Introduction

DeFi stands for Decentralized Finance, and it’s essentially a financial revolution fueled by blockchain technology. Over the years, it has become a crucial part of the global financial landscape, offering programmable, transparent, and anonymous financial services. One of its defining features is its inclusivity; anyone, regardless of age, location, or wealth, can join in without the hassle of identity verification. At its core, DeFi relies on decentralized blockchains and smart contracts. Once these protocols are encoded into smart contracts, users can seamlessly access the system by connecting their wallets.

What is DeFi?

DeFi, short for Decentralized Finance, is the product of blockchain technology merging with finance. Blockchain is the underlying protocol upon which various financial service scenarios are built, such as lending, trading, stablecoins, insurance, contracts, and lotteries. It achieves decentralization, open source, queryability, and anonymity and allows anyone worldwide to participate freely.

Financial services in DeFi do not rely on brokers, exchanges, or banks. Instead, they utilize smart contracts on the blockchain to match transactions. From the protocol layer to the data layer and application layer, all aspects are governed in a decentralized manner. Users can access DeFi services by connecting their blockchain wallets, and no central authority can stop transactions or deny access. In traditional finance, users must undergo cumbersome procedures like identity authentication, background checks, and credit report assessments to collateralize assets for borrowing. However, in DeFi, users only need sufficient collateral assets in their wallets to complete borrowing within minutes easily.

DeFi Ecosystem’s Top Ten Sectors

The development of DeFi can be traced back to the birth of Maker DAO in October 2017. Since then, hundreds of DeFi products have emerged, and the DeFi ecosystem is gradually expanding. From the initial stablecoin and lending services to today’s liquidity mining services and RWAs (Real World Assets), this article will introduce them based on the classification of the well-known DeFi data analysis website Defillama.

Stablecoins

For cryptocurrencies, measuring the value of their tokens is very important. In DeFi, this is mainly addressed by minting stablecoins. Currently, the mainstream approach is to peg them to other assets (such as the US dollar), as seen with common ones like USDT/USDC/DAI. Their prices are generally stable against the US dollar. With stablecoins, other assets (such as BTC/ETH/SOL, etc.) can be paired with them to create new trading pairs and freely circulate in DeFi. In addition to USD stablecoins, there are also stablecoins pegged to various currencies, such as Euro stablecoins, Yen stablecoins, etc.

Decentralized Exchanges (DEX)

DEX (Decentralized Exchange) is a platform running on the blockchain that allows users to trade directly with each other without the need for central institutions or third-party service providers.

The biggest advantage of DEX is that it uses blockchain technology and immutable smart contracts to ensure high determinism. Centralized exchanges like Coinbase or Binance use internal matching engines for trading, while DEX executes trades through smart contracts and the blockchain. Additionally, DEX users can manage their account funds completely independently through their wallets.

DEX users typically incur two types of fees: network fees and transaction fees. Network fees refer to gas fees for on-chain transactions. In contrast, transaction fees are paid to underlying protocols, liquidity providers, token holders, or all of the above, as the protocol specifies.

Lending Protocols

Decentralized lending protocols connect lenders and borrowers in a decentralized manner. They enable borrowers to borrow cryptocurrencies from the platform and pay interest while allowing depositors to earn interest by depositing cryptocurrencies. The entire lending process is executed without intermediaries.

In DeFi lending, transactions like deposits, loans, and liquidations are executed through an on-chain smart contract. Once conditions are met, the contract code is automatically executed, eliminating the need for manual approval processes, which streamlines the lending process and improves efficiency.

Bridges and Cross-chain Protocols

In the world of blockchain, different cryptocurrencies often operate on different consensus mechanisms, operating methods, and programming languages. In most cases, there’s no direct way to transfer assets like in traditional financial services. Cross-chain bridges address this issue by connecting different blockchain networks, acting as bridges between them.

In addition to asset transfers, there’s a need for message passing between different chains, leading to cross-chain protocols that facilitate both information and asset transfers.

Farming and Yield Aggregators

Decentralized exchanges rely on smart contracts to allow users to trade freely. Liquidity providers play a crucial role by supplying funds or asset pairs and receiving a portion of the trading fees.

This method of providing funds for returns is called Yield Farming. Yield strategies are not limited to giving liquidity but include various ways to earn returns. These protocols where users place funds are also referred to as Farms. With the proliferation of Farms, users often need to navigate different protocols to manage funds and returns efficiently, leading to the emergence of yield aggregators. These platforms aggregate farming opportunities, allowing users to access multiple yields in one interface.

Index

The simplicity of index investing offers significant advantages. Anyone can allocate their funds to indexes such as ETFs or mutual funds, gaining exposure to diverse asset portfolios and competitive returns in broader markets. This approach requires minimal knowledge, making it a “set it and forget it” investment strategy.

With the continuous development of the crypto industry, many investors opt for indexes as their investment choice. Common indexes include sector indexes and specific range indexes. Sector indexes focus on specific industries, like DeFi, allowing users to invest in different project tokens within that industry. Range indexes cover specific scopes, such as the top ten token market capitalizations, providing a comprehensive view of the performance of top tokens.

Derivatives

Derivatives are contracts whose value is derived from underlying assets such as stocks, commodities, currencies, indices, bonds, or interest rates. Futures, options, and swaps are common derivatives, each serving different trading purposes. Investors trade derivatives for various reasons, including hedging against volatility in the underlying asset, speculating on the directional movement of the underlying asset, or increasing exposure to the asset. Derivatives are inherently risky, requiring investors to possess rich financial knowledge and strategies.

Like traditional derivatives, decentralized derivatives derive value from underlying assets but are traded on blockchain-based protocols. They typically allow users to retain control of their assets and keys, eliminating the need to transfer them to centralized platforms or third-party custodians.

RWA (Real World Assets)

Real World Assets (RWAs) are a class of crypto tokens representing tangible assets outside the digital realm. These assets can include bonds, real estate, commodities, and machinery, among others. RWAs enable these assets to find a place in the decentralized finance (DeFi) ecosystem, enhancing the accessibility of traditionally hard-to-access financial instruments and opening up new application possibilities.

Crypto-backed RWA tokens offer innovative solutions to inherent challenges in traditional financial assets. One of the most transformative benefits they provide is lowering the barrier to entry. By enabling fractional ownership of real-world assets, they allow people to purchase tokens representing parts of assets like real estate or bonds, fundamentally reducing initial capital requirements and expanding accessibility to previously price-prohibitive markets.

Insurance

Insurance, in legal and economic terms, is a risk management method primarily used for economic loss risks. Various risks exist in Web3, such as fund theft, protocol hacking, stablecoin deviations, etc. Different decentralized insurance solutions have emerged to address these risks.

Web3 insurance not only addresses risks in different blockchain worlds but also integrates this technology with traditional insurance. For instance, some projects offer flight delay insurance or agricultural insurance for farmers.

Liquidity Staking

Liquidity Staking, also known as Liquid Staking, refers to users gaining liquidity by staking their assets. Liquidity staking allows investors to stake their assets and also enables asset stakers to obtain liquidity in the form of derivative tokens.

Currently, the most widespread application of liquidity staking is in POS token liquidity staking. POS blockchain consensus mechanisms require node operators to stake a certain number of tokens to gain node operating rights. Under the incentive of receiving network rewards for staking, many POS tokens are staked to nodes, such as Ethereum’s ETH and Solana blockchain’s SOL.

Advantages and Risks of DeFi

To better understand the significance and advantages of DeFi, it’s essential to be clear about the problems existing in traditional finance. Specifically:

• High barriers to financial services prevent some people from opening bank accounts or using financial services.
• Strict conditions for opening financial services, with all financial services requiring government oversight and control, resulting in a lack of diversity in available financial products.
• Central institutions capture most of the profits, leaving limited returns for investors.
• User data is controlled by centralized institutions.
• Governments and centralized institutions can arbitrarily shut down financial services, leaving investors’ assets out of their control.
• Trading hours are controlled by central institutions, limiting users’ ability to trade freely anytime, anywhere.
• Complex financial service processes, with asset transfers taking several days and high intermediary transaction costs.

In such circumstances, user participation in financial services is heavily restricted, making the advantages of DeFi obvious. Compared to traditional finance, the benefits of DeFi are as follows:

• Anyone can participate, with users only needing a wallet to access all financial services.
• There are no policy barriers, as anyone can create their financial products through open-source protocols.
• Most of the profits go to users, with platforms only receiving a small portion of trading fees, and everything being transparent, giving users choice.
• Anonymous trading, without revealing user identities.
• Trading is available 24/7, allowing users to trade anytime, anywhere.
• Decentralization, with minimal complex processes, and transaction speed depending on network efficiency, with most transactions confirmed within seconds.
• User assets are under their control, with no theft risk, as long as private keys are kept safe.
• Transparency. DeFi is built on blockchain protocols, allowing anyone to view data and protocol operations.

However, DeFi, as an emerging field, also comes with many risks, including:

• Due to anonymity and lack of regulation, issues like money laundering and black market trading exist.
• Contract vulnerabilities occur frequently, with protocols being hacked due to insufficient contract auditing.
• Flash loan attacks, where protocols’ algorithms and pricing mechanisms are targeted in some lending projects, result in the withdrawal of mainstream assets from platforms.
• Impermanent loss occurs when liquidity providers inject funds into liquidity pools, causing loss due to market price fluctuations.
• Exit scams drain liquidity pools, leaving assets bought by investors without a market.

Overall, the freedom and risks of the crypto world have a certain positive correlation. Although DeFi is decentralized and does not rely on central entities, in most cases, users are responsible for themselves when problems arise.

Current Status of the DeFi Industry

According to data from DeFiLlama, as of April 30, 2024, the total value locked (TVL) in DeFi reached its highest point at the end of 2021, exceeding $200 billion. It fell to around $50 billion during the bear market period from 2022 to 2023 but has been steadily increasing with the further ignition of market enthusiasm and the addition of new users in 2024.

Source: DefiLlama

According to statistics from DeFILlama, the areas with the most aggregated funds in the current DeFi industry are liquidity staking, restaking, and lending protocols.

Source： DefiLlama

Prospects and Outlook for DeFi

As a new financial system and model, DeFi is influenced by various factors, including infrastructure, ecosystem applications, and regulatory policies.

Further Risk Control

During the early development of DeFi, various protocols encountered issues such as oracle manipulation and cross-chain bridge compromises. However, with technological innovations and new protocols, many solutions have been developed for these problems. While risks still exist in DeFi, security has significantly improved. For example, previously common issues like oracle manipulation, where hackers manipulated oracle prices to cause pricing errors in decentralized exchanges and lending protocol platforms, have been addressed using multiple data sources. This reduces the probability of oracle manipulation by relying on the weighted average results of multiple oracles. Additionally, if an oracle stops functioning, transactions can immediately switch to a functioning oracle.

Further Aggregation of DeFi Products

With the increasing diversification of DeFi products comes complexity for users. For instance, if a user wants to purchase a BAYC NFT with ETH, they would first need to convert their USDT/USDC stablecoins to ETH and then transfer it cross-chain to the Ethereum blockchain for the purchase. This process is both complex and costly.

Consequently, DeFi aggregators have emerged to address this issue. For example, popular trading aggregator 1inch allows users to trade multiple tokens without needing to search for the highest liquidity themselves; the aggregator provides the best quotes. More operations are being aggregated, such as with the Gate Web3 product, where users can perform token swaps, cross-chain transactions, purchase NFTs, and engage in on-chain derivative trading with just one click. The emergence of these aggregation products makes it more convenient for users to enjoy the benefits of DeFi.

Complementarity with Other Tracks

NFTs, GameFi, SocialFi, DAOs, Metaverses, etc., will also provide ecological support for DeFi. For example, tokenizing NFTs and trading them on AMMs, creating NFT collateralized lending contracts, renting in-game assets, and financializing land in the metaverse are all imaginable use cases in DeFi.

DeFi Indices

Another area of potential rapid growth in the DeFi market is indices. In traditional finance, indices like the S&P 500 and FTSE100 have experienced tremendous growth. This trend has not yet fully realized this DeFi, especially because smart contracts allow users to easily create broad-ranging indices, from DeFi blue chips and metaverses to NFTs. Smart contracts also allow for the automatic rebalancing of these indices. Therefore, it is expected to see more and more DeFi-related indices in the future, which will grow rapidly.

Compliance Management

Currently, unclear rules stifle innovation, making the environment unfriendly for DeFi development teams and users. However, with reasonable regulatory policies, there will be a more friendly and directional policy environment. This will also enable DeFi to reach a wider user market. The existence of RWAs, for example, allows users to understand that real-world assets can be traded on the blockchain with low barriers to entry.

More Traditional Financial Institutions Joining

With increased compliance and innovation, more traditional financial institutions are beginning to enter the DeFi world. RWAs are a classic example, where traditional lending companies tokenize debt and sell it on-chain, allowing users to buy debt even with just a few dollars. As attention shifts away from prices, developers with foresight will continue to create value and propose new ideas, which will nourish the next market cycle. During what seems like calm periods, it is crucial to keep up with the latest trends and focus on the infrastructure construction of DeFi.

Conclusion

DeFi is a new financial system that has changed the operating mode of traditional financial systems, allowing any user with financial needs worldwide to participate, and making high-end financial services accessible to ordinary people. After a bullish development cycle, the DeFi ecosystem applications have matured relatively, and the market has validated their feasibility. As the foundational component of major ecosystem applications, DeFi will continue to evolve and iterate over the next period, with more innovative and disruptive products emerging at the right time. We need to stay focused and keep an eye on these developments.