Decentralized Finance (DeFi) 101
Summary
Decentralized Finance, aka DeFi, provides an open financial system by utilizing protocols, cryptoassets, smart contracts, and decentralized applications.
Benefits of DeFi are that it is: programmable, permissionless, decentralized, interoperable, and transparent.
Common applications of DeFi include: decentralized exchanges, lending, borrowing, savings, and payments.
Estimated time: 2 minutes
What is DeFi?
Decentralized finance or DeFi is often called “open finance”. It utilizes protocols, digital assets, smart contracts, and decentralized applications (dApps), most commonly housed on the Ethereum blockchain, to build a financial platform that’s open to everyone. DeFi aims to remove all of the middlemen from traditional financial instruments, e.g. savings, lending, trading, insurance, etc. DeFi has become the most active field within the blockchain space, providing a wide range of use cases for individuals, developers, and institutions.
“DeFi is short for “decentralized finance,” an umbrella term for a variety of financial applications in cryptocurrency or blockchain geared toward disrupting financial intermediaries." – Coindesk
How does DeFi work?
Although DeFi utilizes multiple blockchains, it is closely related to Ethereum and the cryptocurrency that incentivizes its use. This is because Ethereum is designed to be more of an infrastructure, allowing developers to build decentralized applications or dApps on top of it, and to encode these self-adjusting “smart contracts” to work on the network.
What Are the Benefits of Decentralized Finance?
Programmable: Smart contracts and dApps are highly programmable, which allows for low-cost financial services.
Permissionless: Anyone with a crypto wallet and an internet connection, regardless of their geography and often without any minimum amount of funds required, can access DeFi applications.
Decentralized: Records are not stored on a single server or central network.
Interoperability: Composable software stacks ensure that the construction of DeFi protocols and applications can be integrated and complementary to each other. With DeFi, developers and product teams can flexibly build on existing protocols, customize interfaces and integrate third-party applications. Therefore, people often refer to DeFi protocols as “Money Legos.”
Transparent and Trustless: On the public Ethereum blockchain, every transaction is broadcast to and verified by other users on the network. Ethereum and the DeFi protocols running on it are also built with open source code that is available for anyone to view, audit, and build upon.
Lower Costs: Because there is no middleman involved to charge fees in order to cover their overhead and make a profit, DeFi services are often cheaper to use and/or distribute a larger portion of the returns to its users.
Non-custodial: Traditional finance takes ownership of your assets and credits an account balance to the customer. However, in DeFi, through the use of smart contracts, the user always maintains ownership and control over their assets.
Open 24/7: Unlike traditional financial markets that close after 5 P.M., on weekends, and holidays, DeFi is available 24 hours a day, 7 days a week, and 365 days per year.
Common DeFi Applications
Decentralized Exchanges (DEXs): A decentralized exchange (DEX) is a cryptocurrency exchange that can be operated without central authorization, allowing users to conduct peer-to-peer transactions and maintain control of their funds. Because the maintenance cost is lower, the cost of transaction fees is lower. Also, DEX reduces the risk of price manipulation, hacking, and theft, because encrypted assets will never be kept by the exchange itself.
Rather than relying on market makers to help determine and provide liquidity, DEXs uses an algorithm called an automated market maker (AMM) to set the price. DEXs rely on users to deposit assets into a liquidity pool (in exchange for earning yield) that traders can then trade against. The price is determined algorithmically based on the proportion of the two assets being traded.
Lending and Borrowing: The fastest growing sector of DeFi is lending. Traditionally, borrowing money was facilitated by central institutions such as banks and money markets. Even online peer-to-peer lending is still controlled and facilitated by a central corporation such as LendingClub. In contrast, DeFi lending enables anyone to become a lender or a borrower in a completely decentralized manner while at the same time, allowing users to maintain full custody of their tokens.
Rather than rely on a central authority, DeFi lending takes advantage of smart contract platforms such as Ethereum to create automated money markets for various tokens. Users only need to deposit funds, and they can earn interest from others who borrow the assets. Many lending opportunities in DeFi can provide high-interest rates, especially in an era when zero or negative interest rates have become standard interest rates.
Savings: By inserting a lending pool agreement, the income of interest-bearing accounts provided by many DeFi applications can grow exponentially over traditional savings accounts, depending on dynamic interest rates related to supply and demand. A DeFi activity that revolves around these innovative savings mechanisms is “per yield agriculture.” Yield farming also referred to as liquidity mining, is a way to generate rewards with cryptocurrency holdings. In simple terms, it means locking up crypto-currencies and getting rewards.
Payments: Peer-to-peer payment can be said to be a basic use case for the DeFi space and the entire blockchain ecosystem. Blockchain technology has been architecturally designed so that users can safely and directly exchange cryptocurrencies with each other without the need for middlemen. DeFi payment solutions are creating a more open economic system for the unbanked people. It also helps large financial institutions simplify market infrastructure and better serve wholesale and retail customers.
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