The Decentralized Finance (DeFi) space has witnessed exponential growth over the past years. As the disruptive Defi sector continues to evolve, there has also been an increased number of financial decentralised applications (dApps) developed to democratize equitable access to innovative financial services.
Unlike the Traditional Finance (TradFi) ecosystem which is inherently centralized in nature, Defi is uniquely composable, permissionless, and transparent. Therefore, through Defi permissionless decentralized networks replace expensive centralized databases, whereas algorithmic codes replace fixed interest rates; and finally transparent tamper-proof smart contracts agreements replace the opaque procedures that characterize much of traditional banking.
The Total Value Locked (TVL) across Decentralized Finance (DeFi) blockchains has grown from less than $1 billion in April 2020 to a peak of over $250 billion in November 2021.
Nevertheless, this amount has significantly dropped as a result of the recent market downturn, the Terra Luna crash and other contagion risks that have negatively affected the crypto market.
Decentralized Applications (DApps) and their Importance
Decentralized Applications (DApps), are described as open-source applications that operate autonomously with their backend code (smart contract) running on a publicly accessible decentralized blockchain. Thereby allowing all network participants to keep track of the happenings within the application. This implies that, unlike traditional applications whose data are typically hosted on a centralized server, which consequently means that there is a single point of failure, thereby making the data susceptible to attacks. In the case of decentralized applications, the front-end remains similar to that of traditional applications, whereas the backend is typically a decentralized blockchain network such as Ethereum or Bitcoin having distributed censorship-resistant nodes. Therefore, it is extremely difficult to completely bring down a DApp as it would require a hacker to infiltrate all the distributed hosting nodes within the blockchain network since there is no central point of attack, as in the case of traditional (Web2) applications.
Financial DApps primarily rely on smart contracts to execute the transactions between multiple parties without the need to rely on an intermediary such as settlement networks or financial clearinghouses that mostly charge huge fees and can also be compromised. Therefore, the rule of operations of decentralized applications cannot be altered or modified by any single authority or institution. This is because smart contracts completely replace the intermediary role of centralized financial institutions simply with self-executing lines of code built into a blockchain. Thereby, implying that all finance dApps are censorship-resistant, inherently permissionless and free of any interference or control from a single entity.
As a result, users of financial dApps tend to enjoy substantial benefits, some of which include safeguarding of privacy and confidentiality, since there are no intermediaries within the financial value chain. In addition, developers enjoy flexibility because the codes are open source, and can be utilized or even forked.
It is also important to note that Financial-based dApps typically have cryptographic tokens used to reward network contributors such as liquidity providers. Additionally, there must be a clearly defined consensus mechanism for the token generation.
As time goes, it is predicted that most decentralized applications (dApps) might eventually outpace centralized applications in terms of network valuation, adoption rate, and utility. This is primarily as a result of the structural flexibility, transparency, superior incentivization and distributed nature of these applications.
APPLICATIONS OF FINANCIAL DAPPS
In terms of applicability, financial dApps tend to provide different user groups with a vast array of functionalities which ranges from decentralized exchanges, derivatives trading, as well as savings, lending and borrowing functions.
Decentralized Exchanges (DEXs)
These are autonomous decentralized applications that serves as a peer-to-peer (p2p) marketplace where cryptocurrency traders can make direct transactions without the need for a central intermediary. The daily trading volume across the major Decentralized Exchanges (DeXes) runs in billions of dollars even despite massive capital wipeout and general market downturns experienced since the beginning of 2022. This further signifies the increased confidence of market participants to freely exchange value with others directly through decentralized mediums with no central intermediaries or counterparties.
This type of infrastructure is entirely different from centralized exchanges, since DeXs are non-custodial solutions that enables cryptocurrency buyers and sellers make transactions without having to give control of their funds or wallet’s private keys to a centralized custodian. Hence, all transactions on decentralized exchanges are facilitated through the execution of smart contracts. Using DEXs such as Uniswap and SushiSwap does not require the typical Know Your Customer (KYC) procedure. The diagram below shows an overview of the DEX Daily number of transactions by DApp.
Although, there are certain Terms and Conditions (T&C) that needs to be met, one of which is that the user’s wallet must be compatible with the smart contract on the DEX network. Decentralized exchanges enable permissionless access to various financial services such as token swaps, yield farming, liquidity provision, and staking. Typically, DEX has their native token which is used to pay for transaction fees and also gain governance rights to influence changes over the protocol.
Synthetic Asset and Derivatives Trading
The evolution of Defi has facilitated the emergence of innovative financial products, and one of these innovations is the concept of synthetic assets. Synthetic assets derive their value from real-life financial assets such as stocks, commodities, and other underlying digital assets. DApps such as Synthetix which is hosted on the Ethereum blockchain, enable users to create synthetic assets and track their real-world value even without actual ownership over the assets themselves. Therefore, users all over the world can gain exposure to US equities, stocks, gold and other tokenized financial assets without ever having to own the actual asset which they represent.
A derivative, on the other hand, can simply be described as a mutual contract between multiple parties which is fundamentally based on the value of an underlying financial asset. DApps such as DyDx provides derivatives trading functions through which traders can speculate on the future price movements of different cryptocurrency assets, in hopes of making profits even without having to acquire the asset itself. Corporate businesses and traders also use derivatives for hedging purposes, in a bid to mitigate risks against another position which they have taken in the market.
Lending and Borrowing
The democratization of financial services through dApps has enabled frictionless economic activities such as borrowing and lending in the crypto space.
DApps such as Aave are non-custodial liquidity market platforms that facilitate the offering of crypto loans through which users can participate as depositors or borrowers in an open, transparent, and trustless manner. These DeFi lending and borrowing services allows depositors to provide liquidity or loan their crypto assets to accrue interest. Similarly, users could also borrow by simply using their deposited assets as collateral while enjoying the trustless benefits that the underlying blockchain provides.
The Aave protocol has a Total Value Locked (TVL) of around $5 billion, which is primarily spread across the Ethereum, Polygon and Avalanche blockchain, just as represented in the diagram below.
The lending and borrowing services provided by various DApps have helped in decentralizing access to essential financial services in an unbiased manner. Similarly, other DApps such as Sturdy finance are DeFi lending protocols for interest-free borrowing and high yield lending, whereby the staking rewards are uniquely used to pay interest to depositors.
Limitations of Decentralized Applications
Although finance DApps represents a formidable alternative to traditional financial services, however, the evolution of these DApps is in its very early stages. As a result, there are still some core limitations associated with these applications.
Some of the main technological drawbacks associated with decentralized applications are mainly rooted in the existing limitations of the underlying blockchain. As established, most financial DApps are powered by blockchains such as Ethereum which is presently the leading blockchain-based DApp platform, and this blockchain still has some substantial scalability issues specifically in terms of network congestion, and limited speed. This consequently metamorphoses into high network fees, slow transaction pace or completely failed transactions in financial dApps. Thereby affecting the overall performance and productivity of these applications.
The final limitation relating to Decentralized Applications involves the regulatory risks. The anonymity of peer-to-peer transactions, and lack of intermediaries on decentralized exchanges coupled with the global reach of DeFi, present amplified compliance risks for all actors within this space. DeFi is still in its infancy, therefore, in the absence of clear regulatory guidance, financial DApps face vast compliance issues due to unclear regulatory obligations.
Presently, the United States Securities and Exchange Commission (SEC) is investigating Uniswap Labs, the main developers of the Uniswap DeX. The enforcement attorneys associated with the Uniswap investigation are seeking more clarity on investors’ use of UniSwap, and this could implicate a host of considerations, ranging from consumer protection to anti-money-laundering enforcement and potential federal securities law violations.