A strange thing happened in September 2020. Ethereum transaction fees skyrocketed, reaching as high as $15 per transaction. In fact, Ethereum transaction fees have been on a steady rise for a few months. Additionally, block rewards were up to 50,000 Ether per day, three times more than it was the previous month. But the price of Ether itself wasn’t going up. So what’s accounting for this rising mining profitability?
Everything points to DeFi, an ecosystem of applications and services working on top of the Ethereum blockchain, made possible by Ethereum’s technology. More transactions done through DeFi mean more competition for blockchain processing, which means the more clogged the system gets. Because people will pay to move their transaction further up the line when the system slows, we’re seeing higher transaction fees appearing. Yet despite the fluctuations, DeFi is an incredible benefit to the crypto ecosystem.
But first, what is DeFi? It stands for “decentralized finance,” and refers to different applications that allow individuals to conduct transactions outside of a third-party mediator or institution.
Blockchain and cryptocurrency technologies have been offering this promise of peer-to-peer transactions for a while, with benefits for the unbanked who can now earn, hold, and exchange currency, as well as for those who are wary of institutional involvement in currency. While crypto exchanges and peer-to-peer payments have been around for a while, DeFi is essentially creating the financial services industry around it now.
The whole system is built on the Ethereum blockchain and utilizes its technology to enable these services. It’s expanding the cryptocurrency space by creating opportunities for decentralized exchanges, lending, insurance, derivatives trading, and more.
The Benefits of a Decentralized Financial Ecosystem
The benefits of a decentralized system like this are numerous. First, it can be completely trustless, as there’s no need for a third party you’d have to rely upon to handle the transactions.
Additionally, the parties aren’t required to know one another either — as is often the case in lending or deed transfer — and individuals don’t need to provide extensive personal information in order to exchange.
There are no custody issues as well, in that your coins are never being held by a third-party entity. No one can stop you from having an account, or block you from exchanging.
These transactions are also auditable. Since transactions reside on the blockchain, they can be viewed by anyone, and any smart contract associated with the transaction can be viewed as well. In fact, this is one of the innovations allowing DeFi to flourish.
What DeFi Can Do
One of the biggest DeFi use cases is decentralized exchanges, which allow anyone to buy or sell coins directly with one another, with no need for a bank or broker to process the transaction. Trading volume at these exchanges is steadily growing, as well as liquidity, and they’re even attracting traditional investors. They also offer faster trading due to their decentralization.
The Ethereum platform is easier to build applications on top of, so developers are using Ethereum as the foundation for DeFi apps for exchanges, lending platforms, stablecoins, and more. One of the offerings Ethereum is
most known for is smart contracts, which are unalterable agreements that self-execute when preprogrammed milestones are fulfilled, allowing for more efficiency in how parties work tougher.
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Smart contracts open up a world where peer-to-peer deed exchanges are possible, and where property or asset deeds can be tokenized and kept on the blockchain. Two parties can make a payment and simply exchange the deed via a DeFi platform, using a smart contract. This would remove third parties, making a process that tends to be a headache for most people fast, easy, and cheap.
DeFi also offers opportunities for decentralized lending under the same principle: transparent peer-to-peer trustless borrowing or lending with a smart contract. The only difference is that you need to have collateral in the form of coins. But putting up collateral in the form of currency allows borrowers to continue to stay anonymous and keep their information private, as opposed to centralized lending where sharing private information is a requirement.
Something else we’re seeing as a result of DeFi — and another reason for the rising transaction rates — are arbitrage bots, who are automated to buy and sell on these exchanges, and who look for arbitrage opportunities between markets day and night. They’re programmed to execute trades at sometimes the smallest amounts, but can do so faster and more efficiently than human trading.
DeFi offers other opportunities around decentralized insurance, yield farming, stablecoin creation, and even betting, in an effort to bring more users into an open platform free from third-party intervention. DeFi not only offers more financial options for those seeking decentralized options but as the ecosystem grows, it will lend credibility and legitimacy to the crypto market overall.
But at the end of the day, all of these transactions need to be added to the blockchain, resulting in a congested system, but with higher fees paid out for the miners.
Is the DeFi Bubble Going to Burst?
But will it last? While DeFi offers new opportunities for trustless, permissionless exchanges, and while more work and higher transaction fees are always a boon for miners, what’s happening now isn’t sustainable. A transaction cost of $15 is too high and will force those making transactions to pull back.
Part of the reason it’s that high is that Ethereum has scalability issues. A faster platform — perhaps with the newly expanded gas limit or with the upcoming release of Ethereum 2.0 — will allow for faster transactions and lower fees, but they’re just not there yet.
That doesn’t mean that the bubble will pop completely. DeFi isn’t just a theory and is already being used across a number of applications, from investment funds to no-loss lotteries to automated token exchanges. The possibilities of DeFi are exciting — we just need to make sure there’s a strong foundation to support it.