DeFi Banking Applications
DeFi is actively reshaping the financial landscape by offering a decentralized alternative to traditional banking services. This section explores the wide range of DeFi banking applications and the ways they address everyday financial needs.
Decentralized Exchanges
The rise of decentralized finances (DEXs) represents a significant step in the evolution of decentralized finance. Unlike the centralized equivalents (CEXs), which operate through companies and rely on market makers to manage order books, DEXs use blockchain technology and smart contracts to enable fully transparent trading.
CEXs, while being familiar, pose certain risks because of their centralized nature.
Vulnerability to hacks, potential government intervention, data breaches and privacy concerns are constant threats. DEXs, on the other hand, hand over control to users. Smart contracts instead of financial corporations govern all the exchange components, from trade execution and liquidity provision to withdrawals and deposits. This eliminates the need for intermediaries and offers users transparency throughout the trading process.
This difference in custody is critical: with CEXs, users lose control of their funds once they deposit them while DEXs allow users to trade directly from their personal wallets, enhancing security and promoting user autonomy.
It is worth mentioning that different DEXs may operate in different ways. While some, such as dYdX, have adopted order book systems similar to CEXs, the majority, including Uniswap, Bancor, PancakeSwap, and SushiSwap, take another approach: Automated Market Makers (AMMs).
Automated Market Makers (AMMs)
An automated market maker (AMM) replaces the traditional order book model of centralized exchanges with on-chain liquidity pools. These pools are filled by liquidity providers who lend their cryptocurrency in exchange for a share of the trading fees. The pools become the counterparty to every trade. Users interact directly with the AMM’s smart contract, bypassing the need for order matching.
This innovative approach has several advantages. Decentralization is paramount, as control shifts from a central authority to the users through smart contracts and governance models. This also ensures a non-custodial environment where users retain full control of their assets throughout the trading process, interacting directly from their wallets. Market manipulation, a concern with centralized exchanges, is mitigated by the absence of a central entity that could benefit from such practices. Security is enhanced by the decentralized and distributed nature of DEXs, as hackers can only target liquidity pools, not individual user accounts. Finally, the open and permissionless nature of DEXs allows any token to be listed without the approval of a central authority, promoting greater accessibility to tokens.
However, it is important to acknowledge that AMMs also present challenges. DEXs rely heavily on users to provide liquidity to the pools, and insufficient liquidity can hinder trading activity and impact pricing. Order execution on DEXs can be slower than on centralized exchanges, often due to the lack of sophisticated trading tools. While DEXs have seen significant growth in trading volume, the lack of an order book can result in high slippage, especially for larger orders. Finally, trading on DEXs typically involves a fixed fee for all trades, in addition to gas fees (transaction costs) charged by the underlying blockchain network (such as Ethereum). These gas fees can fluctuate significantly depending on network congestion, potentially leading to high transaction costs.
Lending and borrowing platforms
Lending and borrowing are the other key components of the decentralized finance ecosystem as alternatives to traditional lending models.
Centralized institutions such as banks act as so-called gatekeepers and feature an approval algorithm. The approval process includes strict requirements such as good credit score, stable employment, and minimum collateral. This system naturally excludes those without or with limited access to traditional banking services.
DeFi lending protocols break down these barriers and promote financial inclusion thanks to open and permissionless access to credit. Regardless of background, location, or credit history, anyone with the necessary assets can borrow funds. In addition, these protocols often operate without the stressful identity verification procedures such as know-your-customer (KYC) policies common in traditional finance.
DeFi further propelled the popularity of decentralized lending through the integration of protocols such as Compound, Aave, Maker and bZx. These platforms connect lenders and borrowers directly so that lenders can earn attractive interest rates on their crypto assets and borrowers can gain access to instant liquidity: all without the burden of paperwork and in a secure and anonymous environment.
A particularly innovative feature of DeFi Lending is the concept of flash loans. Unlike traditional loans, flash loans require no collateral and allow users to borrow substantial amounts, potentially millions of dollars. However, these loans come with an extremely short repayment window – they must be repaid before the transaction block is completed. This unique feature makes flash loans suitable for rapid-profit operations such as arbitrage trading and debt refinancing. However, if not managed carefully, they introduce potential vulnerabilities that may be exploited for fraudulent activities.
