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DeFi has come a long way since the first decentralized exchange (DEX) appeared in 2016. The bear markets of 2018 and 2022, countless scams and exploits, as well as some spectacular crashes (Terra was a DeFi protocol 😅).



However, the industry is still immature. Even if its four main sectors –&nbsp;DEXes,&nbsp;decentralized stablecoins,&nbsp;staking, and&nbsp;lending-borrowing apps&nbsp;– have each evolved significantly, they are still a niche waiting for a breakthrough to become popular.



Also, DeFi protocols are still a major temptation for hackers, and since human-written code is unlikely to reach perfection, an effective&nbsp;insurance&nbsp;system that would protect users from its flaws is a must.



This Newsletter is a review of DeFi’s four main sectors, their evolution and perspectives, illustrated by the top 5 protocols: Lido, MakerDAO, Aave, Curve and Uniswap. We believe that DeFi insurance can one day become a full-pledged sector too, and include its leading protocol Nexus in the list ⬇️



<h2>Lido, leader in liquid staking</h2>



This week a liquid staking protocol&nbsp;Lido&nbsp;flipped the oldest DeFi protocol MakerDAO and became the leading DeFi service, with $6.5 billion of TVL&nbsp;(source:&nbsp;<a href="https://defillama.com/">DeFiLlama</a>). Its governance token $LDO has gained 100% in a week. Why?



Staking cryptoassets on Proof-of-Stake blockchains gives users the possibility to participate in their activity (validating transactions and creating blocks) and to earn reward. The main evolution in this sector was the creation of&nbsp;liquid staking protocols, which took away the trouble of running a blockchain node and complying with any additional requirements, and allowed users to easily stake their crypto and earn a passive revenue. What’s more, such protocols issue and give users a sort of IOU token (in case of Lido – an stETH for every staked ETH), which can also be used in the DeFi ecosystem.



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Liquid staking got big after Ethereum launched its PoS chain in the end of 2020 and grew rapidly after the blockchain fully transitioned to the PoS consensus last autumn. The biggest CeFi players like Binance or Kraken jumped on the opportunity instantly, but the fears of&nbsp;<a href="https://d.center/posts/after-the-merge-ethereums-perspectives-and-risks">Ethereum centralization</a>&nbsp;(and the rising mistrust in centralized exchanges) kept them from defying a decentralized Lido, which can now be expected to thrive as long as Ethereum thrives.



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<h2>MakerDAO, a decentralized stablecoin</h2>



Since the end of 2017,&nbsp;MakerDAO&nbsp;has been issuing a decentralized stablecoin DAI, which maintains its value of approximately $1 by over-collateralization: users are required to spend more than $1 worth of ETH to be able to mint 1 DAI. Together with the diversification of the underlying asset portfolio, this allows to maintain the DAI stable.



MakerDAO now registers a TVL of $6.4 billion, and DAI’s market cap is over $5 billion.



Over-collateralization is not an ideal scheme from the business point of view, and the next stage for decentralized stablecoins is expected to be an algorithmic stablecoin. However, its most prominent example –&nbsp;<a href="https://d.center/posts/this-weeks-story-terra-lunas-crash-what-happened">TerraUSD</a>&nbsp;– has failed spectacularly 🌠, and&nbsp;the market is still waiting for a decentralized algorithmic stablecoin that will work.



<h2>Aave, the lending-borrowing specialist</h2>



Launched in 2020,&nbsp;Aave&nbsp;is now the third biggest DeFi protocol, with $4 billion of TVL.



How does a DeFi lending protocol work? A user can deposit their crypto into the protocol’s liquidity pool and borrow another crypto (often a stablecoin) that other users have loaned. The former pay interest, the latter – earn interest, and the volatility issue is tackled by overcollateralizing the loan.



This sector has evolved significantly since the first days of DeFi, notably by introducing the pooling mechanism (pool-to-peer instead of peer-to-peer) and improving user experience.&nbsp;



<h2>Curve and Uniswap, the biggest decentralized exchanges</h2>



Just like centralized exchanges, the first DEXes were using an orderbook to match buyers and sellers. However, this method proved inadequate due to the risk of frontrunning (block validators passing their orders before the clients’) and insufficient liquidity. Replacing orderbooks with AMMs, or automatic market makers, has allowed the DEXes to flourish, and as of today,&nbsp;Curve&nbsp;($3.8 billion TVL) and&nbsp;Uniswap&nbsp;($3.4 billion TVL) are the two biggest ones.



An&nbsp;AMM&nbsp;relies on a math formula to price an asset according to the available liquidity pools, where professionals and individuals deposit crypto to earn reward in form of LP tokens. It has its downsides too: the problem of impermanent loss (when the price ratio of deposited tokens changes abruptly) and the impossibility of placing limit orders (setting a price at which a user would like to buy/sell).



These two issues remain unsolved (although&nbsp;Balancer&nbsp;has claimed to tackle the impermanent loss 🤔), and a future DEX leader may be the one that solves them.



<h2>Nexus, a DeFi insurer</h2>



DeFi insurance is by all accounts an underdeveloped sector: its biggest service&nbsp;Nexus Mutual&nbsp;is currently occupying only 38th place in the DeFi ranking, with a TVL of only $180 million.



At the same time, Chainalysis&nbsp;<a href="https://twitter.com/chainalysis/status/1580312145451180032">reported</a>&nbsp;over $3 billion of&nbsp;crypto hacks&nbsp;as of mid-October 2022, the quasi majority of them concerning DeFi.



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Nexus offers its members a&nbsp;smart contract cover, protecting their crypto from bugs in the contract and the resulting exploits for a small fee of 2.6% annually for most protocols (which can however rise to over 50% for protocols considered as dangerous). The $3 billion of crypto lost to hackers could have been insured… but it mostly wasn’t.



Nexus is developing steadily (recently adding a “custody cover” for funds locked in CeFi), but in our opinion the market’s demand for crypto insurance is much greater.

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How are blockchains being used today? As a basis for cryptocurrencies sure, but also to decentralize traditional businesses and fuel the DeFi. All this brought to public by a well-developed ecosystem allowing anyone to use crypto. 



<h2>Cryptocurrency and Smart contract blockchains </h2>



With <a href="https://d.center/explore/bitcoin" class="ek-link">Bitcoin</a>, the first practical application of the blockchain was currency, or more precisely “P2P electronic cash system”, as described by Satoshi Nakamoto himself. Invented in order to remedy the defective monetary system, the blockchain proved itself to be particularly well suited for such a role, providing an independent, immutable and transparent transaction ledger.&nbsp;



Following Bitcoin, other <a href="https://d.center/explore/cryptocurrencies" class="ek-link">cryptocurrencies </a>have emerged, trying to ameliorate this or that aspect of the blockchain: transaction throughput, privacy… Other cryptocurrencies, namely stablecoins, focus on reducing price volatility. 



Before long people got a further idea to use the blockchain for more complex types of programs, leveraging its freedom from any trusted third party. These programs, called smart contracts, could be autonomous and self-execute when a predefined condition is triggered. An application running on a blockchain (dubbed DApp for “decentralized application”) cannot be modified once registered, not even by its creators. 



The first and most popular <a class="ek-link" href="https://d.center/explore/dapps-platforms">Smart contract platform</a> is Ethereum blockchain, however it also has its share of competitors. 



The difference between a Cryptocurrency blockchain and a Smart contract blockchain is now rather theoretical and can be spotted only by questioning the blockchain’s purpose: whether it was conceived to support a currency or to host elaborate smart contracts. Both types of blockchains need a native coin to pay the network nodes for running the protocol, however in cryptocurrencies’ case the native coin is a goal in itself, whereas for smart contract blockchains it is a payment for running smart contracts. 



In practice, Ethereum native coin ETH is often used as a currency, and Bitcoin can serve as payment for running Bitcoin-based smart contracts, which became possible thanks to the protocol and second layers development. Hence it is now better to speak more generally of cryptoassets as a whole. 



<h2>Blockchain use cases </h2>



The blockchain technology can be used in every sector that would profit from the absence of a trusted third party. Decentralized systems are intrinsically fairer than centralized ones, because they are much better in redistributing value and allow the users to be true and sole owners of their data. This quality is substantial when it comes to online platforms, whether for social media, cloud or ride hailing.



Blockchain being a transparent and immutable ledger, it is also particularly suitable for all data certification purposes.



Blockchain’s capacity to host smart contracts can automate numerous processes, not only increasing the overall cost and time effectiveness, but also providing users with a guarantee that no one will modify the conditions of a DApp using that smart contracts.&nbsp;



Finally, blockchain structure allows fast and easy data and values transfer, without any consideration for borders or other limitations. This quality is not only highly appreciated in the finance world, but can also be used to transfer digitized ownership rights for any type of value.&nbsp; 



<h2>Blockchain ecosystem </h2>



Blockchain is a collective endeavor, and it needs an extensive ecosystem to function and to serve its purposes. Numerous products and services have therefore been developed: <a href="https://d.center/explore/crypto-wallets" class="ek-link">wallets </a>to interact with a blockchain, <a href="https://d.center/explore/crypto-exchanges" class="ek-link">exchanges</a><a href="https://d.center/explore/crypto-exchanges" class="ek-link"> </a>to buy and sell crypto, oracles to interact with the real world and feed information to smart contracts, not to mention the miners who maintain the network or interoperability protocols connecting different blockchains. 



<h2>Blockchain in finance </h2>



Finance is a sector embracing the blockchain like no other. Traditional finance manipulates cryptoassets as a new type of value, incorporating it into the existing circuits, whereas the new type of finance - the DeFi (for decentralized finance) is taking shape.&nbsp;

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Cryptoassets and DeFi (Decentralized Finance) are disrupting existing financial institutions, all while alluring them into profiting from this new type of asset.



The primary goal of cryptocurrencies is to become a new type of money and redefine the basics of finance. Anyone can access a public blockchain and execute near instantaneous transactions, which then can be easily verified thanks to the blockchain’s inherent transparency. With the appearance of <a href="https://d.center/fr/explore/crypto-exchanges" class="ek-link">exchanges </a>it also became really easy to trade cryptoassets against other cryptoassets or [tooltip content=" fiduciary money with no intrinsic value, dependent on the government and the central bank (like dollars or euros) "] fiat money [/tooltip]. Compared to the traditional financial organizations burdened with bureaucratic issues (authorizations to trade, clearing and settlement services, opening hours etc), bank delays and hefty fees... investing in and trading crypto is simple, fast, available 24/7 and less expensive.



<h2>DeFi</h2>







Such great potential prompted the emergence of a new type of finance - the DeFi, or decentralized finance. The DeFi represents an array of financial tools built on a blockchain and managed by its smart contracts accessible via DApps (Decentralized Applications, see <a class="ek-link" href="https://d.center/explore/dapps-platforms">Smart contract platforms</a>): P2P lending platforms, decentralized exchanges (DEXes), synthetic tokens following the price of a commodity, a stock or anything else, prediction markets, decentralized insurance, decentralized asset management etc. The main idea behind this is that everyone can access DeFi products and even create them as long as he or she has the Internet connection. Furthermore, decentralized means that no third party can interfere with the existing protocol, most processes being automated via smart contracts.



Most of the DeFi applications are built on Ethereum, leveraging its smart contracts flexibility and massive development already done on it. Even a new market metrics appeared - TVL (Total Value Locked), representing the collateral locked in different types of DeFi applications. This collateral is most often ETH, but it could also be tokens representing BTC on Ethereum blockchain. TVL can be tracked on sites like <a href="https://defipulse.com/ " class="ek-link">DeFi Pulse</a> or <a href="https://defillama.com/" class="ek-link">DeFi Llama</a>.  



<h2>Crypto exchanges</h2>



A number of financial applications integrate blockchain protocols and cryptoassets within a classical structure. A centralized crypto exchange is one such example: a centralized entity conducting a [tooltip content=" Know Your Customer"] KYC [/tooltip]on its clients and managing their cryptoassets operations, margin and derivatives trading, as well as custody. While the structure is still subject to trusted third party flaws, such as corruption, error or a targeted attack, its blockchain exposure allows moving values from one part of the world to another in a matter of minutes or even seconds.



<h2>Crypto in traditional finance</h2>







Cryptoassets are also of a significant interest to traditional finance, which, without specifically intending to reinvent itself in a decentralized fashion, is willing to profit off it. Indeed, the cryptoassets represent a completely new type of assets: unlike stocks or bonds that derive their value from the profitability, GDP, interest rates or other economic factors, a cryptoasset value depends on its technology, network size, user adoption or regulation. These factors, uncorrelated with traditional economic criteria, mean that a cryptoasset represents an excellent means of diversifying an investment portfolio. Furthermore, cryptoassets domain is still in its early days, so potential gains could be huge.



A number of crypto Asset Management companies now allow institutional investors to get a crypto exposure without buying crypto themselves.



For the investors who are bold enough not only to invest, but also own cryptoassets, a number of professional custody services have emerged. These companies stock the clients' private keys in vaults, guaranteeing them a peace of mind (not to lose the private key) and all the necessary protection, often required by the regulation.



As an emerging technology with great potential, the blockchain itself attracts investments, venture capital being the most popular means of financing blockchain-related companies today.



<h2>Crypto for fundraising</h2>







Another important function of the financial industry - the fundraising - now also has its crypto equivalent. The ICO, or Initial Coin Offering, has come to reinvent the traditional IPO (Initial Public Offering). Issuing tokens instead of shares has proven quite useful: not only they are accessible by a wider public, the tokens also enjoy a seamless, borderless and fast transfer on the blockchain, so that transactions can take minutes instead of days. The ICOs issuing tokens with securities characteristics are now usually called STO, or Security Token Offering. Many countries impose on STOs the same legal constraints as on IPOs, in order to protect the customer.&nbsp;



<h2>Crypto financial products</h2>







There is a number of different financial products related to the cryptoassets.



Derivatives on crypto (futures, swaps or options) can be bought on specialized crypto exchanges both centralized and decentralized, as well as on the traditional derivatives exchanges, such as Chicago Mercantile Exchange. Synthetic derivatives on real-world assets can be created and traded on platforms like <a href="https://kwenta.io/" class="ek-link">Synthetix</a> or <a href="https://ftx.com/" class="ek-link">FTX</a>.



For the investors who prefer to (or are obliged to) deal with more traditional values, a number of asset management firms propose a crypto exposure via private funds and exchange-traded notes (ETNs). For the moment the majority of financial regulators are having their concerns and asset managers are not yet authorized to create widely accessible crypto-based investment vehicles, such as long-awaited ETFs (exchange-traded funds). The process however has already started in Germany, Canada and Hong Kong, bringing hope that ongoing discussions with the regulators in other countries would bear fruit.







There are some controversies as to the role of big money in blockchain. Some argue that traditional finance would undermine the very idea of decentralization (see <a href="https://d.center/fr/explore/decentralization" class="ek-link">On the importance of decentralization</a>). An opposite opinion actually favors the adoption of cryptoassets by the big finance: the more money is involved in a blockchain, the more profitable (and more secure) is its cryptoasset. And as the majority of the world's investment is institutional (pension funds, insurances etc), the adoption of cryptoassets can contribute to notoriety and development of blockchain technology overall.

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DeFi reinvents and democratizes finance, replacing traditional financial intermediaries with DApps accessible to everyone. 



Decentralized finance, or DeFi, is a new ecosystem of financial services that is based on a blockchain and uses smart contracts. DeFi transforms classic finance thanks to decentralization, transparency, transaction efficiency, immutability, ability to control your data and accessibility to everyone. The first DeFi applications appeared on Ethereum blockchain, which still keeps its leader position.



DeFi brings a decentralized alternative to the functions of CeFi and TradFi, such as 



📌 exchanges, 



📌 lending-borrowing, 



📌 asset management,



📌 stablecoins, 



📌 insurance,



 as well as completely new sectors proper to DeFi, such as:



📌liquid staking, and



📌 liquidity providing. 







<h1>DeFi characteristics</h1>



 DeFi enjoys typical blockchain qualities, which make it different from the traditional finance: 



Non-custodianship : DeFi users control their assets at all times, as they own the corresponding keys. It means there’s no trusted third party, like a bank, an asset management or a custody that would ensure assets’ conservation.



Free access : every person with Internet access and a <a href="https://d.center/explore/crypto-wallets" class="ek-link">wallet </a>allowing to communicate with the blockchain can be an actor of the DeFi. This opens the finance to everyone, regardless of borders, authorisations from whatever organization or minimum investment amounts.



Transparency : DeFi <a href="https://d.center/explore/smart-contract-platforms" class="ek-link">Dapps</a>’ code is open source, allowing everyone to audit it and to learn how exactly it operates.



Interconnectivity (composability) : open source allows developers to copy, modify, assemble, leverage and interconnect DeFi applications, enhancing competition and boosting innovation.



Decentralization : DeFi DApps are based on smart contacts inscribed into a public blockchain that guarantees their censorship resistance and independence from any central authority. Their users can more and more often take part in DApp-related decision taking and profit from DApp’s success via tokens they receive for using it. However a complete decentralization is rarely present, for the teams who conceive DApps prefer to keep a privileged access to certain functionalities linked to their security.







<h1>DeFi sectors</h1>



<h2>Decentralized exchanges (DEX) </h2>



Decentralized version of exchanges, a DEX allows users to exchange cryptoassets directly on a blockchain, without having to entrust anyone with their private keys. So while an attack on a centralized exchange could endanger user data and funds, a DEX does not control neither the funds, nor the user data, which enjoy the security provided by the blockchain. #notyourkeysnotyourcoins



In order to use a DEX one has to download a compatible wallet, which will generate private keys accessible only to its owner and will send orders to a DEX.&nbsp;



First decentralized exchanges appeared thanks to the possibilities of smart contracts, but they had hard times establishing themselves: unlike centralized exchanges, they didn’t have enough liquidity or market makers. A new generation of DEX solved this problem, mostly thanks to liquidity pools (LP) and automated market making (AMM).



Liquidity pools are types of smart contract that allow to deposit tokens that will be used by a DEX when needed for an exchange. 



Automated Market Makers. AMM is a program that allows, using math formulas and depending on supply and demand, to determine a quotation for token exchange. It’s done automatically and without any human intervention. There are several types of AMM today, the first one operated liquidity pools by pairs of tokens, where equal amounts of each token must be deposited (it is used by Uniswap - the first DEX to have conquered a significant market share). 











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DEX also have their share of disadvantages, notably their incapacity to exchange crypto against fiat money or cryptoassets from different blockchains. Another disadvantage is a risk of loss specific to DEX called “impermanent loss”. It is also worth noting that DEX are often quite difficult to use for an average person.



Solutions to counter these disadvantages exist. While integration of fiat money still seems impossible, other issues are subject to constant improvements. Exchanges of tokens from different blockchains can now be possible with cross-chain DEX, impermanent loss can be tackled with different techniques of LP and AMM, and more user-friendly DEX appear.



The main DEX today are Uniswap, Sushiswap, Pancakeswap, Balancer and Curve.



<h2>Lending & borrowing </h2>



To use a DeFi service of lending & borrowing one has to simply deposit a cryptoasset into a specialized wallet. From there two possibilities exist:



<ul>
<li>earning a passive interest,</li>



<li>in addition to a passive interest a cryptoasset can serve as a collateral to borrow another cryptoasset, the amount that can be borrowed depends on a deposited crypto. The lending or borrowing rates depend on the supply and demand, and the type of interest can be either fixed for a period of time, or adjustable according to the market.</li>
</ul>







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DeFi also enables a specific type of borrowing called flash loan. It allows to borrow the whole amount available without any collateral, insofar as the loan and its repayment are made within one transaction, which is possible using smart contracts. Flash loans are still very complex though, and their usage is essentially limited to professionals with advanced technical skills (even if tools for beginners are being developed).



DeFi loans users’ main risks are liquidation (when the collateral amount falls below a minimum threshold) and smart contract code vulnerabilities (just like for any other DApp).



Some of the most famous lending & borrowing DApps are Aave, Compound and Maker DAO, also the issuer of DAI stablecoin. The sector is evolving very quickly though, so we've created a separate <a href="https://d.center/posts/defi-projects-resources" class="ek-link">list</a> of DeFi projects that we update regularly. 



<h2>DeFi Asset Management</h2>



DeFi counts a great variety of funds managed in a variety of ways:



💰 Passive funds - sectorial indexes, like DeFi Pulse, or Metaverse index



💰 Active funds, like Enzyme protocol, allowing users to raise money and manage their own funds



💰 Investment DAOs - decentralized autonomous organizations that actively manage all kinds of assets, like for example BitDAO



💰 Yield optimization protocols - automated systems that find the best placement opportunity across the DeFI space







<h2>Decentralized stablecoins</h2>



There are two main approaches to decentralized stablecoins:



🪙 overcollateralized stablecoins like DAI, when the 1:1 dollar peg is maintained through the system of Ethereum-based smart contracts managing an overcollateralized loan: users deposit ETH and borrow newly created DAI coins.  Together with the diversification of the underlying asset portfolio, this allows to maintain the DAI stable;



🪙 algorithmic stablecoins like the defunct TerraUSD, which aimed to achieve price stability via an elastic money supply (contracting and expanding when price deviates from the peg), enabled by stable mining incentives (miners absorb supply contraction costs in the short term and are compensated with increased rewards in the mid to long term). This mechanism did not stand the test of time, and crashed spectacularly. 



As of now, there is still no truly viable algorithmic stablecoin on the market.



 



<h2>Insurance</h2>



Decentralized finance is booming, the amounts blocked in DeFi protocols will soon reach hundreds of billions of dollars, and the number of users grows steadily. Such success must not let us forget that DeFi is a very young sector and is still in the discovery phase. It consists of smart contracts and decentralized protocols, hence it’s vulnerable to mistakes of code, hacks, and unforeseen usages steaming from interconnectivity between the protocols. All this can cost DeFi users significant losses, so quite naturally a new DeFi sector appeared to counter them - insurance.



Insurance DApps act in a way like traditional insurance: clients pay a premium to protect themselves against a specific risk (linked to smart contracts, exchanges, stablecoins…) The price of this premium depends on the risk type, amount to insure and on the platform on which the amount was invested. New ways of determining the premium and the insurer’s fees are being constantly developed. Incidentally, insurance DApps can themselves carry the risk against which they are supposed to insure…



Generally, insurance DApps can also be used by traditional insurers, using blockchain qualities to speed up the paperwork and create additional guarantees for the clients.



The main DeFi insurance are Cover protocol, Nexus mutual, Tidal finance, Union UNN finance, Etherisk, Nsure et Bridge Mutual.



<h2>Liquid staking</h2>



Staking cryptoassets on Proof-of-Stake blockchains gives users the possibility to participate in their activity (validating transactions and creating blocks) and to earn reward. 



The main evolution in this sector was the creation of liquid staking protocols, which took away the trouble of running a blockchain node and complying with any additional requirements, and allowed users to easily stake their crypto and earn a passive revenue. What’s more, such protocols issue and give users a sort of IOU token (in case of Lido – an stETH for every staked ETH), which can also be used in the DeFi ecosystem.



The biggest liquid staking protocol is now Lido.



<h2>Liquidity providing</h2>



With the advent of AMM-based DEXes, users can now earn money by supplying liquidity. 



People who deposit tokens in DEXes' liquidity pools act as market makers and are rewarded by a part of the fees gathered by an exchange. Furthermore, they receive LP tokens (liquidity pool tokens) that represent their participation in the liquidity pool. These LP tokens often can be deposited too (in the DEX DApp or even other DApps), allowing to gain a supplementary reward, thus creating more incentive to provide liquidity.



DeFi composability allows numerous combinations and the imagination of DApps creator is limitless. 



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DeFi is in constant evolution and progress, and the amounts brought into play become more and more impressive, both in collateralized assets and in DApps’ market caps. Moreover, bridges are being built between the DeFi and the traditional finance.



Started on Ethereum, which is still the main blockchain, DeFi DApps are being developed on other blockchains too, and the projects are numerous. However, there are still many things to do before this sector becomes mature and easily accessible to the general public.



Today’s DeFi is in its youth and it is both the Eldorado and the Far West, with all the opportunities and the dangers it carries.