance

To mitigate risks associated with the operation of DeFi protocols—including risks related to smart contract hacking or the risk of a stablecoin losing value—users can purchase decentralized “insurance policies” on the Ethereum network. Specifically, users contribute their crypto-assets to a liquidity pool in exchange for interest, and if a risk materializes (which is inherently random), those who have purchased the “insurance policy” are compensated from the funds held in the liquidity pool. 

Several projects, such as Unslashed and Nexus Mutual, offer this type of service on the Ethereum network. 

Online dispute resolution platforms

Some decentralized finance protocols use smart contracts to resolve various types of disputes, including those related to commercial matters, intellectual property, and decentralized governance. This is akin to a form of private arbitration to which users of a smart contract consent by choosing to use it.

Kleros is the most widely used decentralized justice protocol to date. Founded in 2017, the platform allows holders of the protocol’s native token ($PNK) to serve as anonymous jurors and participate in dispute resolution. Since its deployment on the Ethereum blockchain, the platform has facilitated the resolution of more than 900 disputes. 

And a wide variety of other use cases…

Finally, it is worth noting that there are a variety of other use cases in the DeFi sector, such as prediction platforms (with Augur), no-loss lotteries (with PoolTogether), real estate investment platforms that interact with various protocols like Aave (with RealT), the stabilization of expected future yields from a DeFi protocol (with APWine), projects related to the governance of DeFi protocols (with Paladin or StakeDAO), etc. 

Conclusion 

In many ways, decentralized finance is reshaping the current financial system. Thanks to its inclusivity, accessibility, and decentralized nature, its applications—still under development—offer an attractive alternative to the financial services provided by traditional financial institutions. To date, more than $50 billion in assets are under management across various decentralized finance protocols, and this figure is expected to continue growing. 

DeFi, a virtuous system, fully leverages the opportunities offered by blockchain networks, which ensure the traceability of past transactions (since the transaction ledger is public), mitigate counterparty risk (a user can only borrow if they have previously deposited collateral of a higher value on the same protocol), and are resistant to censorship (blockchains are based on a decentralized architecture and are accessible to anyone with an internet connection).