What is Decentralized Finance (DeFi)
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What is Decentralized Finance (DeFi)

Key Points:

  • Decentralized finance (DeFi) refers to a set of financial applications built on a blockchain that do not rely on middlemen.
  • DeFi uses smart contracts to undercut centralized intermediaries. 
  • DeFi protocols can be used to trade, swap, lend, and borrow digital assets.

What is Decentralized Finance (DeFi)

Decentralized Finance or “DeFi” is a catch-all phrase for all financial programs that run on public blockchains like Ethereum. These apps can perform traditional financial tasks of trading, lending, borrowing, and more without the need for a middleman or third party.

Instead, DeFi projects use blockchain technology and smart contracts, a set of instructions that run when predetermined conditions are met, to automate financial services. There is currently a wide range of DeFi protocols that allow users to perform all sorts of financial tasks.

DeFi vs. traditional finance

DeFi and traditional finance (TradFi) are both involved with financial transactions, which can range from simple activities like borrowing and lending to more complex ones like providing liquidity. However, the main difference between DeFi and TradFi is how they handle these financial transactions.

TradFi revolves around central authorities like brokerage firms, banks, and other financial institutions. These are largely brick-and-mortar organizations characterized by a high degree of centralization, Know Your Client (KYC) obligations, government regulations, and overall high barriers to entry.

On the other hand, DeFi aims to remove the need for central authorities and give power to the communities using novel technologies like blockchain and smart contracts. This also makes DeFi more efficient since third parties, who usually take a cut of the transactions, are not involved. 

Unlike TradFi applications, DeFi projects are open and permissionless, meaning they are available to everyone. In contrast, TradFi applications are difficult to access, not available to people from all jurisdictions, and most importantly, expensive. Notably, DeFi is open 24/7, 365 days a year while TradFi markets are open only at specific hours on specific days.

DeFiTraditional Finance
Uses smart contracts to remove middlemen.Uses central authorities like banks and brokerage firms to process transactions.
Open and permissionless, meaning DeFi applications are available to everyone.Available to a limited cohort of people.
DeFi is transparent since all transactions are recorded on public blockchains.Not transparent as TradFi applications are closed source.
Immutable, not susceptible to change.TradFi is not immutable since a centralized entity has the power to change details of transactions and other things.
Users have utter control over their funds in DeFi since it is non-custodial.It is custodial, meaning a third party is in control of your funds.

How Does DeFi Work?

DeFi uses blockchain, the technology that underpins cryptocurrencies, and smart contracts to allow financial services to be programmed, removing the need for financial institutions and other centralized intermediaries that act as guarantors for transactions. Participants in DeFi can interact with each other directly and enjoy the transparency and security of the decentralized finance ecosystem.

In DeFi, users can access their funds, which are cryptocurrencies, using digital wallets. These wallets are non-custodial, meaning users are in full control of their funds and they only need the seed phrase to access their funds. Users also have the option to set specific conditions for a transaction using smart contracts. 

For example, a user can set up a smart contract to send specific amounts of cryptocurrencies to another wallet across regular intervals. Smart contracts can also be used to create more complicated transactions and automate trading, investing, lending, and borrowing processes. It is worth noting that smart contracts are immutable, so they cannot be altered once set up. 

The bulk majority of DeFi apps (DApps) are built on the Ethereum blockchain, which was the first platform with smart contract functionality. However, the rise of other blockchains, like Solana, Binance, and Cardano, which also support smart contracts functionality has allowed the creation of DeFi platforms beyond Ethereum. 

Use cases for DeFi

On the surface, DeFi allows everyone to perform financial transactions without the need for intermediaries. However, there is more to this disrupting industry. From DAOs to synthetic assets, DeFi apps have unlocked some exciting new opportunities for everyone around the world. Here are some potential DeFi use cases:

1. Decentralized Exchanges (DEXes)

DeFi wallets leave users in full control of their funds, which brings the need for a wide range of tools that users need in order to manage their assets. Decentralized Exchanges (DEXes) can address these needs, allowing users to purchase, sell, trade, and transfer digital assets. 

As the name implies, DEXes are not controlled by a central entity. Instead, they are peer-to-peer (P2P) marketplaces that rely on smart contracts and allow users to execute orders directly with other traders. Unlike centralized exchanges, DEXes do not take custody of funds when users interact with them. 

2. Lending Platforms

Another popular DeFi use case is lending platforms. Essentially, these are DeFi applications that allow users to either lend their cryptocurrencies out to other users and earn relatively high earn interest rates or borrow digital assets from other users in exchange for some interest. 

Since DeFi lending platforms do not require KYC and other obligations, borrowers need to lock crypto worth more than the loan amount as collateral in order to secure a loan. Generally, the minimum collateralization ratio is 150% to protect the lender from the extreme volatility present in crypto. 

3. Synthetic Assets

One rather innovative use case of DeFi is synthetic assets. Sometimes also referred to as synths, synthetic assets are tokenized derivatives that mimic the properties of something else, usually commodities like precious metals or securities like stocks of major companies. 

Similar to other digital assets, synthetics can be purchased, traded, and sold, somehow giving crypto users exposure to the traditional financial markets. For instance, synthetic versions of Tesla, Apple, and other major tech companies are currently available for trading on DeFi platforms.

4. Decentralized Autonomous Organizations (DAOs)

Decentralized Autonomous Organizations, or DAOs, are new types of organizational structures not influenced by a central entity. DAOs are built on top of a blockchain and are governed by community members or token holders. 

Pros and cons of DeFi

Pros

  • Available to everyone
  • Open 24/7, 365 days
  • Transactions are transparent
  • Non-custodial

Cons

  • Not regulated
  • Susceptible to hacks and exploits
  • Scalability issues
  • Low liquidity

Pros

Available to everyone

DeFi applications are permissionless, meaning that users do not require permission to use them. Therefore, everyone with an internet connection can access DeFi projects and interact with them.

Open 24/7, 365 days

DeFi markets are open 24/7, 365 days a year since they use smart contracts instead of centralized brokerage firms or banking institutions.

Transactions are transparent

Since DeFi applications are built on blockchain technology, they offer unparalleled transparency. More specifically, all transactions and data are public and easily traceable. 

Non-custodial

DeFi wallets are non-custodial, which means users are in full control of their funds.

Cons

Not regulated

The decentralized nature of DeFi has made it next to impossible for regulators to bring this industry under their regulatory overreach. 

Susceptible to hacks and exploits

DeFi protocols are open source, meaning everyone can view and test their code. While this helps promote transparency, it also allows bad actors to review the test and look for loopholes. 

Scalability issues

One major problem with DeFi protocols is the scalability of blockchains. For instance, the Ethereum blockchain currently supports 15 transactions per second, which fails to meet the increasing demand and results in heightened gas fees and low transaction speeds. 

Low liquidity

As of now, the total value locked (TVL) in DeFi is over $35 billion, which is not much compared to the trillions of dollars of liquidity found in traditional financial systems.

Ethereum and DeFi

Ethereum is the second-largest cryptocurrency and a decentralized finance giant. In fact, the network was the first blockchain platform to support smart contract functionality. This has given Ethereum a first-mover advantage, which describes why most of the DeFi ecosystem is created on the Ethereum blockchain.

Despite the increase in the number of rival blockchains, Ethereum still accounts for the lion’s share of the DeFi ecosystem. That is largely due to the cryptocurrency’s buzzing community as well as passionate developers, who continue to innovate regardless of the crypto climate. 

Decentralized finance projects

DeFi projects are decentralized protocols running on top of Ethereum or other blockchains. These protocols use blockchain technology and smart contracts to automate financial services and undercut the need for intermediaries. 

  • MakerDao: MakerDao is a decentralized, peer-to-peer crypto lending protocol. Users can lend their ETH and receive DAI, a decentralized stablecoin, in return. 
  • Lido: Lido is a DeFi protocol that allows users to stake their coins.
  • Uniswap: Uniswap is one of the oldest decentralized exchanges that facilitate automated transactions.
  • Curve: Curve is a DEX focused on stablecoin trading.
  • Aave: Aave is a decentralized lending protocol.
  • Compound: Compound is a blockchain-based lending protocol. 
  • Convex: Convex is a DeFi project that boosts rewards for Curve stakers and liquidity providers.
  • Balancer: Balancer is a leading automated market maker (AMM) and a DEX.
  • Yearn Finance: Yearn Finance is a yield farming and lending protocol.
  • RocketPool: RocketPool is a decentralized staking pool.

How to invest in DeFi?

DeFi has burst in popularity over the past couple of years, becoming an attractive investment option for many investors. With the promise of high returns, DeFi offers a myriad of ways for interested users to invest in what could become the future of finance. Here are some of the best ways to invest in the booming DeFi sector:

  • Purchase DeFi coins: One rather straightforward way to invest in DeFi is to buy and hold the native token of DeFi protocols. That is because as DeFi projects grow in popularity, their native tokens also appreciate in value. 
  • Staking: DeFi staking platforms offer one of the most generous return rates for users who lock up their coins for some time. 
  • Yield Farming: Similar to staking, this method involves lending cryptocurrency. However, yield farming is a bit more complex and risky than staking, but also offers greater rewards.
  • Lend Stablecoins: Possibly one of the best ways to invest in DeFi without volatility concerns is to lend stablecoins. Users can open a DeFi interest account and earn relatively high rates on their stablecoins. 

History of DeFi

The term DeFi was born in 2018 in a telegram chat between some prominent Web3 developers. However, the idea can be traced back to the inception of Ethereum, the first blockchain with smart contract functionality. 

  • 2015: The Ethereum blockchain launched and developers started building all sorts of decentralized applications.
  • 2017: Maker, one of the oldest and first DeFi projects, launched at the end of 2017.
  • 2017: EtherDelta, one of the first DEXes, launched in 2017. However, at the end of 2017 the project was hacked. In 2018, the SEC also charged its founder for running an unregistered exchange. 
  • 2017 – 2018: Known as the ICO boom, this period saw projects using Ethereum to raise funds by selling tokens. While the period is marked by the number of scams and rug pulls, many popular DeFi projects, like Aave, Synthetix, and 0x, were also created at this time.
  • 2018: The first versions of Uniswap and Compound were launched. 
  • 2019: Uniswap became the go-to DEX and Initial Exchange Offerings (IEOs) took off. 
  • 2020: DeFi summer, which was characterized by yield farming and staking reward, started. Yearn Finance was also launched in early 2020.
  • 2021: Along with the crypto boom, DeFi continued to grow, and new projects were launched.

To sum it up

DeFi is a blanket term for financial products built on a blockchain. During its short life span, the industry has witnessed logarithmic growth. From DEXes to lending and borrowing protocols, DeFi projects have proliferated over the past couple of years, with each trying to address a need or shortcoming of this nascent industry.

  1. What does decentralized finance do?

    DeFi is a suite of financial applications built on blockchains.

  2. How big is decentralized finance on Ethereum?

    The total value locked (TVL) in Ethereum is currently over $35 billion.

  3. Is decentralized finance the same as crypto?

    No, cryptocurrencies act as the currencies of DeFi.

  4. Is Ethereum part of DeFi?

    Ethereum is a big part of DeFi as most of DeFi apps reside on the network.

  5. Does DeFi work on Ethereum?

    Yes, the majority of DeFi projects are created on Ethereum.

  6. Is Ethereum decentralized finance?

    Ethereum is a blockchain that can be used to create DeFi applications.

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