Digital dollar stablecoins provide a price-stable digital asset that crypto investors can use to generate yield in the global DeFi market through different blockchain networks.
DeFi — which stands for decentralized finance — aims to replicate existing financial products and services using smart contracts and decentralized protocols on a blockchain.
In simple terms, DeFi refers to financial software that operates independently on a blockchain network that anyone with an internet connection can use to access basic financial services — such as borrowing, lending, and investing — without the need for a financial intermediary.
For example, instead of depositing money in a savings account in a bank, a cryptocurrency holder could place funds into a decentralized lending protocol to earn interest — typically at a much higher rate than traditional savings accounts.
DeFi provides internet-native alternatives to popular financial services in the form of decentralized protocols on a blockchain. Essentially, what that means is that anyone with an internet connection can take part in the global financial system, even if they don’t have a bank account.
—Jeremy Allaire, Circle CEO
Individuals worldwide can use DeFi applications to earn interest, borrow funds, invest in new financial products, take out insurance policies, and more — all made possible by smart contracts and blockchain technology.
Technically, the age of decentralized finance started in 2009 with the birth of Bitcoin as it enabled individuals to store and transfer funds over the internet in a completely decentralized manner for the first time. However, what we refer to as DeFi today are decentralized, smart contract-powered applications on top of a blockchain that aim to replicate traditional financial services.
The first decentralized finance applications were decentralized exchanges on the Ethereum network. A DEX leverages smart contracts to allow investors to convert ETH into ERC20 tokens, and vice versa.
The next step in the DeFi movement was the creation of yield-generation savings protocols in late 2018, with Compound Protocol as the frontrunner. In the following twelve months, numerous new lending and borrowing applications emerged as well as new types of decentralized financial applications.
The decentralized finance market has grown into a multi-billion dollar industry, with over $6 billion locked up in DeFi protocols as of August 24, 2020. According to CodeFi, there were over 80,000 DeFi application users in Q2/2020, an increase from 62,000 in Q1.
The vast majority of DeFi protocols operate on the Ethereum blockchain, the world’s leading smart contract platform. According to DappRadar, there are currently over 100 DeFi applications on Ethereum, ranging from decentralized exchanges and lending protocols to trustless derivatives trading platforms and yield-generating liquidity pools.
As the DeFi market continues to grow, new protocols are created to address new market needs as well as build innovative, new models for financial contracts.
The DeFi market is currently a playing field for experienced crypto investors who understand how to interact with smart contracts and manage multiple digital assets. The average retail investor is yet to enter the DeFi market as the knowledge barriers are still quite high. In the future, we can expect that to change.
Tomorrow’s DeFi market will most likely allow anyone across the globe to access a decentralized, global financial marketplace that provides all the services traditional financial institutions offer.
For example, a woman running a market stall in Kenya will be able to borrow funds at competitive rates from a decentralized lending protocol using just her smartphone. Conversely, a merchant in India who is concerned about inflation could place funds into a yield-generating protocol that earns a higher APR than India’s prevailing inflation rate.
Some of the features that we expect to see in the future of DeFi are actually already possible thanks to market-leading applications such as the DeFi app, Dharma.
Dharma is an Ethereum-native money management app that enables users to securely store, send, receive, buy, and save ETH and ERC-20 tokens with the click of a button in the smartphone app.
For example, a Dharma user can lend USDC to earn above-average interest rates on digital dollars via the in-app digital dollar savings feature.
The DeFi movement is arguably one of the most promising markets in the financial technology sector, but that does not mean it is not without its challenges.
Currently, the vast majority of DeFi protocols operate on the Ethereum blockchain. Unfortunately, the Ethereum ledger cannot handle the high number of transactions it is processing, as DApp usage exploded in 2020, mainly due to the boom in DeFi. As a result, transaction costs — known as “gas” fees — and transaction processing times have increased substantially on the Ethereum network, reaching the highest since 2017 this August.
For DeFi users, that means absolute returns are being diminished due to the high gas fees that need to be paid to move in and out of DeFi protocols. While the Ethereum developer community is working to address these issues with future network upgrades, the future of DeFi will likely be multi-chain.
Ethereum will not be the only blockchain network that houses DeFi protocols. Global stablecoins will, therefore, also become multi-chain digital currencies. USDC is already taking that step with its plans to move the digital dollar stablecoin onto Algorand.
Arguably the most talked-about trend in today’s DeFi market is yield farming.
Yield farming refers to placing cryptoassets into DeFi protocols to generate the highest returns possible.
Yield farming can take various forms, with the most common being depositing funds in high-yielding lending protocols. Compound and Dharma are two examples of the convergence of fintech and crypto, where crypto-native applications enable simple savings solutions.
Compound is an autonomous money market protocol that enables crypto investors to deposit digital assets to earn crypto-native interest. For example, Ethereum users can deposit USDC — which operates as an ERC-20 token — into the Compound protocol to earn an estimated 2.53% APY. Conversely, an investor who wants to go long on margin could tap the Compound protocol to borrow USDC at 6.43% by providing collateral. The investor can borrow the funds for as long as his Borrow Balance does not exceed his Borrow Limit, at which point his position would be partially liquidated.
Dharma is an incredibly user-friendly savings protocol that enables crypto investors to earn yield on their digital asset holdings. Built on top of the Compound protocol, Dharma provides an app that allows users to manage their Ethereum tokens and invest them in DeFi to earn investment income.
The latest yield farming trend that has emerged in 2020 is the concept of liquidity mining.
Liquidity mining refers to providing liquidity to DeFi protocols in exchange for newly minted protocol tokens.
DeFi protocols Balancer and Compound, for example, reward liquidity providers with protocol-native tokens for participating on their platforms. As these tokens can be traded in the secondary market, an incentive structure is created where investors can earn substantial returns in the form of protocol tokens for contributing as much capital to a protocol as possible.
Balancer is an autonomous market maker protocol that rewards liquidity pool participants with its governance token, BAL, on top of pool fees. The more protocol participants contribute to a pool, the more they will earn in governance tokens, which is a prime example of liquidity mining.
Conversely, some DeFi market participants are borrowing and lending two different stablecoins using the Compound protocol to earn as many COMP tokens as possible to generate a higher return than the interest rate differential between the borrowed and deposited funds. This would be another — albeit more esoteric — example of liquidity mining.
Global stablecoins enable investors to generate yield on their cryptoassets in the DeFi market while alleviating the potential adverse effects of market volatility.
If an investor places ETH into the Compound protocol to earn interest, for example, there is the possibility that an ETH price drop offsets all yield earned, leaving the investor with a loss. However, if the same investor uses a stablecoin, such as USDC, the value of the underlying asset would remain stable so the yield would remain unaffected by crypto market volatility.
Investors looking for more yield than traditional fixed-interest investments — such as savings accounts, money market funds, or bonds — can digitize their funds to earn above-average yields in the DeFi market. Arguably, the easiest and safest way to do that is to tokenize US dollars into USDC, which can then be used to deposit into DeFi protocols.
Unsurprisingly, digital dollar stablecoins are becoming increasingly important assets in the DeFi lending markets. USDC, for example, has established itself as one of the most popular lending assets on platforms such as Compound, dYdX, Nuo, and Aave with lending rates ranging from 0.15% to 11.82% APY.
While decentralized lending and borrowing protocols have emerged and grown substantially, so have the more traditional centralized services built on top of crypto markets. Services like Genesis, BlockFi, and even Coinbase, have rolled out crypto back loans for largely both institutions and retail investors. According to CredMark, at the end of Q1 2020, there was $5.1B in crypto collateral on $2.6B of active debt — this is on top of what’s already locked up in DeFi.
Most centralized crypto services, meaning where the company custodies the private keys of its customers, will start to resemble crypto banks who offer a variety of financial services built on crypto, however, still with an intermediary providing services on top of decentralized protocols.
USD Coin (USDC) is the fastest-growing, fully reserved digital dollar stablecoin that enables businesses and individuals across the globe to transfer digitized US dollars over the internet.
USDC is issued by regulated financial institutions and redeemable 1:1 for US dollars. All US dollar reserves are attested by global accounting firm, Grant Thornton LLP on a monthly basis to provide utmost trust and transparency.
USDC is a highly-transparent, regulated, price-stable digital currency that can be used to securely interact with DeFi protocols. Whether you are looking to borrow, lend, or take part in high yielding protocols, USDC offers a secure on-ramp for DeFi.
What’s more, experienced DeFi investors can use the Circle Account as a home base to seamlessly tokenize US dollars and move digital dollars in and out of DeFi protocols, as well as back into fiat currency.
USDC possesses the largest stablecoin ecosystem in the world, with support from hundreds of applications, wallets, exchanges, payment services, OTC lending desks, and DeFi protocols.
Let us connect you with the right team at Circle.