What Is Decentralized Finance?
Unlike traditional finance, DeFi, or Decentralized Finance, is an ecosystem of peer-to-peer financial applications that can be used without intermediaries. It is developed on top of blockchain technology using financial primitives as the building blocks, such as credit (lending & borrowing), payments, derivatives, and exchanges for trading assets. DeFi platforms are designed to ensure equal and open access to their services across all users. At its peak in December 2021, the total value locked (TVL) in DeFi protocols across leading blockchains has exceeded $256 billion, increasing by nearly four times within one year.
Sounds complicated? Don't worry. This detailed guide will go through DeFi and its ecosystem, from its history to financial primitives, top-performing protocols, and future outlook.
If we go back in time, the 'currency' had taken many shapes and forms, but the most dominant use-case of currency was to buy goods and services. As the size of the economies grew, we saw the emergence of different financial instruments to cater to the needs of a growing economy.
Importance of DeFi
One of the earliest financial instruments we saw was credit, i.e., lending money to people and businesses at a pre-specified interest rate. Soon after, we saw several business model innovations that gave rise to banks and financial institutions offering different services.
Centralization Brings Lack of Trust
The biggest problem with these financial service providers is centralization and lack of trust. Throughout history, we witnessed many financial crises and hyperinflation events affecting billions of people around the globe.
Traditional Financial Services Are Not Accessible to All
The second biggest problem is the lack of access. You will be surprised to hear that 1.7 billion adults worldwide are still unbanked; they don't have access to even the most basic financial instruments, such as a savings account or the ability to take out a loan.
DeFi Opens Up Access to Financial Instruments
Blockchain technology took the currency out of the control of central banks and governments, and DeFi is doing the same with traditional finance, giving everyone access to financial instruments.
Now with DeFi products, you can take out a loan in less than 3 minutes, open up a savings account almost instantly, send payments across the world at lightning speeds, and invest in your favorite company through tokenized securities no matter where you are.
How Does Decentralized Finance (DeFi) Work?
DeFi applications live on blockchain networks powered by smart contracts, programs stored on a blockchain. You can think of a smart contract as a program representing a set of digital agreements. The program executes once it meets certain predefined conditions, e.g., release a loan to a specified address once the collateral amount is sufficient.
The Ethereum blockchain introduced smart contracts with its Ethereum Virtual Machine (EVM), a quasi–Turing-complete state machine. EVM is a computation engine for Ethereum that compiles and runs smart contracts.
Developers write code for smart contracts in programming languages that can compile into EVM, such as Solidity and Vyper. Solidity is by far the most popular programming language for coding smart contracts on the Ethereum blockchain.
Ethereum gained a lot of momentum and became the second-largest cryptocurrency after Bitcoin due to the flexibility it offered through EVM and smart contracts. However, Ethereum isn't the only smart contract platform out there. Many other blockchain protocols, called 'Ethereum alternatives' or ‘Ethereum killers,’ support smart contracts.
Some of the most popular smart contract platforms beyond Ethereum include Cardano, Polkadot, TRON, EOS, Solana, Cosmos, etc. These platforms are distinct and offer a completely new design approach and architecture to solve many problems, such as scalability, interoperability, and transaction throughput.
Even though some smart contract platforms are way better in terms of technology, nothing comes close to Ethereum when we look at the numbers. Due to the network effect and first-movers advantage, Ethereum has gained a strong foothold in terms of adoption.
If we talk about DeFi applications alone, DeFiPrime states that there are 202 DeFi projects so far, and 178 of those projects are on Ethereum.
DeFi platforms are smart contracts that live on the supported smart contract platforms. Ethereum smart contracts hold the largest share of this market, so the most popular DeFi applications are on Ethereum.
How Is Decentralized Finance Different From Traditional Finance and Centralized Finance: DeFi vs. TradFi vs. CeFi?
Traditional finance, also known as centralized finance, uses intermediaries from banks and other financial institutions that offer services to their users or customers. On the other hand, DeFi products leverage blockchain technology to employ a decentralized, peer-to-peer, flatter, and less hierarchical structure for financial transactions, focusing on greater accessibility. Here are the essential differences between DeFi and CeFi models.
With a lack of intermediary services, DeFi applications usher in a new wave of transparency in their services thanks to their peer-to-peer nature. Their processes and rates are decided in a transparent model, with participation from users instead of leveraging an invisible, centralized entity for governance purposes.
As a result, a DeFi application and its workings are more transparent than its CeFi equivalent. In addition, eliminating the intermediary in DeFi’s P2P model removes a single point of failure for the financial system - be it as a target for hacks or manipulation. Unlike CeFi, DeFi is consensus-driven and cannot be manipulated without awareness among its user base.
Eliminating an intermediary who controls transactions also makes the processing of transactions faster in a DeFi application. Transaction handling is less time-consuming, and records are clearly maintained, tamper-proof, and visible to all participants.
In addition to the speed, the decentralized model makes transaction processing much cheaper in DeFi. In CeFi, basic financial transactions like remittances need to depend on inter-bank communication across geographies and the process is further slowed down by regulations imposed in each country. On the other hand, a cross-border transaction using DeFi can be processed in a few minutes instead of taking several days at a fraction of the cost.
Greater Control to Users
DeFi users are assigned complete custody over their assets, and security is their own responsibility. As mentioned above, this prevents a central authority from becoming a lucrative target for hacks and attacks trying to access users’ funds.
This model also brings about higher cost efficiencies as financial institutions spend large sums of money on protecting their customers’ assets and insuring against loss. DeFi does not require such extravagance.
Regular financial markets operate only five days a week during banking hours, which can vary worldwide. However, DeFi relies on always-on digital technology, keeping markets open and accessible to users anywhere in the world at any time.
DeFi markets operate 24 hours a day, seven days a week, with no time for market closing. As a result, DeFi markets' liquidity can be maintained more steadily than in traditional financial markets, where it can get thinner on market closing.
Built on superior blockchain technology, DeFi applications employ smart contracts that store and process data in a tamper-proof manner. Traditional financial organizations are susceptible to hacks and manipulation by malicious insiders or external attackers. On the other hand, DeFi leverages a P2P transaction model, with all participants gaining complete visibility, which can prevent such manipulations.
What Can Decentralized Finance be Used For? Most Popular Applications For DeFi
Financial primitives are the building blocks, or money legos, that serve as the foundation for today's financial services industry. DeFi apps provide an alternative financial system with financial primitives built into smart contracts.
Decentralized Exchanges - Provide liquidity and the ability to swap two different assets.
Stablecoins - A digital asset that is stable in value.
Credit - Lending and borrowing, and the ability to earn interest on idle assets.
Decentralized Exchanges (DEXs)
DEXs, or decentralized exchanges, is the third financial primitive for the DeFi ecosystem. Decentralized exchanges let users trade their crypto assets completely trustless and decentralized. They don't require any KYC and have no regional restrictions.
Decentralized exchanges have recently gained significant momentum, with more than $26 billion locked in value across all DEXs. Unlike a centralized exchange, DEXs don't deal in fiat and only support crypto-crypto trades.
If we categorize decentralized exchanges, we see two most common types:
DEXs based on order books - These decentralized exchanges operate on a commonly used order-book model that almost all centralized exchanges employ.
DEXs based on liquidity pools - These decentralized exchanges are called 'Token Swap Platforms.' Unlike the traditional order-book mechanism, these DEXs employ liquidity pools, allowing you to trade (swap) one pair at a time.
As the name suggests, stablecoins provide a stable digital asset. Stablecoins are cryptocurrencies pegged to a stable external asset (like the Fiat US dollar) or a basket of different assets that limit price fluctuations and volatility.
Stablecoins are the backbone of DeFi. In just five years, stablecoins have surpassed a total market capitalization of $146 billion. The graph below shows the growth of the nine biggest stablecoins by their market cap.
There are four types of stablecoins:
Crypto-backed - These are the kind of stablecoins backed by overcollateralized crypto assets. The over-collateralization exists because the underlying crypto assets (e.g., ETH, BTC) are volatile. Examples include DAI, sUSD, aDAI, and aUSD.
Commodity-backed - The kind of stablecoins backed by a commodity like gold or silver. Examples include PAXG, DGX, XAUT, and GLC.
Algorithm-backed - These are the stablecoins backed by algorithms that control the price and sustain it at a certain level. Unlike others, these stablecoins don't require any collateral. Examples include AMPL, ESD, and YAM.
Many stablecoins today also use a hybrid model. They combine the above-mentioned categories to achieve a stable price and less volatility. RSV is one of the hybrid stablecoins that use a pool of different assets, including crypto-backed and fiat-backed assets like USDC and DAI.
One unique property of stablecoins is that they are 'chain agnostic' because they are pegged to external assets. They can exist on many blockchains, e.g., Tether is a popular stablecoin that co-exists on Ethereum, TRON, OMNI, and a few other platforms.
The credit market for lending and borrowing is the second financial primitive for the DeFi ecosystem. An entire banking sector worldwide stands on these credit markets, where lending and borrowing comprise a significant portion of their business model.
The lending segment is the largest DeFi segment, with over $38 billion locked in various DeFi lending protocols. As a comparison, the total value locked in DeFi stands at $89.12 billion as of May 2023, meaning that DeFi lending protocols represent almost 50% of the total market share.
Lending and borrowing in the DeFi space are very different from the traditional mechanisms employed by banks and other financial institutions. You don't need many documents or a credit score when borrowing money. All you need is two things; enough collateral and a wallet address.
DeFi also opens up the broader P2P lending market for those who want to lend their crypto assets to borrowers and earn interest. The lending marketplace makes money on a net interest margin (NIM), just like banks or traditional P2P lending institutions.
The whole DeFi ecosystem is standing on these three financial primitives. When you combine them properly, you get an alternative decentralized financial services industry that is open, transparent, trustless, and borderless.
How Do You Earn in DeFi?
DeFi can be an exciting avenue for investors looking to generate additional returns from their crypto holdings. Let’s look at the different ways to earn additional income via decentralized finance applications.
Staking is a process that lets users earn rewards for holding some cryptocurrencies which employ a Proof of Stake (PoS) consensus mechanism. A staking pool within a DeFi app functions like a savings bank account, letting users add their holdings of specific cryptocurrencies to the pool to earn a percentage as a reward over time. Cryptos staked are then put to work by the DeFi protocol, and the rewards generated are distributed among the community of investors.
Yield farming is a more advanced investment strategy in DeFi than staking. It is one of the most popular methods to generate more crypto holdings returns, offering users a good stream of passive income. DeFi protocols employ yield farming to maintain sufficient liquidity of crypto assets on their platforms, giving DEXs the necessary liquidity to sustain exchange and lending services.
Yield farming is offered by AMMs (automated market makers). AMMs are smart contracts that use the power of mathematical algorithms to support the trading of digital assets on DEXs. Regarding yield farming, AMMs enable adequate liquidity without an intermediary, leveraging liquidity pools and providers for this purpose.
While liquidity mining and yield farming are used interchangeably, there is a subtle difference between the two terms. Like yield farming, liquidity mining helps maintain sufficient liquidity to facilitate trading and transactions within DeFi protocols. However, liquidity mining leverages smart contracts and liquidity providers, while yield farming requires AMMs.
While yield farming offers rewards in the form of APYs for a fixed duration when the users lock in their crypto assets for liquidity, liquidity mining offers rewards in the form of liquidity provider (LP) tokens or governance tokens.
Although crowdfunding has existed for several years, DeFi has boosted it by making it easier and more accessible. The power of decentralization merged with this popular way to raise funds for causes and projects makes crowdfunding one of the most exciting ways to earn revenue from DeFi.
DeFi projects allow users to invest their crypto holdings in exchange for rewards or equity in upcoming projects looking to raise funding. Crowdfunding also allows users to donate to social causes in DeFi. In addition, peer-to-peer crowdfunding lets users raise funds from each other and generate rewards for their contributions in a transparent and permissionless manner.
What Are the Risks of DeFi?
DeFi may be the future and grow in awareness and adoption, but it comes with risk factors and challenges. Let’s look at some of the biggest risks DeFi faces.
Software Risks Within Protocols
DeFi protocols run on smart contracts, which may have vulnerabilities that can be exploited. According to estimates by Hacken, DeFi hacks have led to over $4.75 billion in losses in 2022, up from around $3 billion in 2021. The attacks were carried out by hackers who successfully identified and exploited key vulnerabilities in the software.
Frauds and Scams
The high level of anonymity and lack of enforcing KYC processes makes it very easy for some users to launch fraudulent projects and scams in the DeFi market. From rug pulls and pump-and-dump schemes, many such instances have been prevalent in the news through 2020 and 2021, scaring investors away. Recent trends highlight scam projects stealing many investors’ funds from leading DeFi protocols. They are one of the most significant risk factors keeping large institutional investors wary of entering the market.
Risk of Impermanent Loss
Owing to the high volatility in cryptocurrency prices, prices of tokens in liquidity pools in DEXs can vary at different rates. Suppose the price of one token in the liquidity pool surges rapidly while the other token holds mostly stable. In that case, users’ earnings get affected significantly, sometimes to the downside, resulting in losses. While the risk of impermanent loss can be mitigated to some extent by performing historical data analysis on the token’s price before adding liquidity to a pool, it cannot be eliminated due to the crypto market's highly volatile and unpredictable nature.
Some DeFi applications in the derivatives and futures space offer users very high leverage, up to 100x. While the high leverage can seem lucrative for winning trades, the losses can also be severe, especially considering the cryptocurrency market's highly volatile price action. Fortunately, the most reliable DEXs offer manageable levels of leverage to prevent users from borrowing too much while placing bets in the market.
Every token invested in using DeFi protocols needs to be thoroughly researched by users, but this is more often not the case. In a hurry to get in on the next exciting trend, most users fail to perform due diligence and checks before investing their crypto capital. When investing in new tokens, the risk element is exceptionally high, even though the potential for rewards could also be higher. Investing in tokens without reputable developers and backing can lead to significant losses among investors.
While the DeFi market enjoys a TVL amounting to several billions of dollars, financial authorities still do not regulate it. Several countries and governments are still trying to understand how the market works and are considering implementing regulations to protect investor interests. However, most users investing in and utilizing DeFi services lack awareness about the absence of regulations in this sector. Investors who lose their crypto capital to frauds and scams have no legal recourse in getting their funds back and are at the mercy of the DeFi protocols for safeguarding their funds.
Conclusion: Future Outlook For DeFi
Decentralized Finance has the potential to make financial products accessible to more people worldwide. The DeFi sector has grown from just a few DApps to providing a new alternative financial services infrastructure that is open, trustless, borderless, and censorship-resistant. The above-mentioned applications offer a foundation for building more complex and sophisticated applications in the DeFi ecosystem, such as derivatives, asset management, and insurance.
Ethereum clearly dominates the DeFi ecosystem because of its network effect and flexibility. However, alternative platforms are gaining traction, slowly attracting the talent pool towards them. The ETH 2.0 upgrade has the potential to improve many things in Ethereum with sharding and a Proof-of-Stake consensus engine, and we might see intense competition between Ethereum and alternative smart contract platforms for a share of DeFi's emerging ecosystem.
Key Takeaways: Decentralized Finance (DeFi) Explained
1. DeFi is a financial system built on blockchain technology that aims to democratize finance by removing intermediaries and providing greater access to financial services.
2. The importance of DeFi lies in addressing the lack of trust in centralized systems and making financial services more accessible to everyone, regardless of their location or financial status.
3. DeFi operates through smart contracts, which are self-executing agreements with the terms of the contract directly written into code, allowing for automation and decentralization.
4. DeFi differs from traditional finance and CeFi in several ways, including increased transparency, faster transaction speeds, greater control for users, 24/7 availability, and enhanced privacy.
5. Popular applications for DeFi include decentralized exchanges (DEXs), stablecoins, and credit services such as lending and borrowing.
6. Earning opportunities in DeFi include staking, yield farming, liquidity mining, and crowdfunding.
7. Despite its potential, DeFi also comes with risks, such as software vulnerabilities, frauds and scams, impermanent loss, leverage, token risks, and regulatory uncertainties.
8. The future outlook for DeFi is promising, with continued growth and innovation expected in the space. However, users should be aware of the risks involved and conduct thorough research before participating in DeFi projects.
In conclusion, decentralized finance offers a new and innovative approach to financial services, aiming to create a more inclusive and transparent system. As technology continues to evolve, DeFi has the potential to reshape the financial landscape and provide greater access to financial instruments for people worldwide.