Decentralized Finance, called “DeFi” for short, is a term that’s used to describe the various financial applications in cryptocurrency or blockchain that focused on disrupting financial intermediaries.
That means instead of relying on banks, credit unions, etc. it operates independently. Users can trade, invest, transfer, and transact peer to peer using digital assets and cryptocurrencies through automated smart contracts.
What is DeFi?
DeFi builds upon the ideas behind blockchain like Bitcoin which enables several entities to have a copy of historical transactions so it’s not controlled by one single source.
This is relevant because centralized systems and human gatekeepers can slow down processes and users don’t have as much control over their money. What’s unique about Defi is that it expands on the use of blockchain to offer more complex financial use cases.
Think of legacy digital payment methods as those run by Visa or Mastercard. They act as the middlemen in transactions. For example, let’s say you go out for lunch at a local sandwich shop. When you use a credit card to pay for your food, there’s a financial institution that is in the middle of the transaction between you and the merchant.
This financial institution has control over the transaction which enables them to stop or pause it. Recording of the transaction occurs in their private ledger. Bitcoin and other digital-native assets cut these institutions out.
Cutting out the middleman from these direct purchases is among the reasons why DeFi is beneficial. DeFi also seeks to remove them from other financial applications including loans, crowdfunding, derivatives, betting, and insurance.
The costs are reduced and the speed of these financial applications is increased by eliminating these intermediaries. The idea of DeFi was previously known as “open finance” for these reasons.
Scope and Types of Applications of DeFi
Even though other trends and currencies are emerging, currently the majority of applications that consider themselves DeFi are built on top of Ethereum. This cryptocurrency is the second largest in the world. What sets it apart from Bitcoin’s platform is that it’s easier to build other types of decentralized applications.
Ethereum can go beyond simple transactions to offer complex financial use cases. Many of these were highlighted originally in 2013 by Ethereum’s creator Vitalik Buterin.
These complex financial transactions can happen because of Ethereum’s platform for smart contracts. These contracts will automatically execute transactions once certain conditions are met.
Solidity and other Ethereum programming languages are designed to create and deploy these smart contacts.
Now let’s say that you want to send money to a friend on Saturday. But you only want it to be sent if the Lakers win the game against the Celtics as reported on ESPN.com. A smart contract has these rules written as such.
The total value locked (TVL) rose sharply during the “DeFi Summer” in 2020. During this industry boom, smart contracts went from being worth a few hundred million dollars to $20 billion U.S. dollars in a few months. Compared to the traditional financial system, the DeFi space is still small. But its growth doesn’t seem to be slowing down and interest has only risen.
Here are some other DeFi applications that are found today discussed below:
Decentralized Exchanges
If you want to exchange your currency for another, decentralized changes can help you accomplish this. This includes the U.S. dollar, foreign currencies, bitcoin, ether, etc.
That means you can take your U.S. dollars and exchange them for etherium or your etherium for bitcoin. Users that want to directly trade their cryptocurrencies for another without having to use an intermediary typically prefer this type of exchange.
Prediction Markets
The DeFi version of betting on the outcome of a future event removes the intermediaries from the picture. It’s among the first applications of DeFi that exists. This type of prediction market seeks to have the same functionality as non-DeFi versions offer.
DeFi prediction markets can often provide better outcomes than traditional methods. When prediction markets run in a centralized manner, they are often shut down by governments. This offers DeFi the potential to spark interest in using this method as an alternative.
Lending Platforms
Using smart contracts, these platforms remove banks and other intermediaries that are between the lender and borrower. This is one of the use cases that is rapidly growing in the cryptocurrency ecosystem is DeFi loans.
This allows crypto holders to earn interest on assets they lend to others. Borrowers must provide collateral that’s valued above the loan to protect from price fluctuations.
This collateral is typically ether which is the token behind Ethereum. Users don’t have to provide their identity or other typical information such as their credit score which is typically provided when taking out a non-DeFi loan.
The compound is one of the most popular platforms available. It allows users to borrow or offer their own loans using cryptocurrencies. The interest rates are set using algorithms in a way that they increase as there is a higher demand to borrow a cryptocurrency.
“Wrapped” bitcoins (WBTC)
Using this method of sending bitcoin through the Ethereum network allows it to be used directly in their DeFi system. Users earn interest in bitcoin that’s lent out using the leading platforms discussed above.
Stablecoins
This is a cryptocurrency that is pegged to a non-crypto currency asset to stabilize its price. For example, it could be tied to the euro or the U.S. dollar. The price fluctuations that occur with cryptocurrencies are sharper than what’s experienced with fiat money. This can make it challenging for people who want stability in their money’s value. Stablecoins that are redeemable in currency, fiat money, or commodities are considered backed.
Ethereum and Bitcoin are the two largest DeFi applications that are controlled by large networks of computers instead of individual computers.
For example, Dai has gained popularity to become the third most widely used DeFi application. It is a stable coin cryptocurrency with the purpose of keeping its value as close to 1:1 as the U.S. dollar. It uses an automated system of smart contracts on the Ethereum blockchain to do this.
Other Applications
The applications that were mentioned above are those that have helped shape DeFi. There are new concepts that have developed more recently that further diversify how it’s applied to the industry including:
- Yield Farming – Users can scan to search for opportunities that may yield higher returns through the use of various DeFi tokens.
- Composability – Since DeFi apps are open source, that allows anyone to view the code behind them. That means these apps can help “compose” new apps using their coding as a framework.
- Money Legos – Another way that DeFi apps can be used is by being put together with similar apps to create new financial products, like “money legos”.
- Liquidity mining – This is another type of yield farming that goes further by enticing users to their platforms by offering free tokens.
Markets
Ethereum is the most popular blockchain that’s used today and that’s where most of the applications of DeFi are based on. Billions worth of these transactions happens each week. Often called the “next internet”, the Ethereum network gained this title because of the ability to decentral services, particularly those in financial services.
Communities across the globe can be brought together with its network.
The Ethereum blockchain has hundreds of decentralized applications, or dApps available. More than one million monthly users are part of the top ten of these applications. The 24-hour trading volume is over $35 billion dollars strong. Each transaction garners a fee that’s used to incent user that builds and maintain the network
As a result of the fast rise of users to the network and increase in the price of Ether, there’s been a spike in the “gas” fees that are charged in these transactions. Ethereum 2.0 is intended to deal with this issue of scalability.
Benefits of DeFi
Decentralized finance allows for instant or near-instant transfers at reduced costs and fees. With only an internet connection, users can trade and transact at any time from anywhere.
There are fewer intermediaries between the interaction so fewer parties take a slice of the pie. This is an advantage that those who use traditional finance methods do not see.
One example of this can be seen in the protocols found in DeFi lending. Users that stash their cryptocurrencies in a depositary can yield much higher interest rates for those deposits. The terms on loans and lines of credit are also more favorable, with lower fees involved.
Another key benefit of DeFi is that it provides access to financial services to virtually everyone. Think about how traditional financial institutions operate.
Their services are often out of reach for low-income, minorities, and immigrant populations. The open ecosystem of DeFi allows these individuals who otherwise wouldn’t have access to financial services to benefit at a reduced cost.
As an added benefit, these individuals can tap into a broader range of financial services provided by various DeFi applications.
There is also no single point of failure with financial services that use DeFi. That is because these services are deployed on top of blockchains. It takes the data recorded on the blockchain and spreads it to thousands of nodes. This makes it difficult to censor and minimizes the possibility of a shutdown of the service.
The frameworks for DeFi applications make it possible to build in advance. Therefore the deployment is simplified and more secure.
The “open finance” model is already one of the building blocks of DeFi. The blockchain allows every transaction to be publicly visible. This transparency is also found in the information that’s available between the pro traders and everyday users.
You can easily see what current loan rates are or how much a protocol has been used. And of course, the theme of transparency is also extended to its code. Anyone can see how a DeFi application is coded so they can understand how it works and use it to build new protocols and platforms.
Finally, when you use DeFi you are taking part in the innovation and change in the finance world. It allows you to do things like own 0.054% of a real estate property, readily trade assets that take the form of tokens, and build “money legos” to create flexible financial systems.
Risks of DeFi
The advantages of DeFi make it a compelling offering for users. However, there are risks that should be also be mentioned.
Ethereum’s smart contract system that offers many of its advantages can also in certain cases be its greatest weakness.
For example, someone with ulterior motives could exploit a smart contract since it’s open-source and publicly verifiable. This action could put funds involved at risk.
Smart contracts are often controlled with admin keys. Important changes to the code like upgrading the protocol are controlled by these key holders. These smart contract administrators will typically use advanced security methods including time-locks to protect their admin keys. Still, you need to rely on these key holders to adequately protect and care for these smart contracts.
There are also some DeFi protocols that have community governance options. These come in the form of governance tokens which let holders propose and vote on key decisions prior to being implemented to the platform. You will need to keep track of any big changes because your returns could be affected.
There are also financial risks you need to weigh with DeFi markets. You need to keep up with the market as it moves fast, putting your investments at risk. Over-collateralization can multiply this risk factor.
Additionally, there are a number of ways you could lose access to your crypto assets. Forgetting or misplacing a private key or wallet file is one of the common ways this occurs. You should protect yourself by using a non-custodial wallet that gives you only access to the funds.
You should also be aware that this industry is popular for scam artists. Common attack vectors that encourage you to earn free rewards by sending your crypto to an address should be viewed with scrutiny.
Opportunities
2020 was one of the most challenging years the world had faced due to the COVID-19 pandemic. Economies buckled on collapse and governments were forced to make changes in monetary policies and provide stimulus packages. But for the cryptocurrency community, the year brought success and major milestones. The uncertainty and monetary policy caused cryptocurrencies and other alternative asset classes to become attractive to investors and others.
Bitcoin reached its higher levels that have been absent since its 2017 bull run. It also broke a new record for overall market capitalization. DeFi itself put up impressive numbers in 2020. It benefited from the increased activity and value move found in the Ethereum ecosystem.
Check out the DeFi projects in our Founders Community.
The DeFi space achieved a notable milestone in August 2020 when the market surpassed $7 billion in value locked between the platforms that are part of the ecosystem. Coupled with the rising price of Ether as investors dived into the yield farming sector, DeFi applications are close to 50% of the total value of the Ethereum system.
Decentralized Finance is still at the experimental stage so there’s bound to be some growing pains and issues. Many believe that these problems will be solved in the future. As long as DeFi platforms continue to drive adoption and provide more uses for DeFi projects, the future looks exciting!
