Decentralized finance (DeFi) is a financial technology that provides banking services without intervention from traditional banks. Instead of relying on centralized financial institutions, DeFi platforms run on algorithmic code called smart contracts to provide services such as lending, borrowing, and insurance.
This article outlines some of the key concepts and real world applications in DeFi and explains how it differs from traditional finance.
How is DeFi different from traditional finance?
Consider the following example to understand how decentralized finance functions differently from centralized institutions.
When Bob goes grocery shopping, he uses his debit card to pay for the bills. This seemingly simple payment process requires multiple steps.
First, the merchant forwards a request to an acquiring bank. The bank then forwards it to the card network, which requests payment from Bob’s bank account. The money is then debited and transferred into the merchant account. Since each intermediary charges a service fee, financial transactions become costly for the merchant. DeFi aims to bring down the transaction costs by facilitating a direct peer-to-peer payments system without involving any traditional banking institutions.
A peer-to-peer network can also reduce friction points for people applying for loans or buying insurance. Users don’t need to visit their local bank branch to submit a loan application and wait for approval. Instead of relying on their credit score and paying hefty service fees, they can pay collateral and borrow money instantly.
How is DeFi superior to traditional finance?
Decentralized finance has an edge over centralized finance for a number of reasons.
Minimal transaction fees
In the absence of a financial institution, DeFi participants don’t need to pay high fees for complex financial transactions. DeFi applications do, however, charge a small fee for the maintenance and upkeep of their platforms.
With smart contract-enabled DeFi applications, users no longer need to trust an institution with their money. Users retain control of all their cryptocurrency assets in a secure digital wallet and use their private keys for financial transactions.
Low entry barriers
DeFi users don’t need to go through an extensive onboarding process by completing Know Your Customer (KYC) and Anti-Money Laundering (AML) forms. A stable internet connection is enough to start using decentralized financial applications from a mobile phone or computer.
Fast transaction settlement
Since traditional financial infrastructure involves multiple intermediaries, the transaction processing and approval time is high. In a peer-to-peer network, however, transaction settlement happens instantaneously and users can transfer their crypto assets in seconds.
Better identity protection
DeFi applications do not ask for a user’s name, email, or any other personal information, thereby protecting the user's identity. Anonymous usage prevents any possibility of theft of user data.
DeFi concepts you should know
Yield farming is the process by which digital asset holders generate income by providing liquidity to DeFi applications. It is similar to depositing funds in a bank’s savings accounts but DeFi interest rates are much higher than banks.
Liquidity providers form a large section of yield farmers who deposit their digital assets in trading protocols to facilitate crypto trading. In return, farmers get Liquidity Provider (LP) tokens to stake in DeFi platforms or participate in initial DEX offerings (IDOs). Yield farmers also provide capital to smart contract-enabled lending platforms to earn interest from lending/borrowing digital assets.
Liquidity mining is the process by which miners can earn interest by providing digital assets to the liquidity pools of decentralized exchanges (DEXs). Some exchanges like Uniswap require an equal proportion of token pairs in the liquidity pool while Balancer allows a customizable pool.
Liquidity mining is a popular passive income strategy for DeFi users. Such platforms offer lucrative rewards to users like a percentage of trading fees and governance tokens. Investing in a liquidity pool with a high Annual Percentage Yield (APY) will generate more returns.
Simultaneously, DeFi projects issue governance tokens for project users, empowering them to directly participate in governance decisions. Thus, governance token holders have voting powers with each token equivalent to one vote. Users can vote on issues like adjusting transaction fees, adopting new rules, protocol modifications, etc.
Token swapping is the process by which crypto holders swap their current tokens for other tokens. Swapping happens through smart contract-enabled decentralized exchanges that leverage an Automated Market Maker (AMM) for exchanging tokens.
An Automated Market Maker is an underlying protocol in a decentralized exchange that replaces a traditional order book with an automatic pricing algorithm, facilitating trustless trading.
DeFi users swap tokens for two purposes: to execute a currency exchange and acquire a different token than the one they are currently holding, and to make a profit from swapping tokens with different prices.
Staking is the process by which users lock their digital money to validate transactions in a Proof-of-Stake blockchain. Stakers who deposit their crypto in a staking pool earn rewards for keeping the blockchain safe.
The protocol offers a percentage of fees and governance tokens for successfully validating legitimate transactions on the network. Staking is comparatively easier than yield farming but has fixed lock-in periods with stable APYs. Thus, staking is more suitable for retail investors with a low-risk appetite.
DeFi composability refers to the interoperability of DeFi platforms in which the value locked across different protocols is available for all decentralized applications. Users can therefore leverage the value locked across Aave, Maker DAO, and Curve Finance, and use it in other protocols.
Composability enables DeFi platforms to unlock new revenue streams as the liquidity no longer remains isolated. Thus, users can trade assets, stake them, deposit tokens in liquidity pools, lend, and borrow cryptos across blockchain networks.
Popular DeFi applications and use cases
Decentralized exchanges (DEXs)
Most crypto users trade assets on a centralized exchange in which a central entity has control over user funds. In 2021, centralized exchanges (CEXs) recorded $14 trillion in trading volume, a sharp rise of 689% from 2020. Users are beginning to realize, however, that CEXs require them to trust third parties, which goes against a fundamental principle of crypto. It can also be risky: some CEXs have kept users’ funds when facing collapse.
In smart contract-enabled DEXs, users can trade a particular digital asset without involving any intermediaries. This peer-to-peer (P2P) trading helps users retain sovereign control of their funds.
The use of decentralized exchanges is thus rising. In 2021, DEXs recorded $1 trillion in trading volume, a steep rise of 858% from 2020. As the data demonstrates, DEX trading grew more in the last year than CEX trading.
Lending and borrowing
Unlike traditional finance in which banks manage lending and borrowing, in DeFi, smart contracts facilitate these services. Automating lending and borrowing services via smart contract helps to reduce application processing time and high overhead charges. A user can therefore instantly get a loan without having to complete any paperwork.
DeFi platforms running on smart contracts also offer flash loans to users. A flash loan is an uncollateralized loan in which traders borrow and return funds instantaneously. Some DeFi platforms offer dynamic interest rates with the smart contract regulating rates based on the supply-demand ratio.
Stablecoins have come up as a DeFi innovation to address the notoriously high crypto market volatility. A stablecoin is a cryptocurrency whose value is pegged to fiat currency (US Dollar, Euro) or commodities like gold.
Stablecoins stabilize the price of cryptocurrencies and allow low-risk investors to participate in the DeFi ecosystem. Some of the most popular stablecoins include Tether (USDT), USD Coin (USDC), Binance USD (BUSD), and Dai (DAI).
Wrapped cryptos are a unique technology that strengthens DeFi composability. Wrapped cryptocurrencies refer to digital tokens whose value is pegged to another crypto on a different blockchain in a 1:1 ratio. Wrapped tokens can work on non-native blockchain networks, making assets more interoperable.
For example, wrapped Bitcoin (wBTC) can function on Ethereum protocols, enabling Bitcoin holders to participate in the DeFi ecosystem. Some companies like DG Labs and Suredbits are even exploring the possibility of incorporating smart contract functionality into the Bitcoin network. Instead of wrapping BTC, they are developing discreet log contracts to facilitate derivatives trading and pay for futures contracts.
DeFi offers miscellaneous banking services like buying insurance or trading derivatives and futures contracts. The experience is similar to buying or selling stocks, but without the involvement of brokers.
DeFi has made inroads into betting and prediction. Prediction markets are empowering users to rely on quantified forecasting as an essential tool to better predict future results. Prediction markets can help to answer complex social questions and deliver robust information by weeding out faulty forecasters.
DeFi and Ethereum
In 2013, Vitalik Buterin first proposed the idea that cryptocurrencies can expand beyond simple transactions to include complex financial services. In the Ethereum white paper, he introduced the concept of smart contracts, which would enable developers to design decentralized apps. Solidity, the programming language of Ethereum, was conducive to writing the contract code for dApps and deploying them on the blockchain.
Ethereum, therefore, inaugurated the DeFi movement and is still host to the majority of dApps. Currently, the Ethereum network dominates the DeFi sector with a 61% market share.
This market dominance has some disadvantages, however. The transaction fees (gas) have skyrocketed during periods of high network congestion and led to more transaction processing time. Moreover, Ethereum relies on the energy-intensive Proof-of-Work consensus mechanism that leaves behind a high carbon footprint.
What are the risks of DeFi?
Hackers can exploit a bug or other vulnerabilities in the smart contract code to steal investor funds. According to a few reports, in 2021, DeFi hacks constituted 75% of all cryptocurrency hacks, totalling $10 billion.
Minimal consumer protections
In the current financial system, banks maintain a private ledger that is open to scrutiny from regulatory bodies. With DeFi, however, transactions are beyond the scope of regulatory bodies like the Securities and Exchange Commission (SEC) or the Federal Deposit Insurance Corporation (FDIC). DeFi investors, therefore, have no protection from rug pulls or fraud.
Private key management
DeFi users often use a non-custodial wallet to store their cryptocurrencies, making them sovereign owners of their assets. Losing these keys, however, means losing access to the wallet’s funds. Users must therefore take extra precautions to safely store their keys
Is it safe to invest in DeFi?
DeFi offers a very high ROI, but high-profit percentages are often accompanied by greater risks. Users therefore need to do their own research before investing in DeFi platforms.
It is best to choose protocols that offer bug bounty programs, invite whitehat hackers, and conduct third-party audits. These methods help lower the risk of major theft. It is also safer to avoid fully anonymous teams and projects with inactive social media profiles.
The Future of DeFi
DeFi is one of the fastest-growing blockchain sectors, recording 47% growth in a year. During the 2021 bull run, the total value locked in DeFi protocols surpassed $233 billion from just $13.6 billion in 2020.
As DeFi protocols continue to innovate and become more decentralized, they will successfully decouple themselves from legacy market conditions. Once that happens, the DeFi market will become stable and bring more value to the global economy.
Frequently Asked Questions (FAQs)
What is DeFi?
DeFi refers to “decentralized finance”, a sector in which all financial transactions take place without any intermediary agencies like banks. Instead, self-executing computer codes called smart contracts manage these transactions.
How do you make money in DeFi?
Users can make money in DeFi by trading their assets on a decentralized crypto exchange and participating in lending, borrowing, yield farming, staking, or prediction markets.
Is Bitcoin part of DeFi?
Initially, Bitcoin was not a part of the DeFi ecosystem. However, Wrapped Bitcoin (wBTC), as well as other technologies like discreet log contracts, are enabling Bitcoin DeFi transactions.