What is DeFi (Decentralized Finance)
|— Decentralized Finance (DeFi) is the term used to describe the blockchain-based protocols, products, and platforms that serve as alternatives to traditional financial infrastructure.|
— DeFi apps are permissionless, transparent, and accessible to anybody with the right blockchain wallet. There are no regional restrictions, no KYC requirements, and no centralized entities pulling the strings. Some DeFi apps can also generate significant returns for investors.
— The variety of DeFi use cases has grown with time, but lending, automatic market maker, synthetic asset issuance, and decentralized insurance protocols are the most common.
If you have been involved in the blockchain or cryptocurrency industry for more than a short stretch, then you have probably stumbled across the terms ‘decentralized finance’, or ‘DeFi’ on more than one occasion. These are the financial applications built using blockchain technology—but mostly on Ethereum.
DeFi has exploded in popularity throughout 2019 and 2020 and is now one of the major use cases of blockchain technology. Here’s what you need to know before trying it out for yourself.
What is DeFi?
In a nutshell, Decentralized Finance is a term used to describe the decentralized financial tools, protocols, and platforms people use to manage their money, without having to rely on traditional financial infrastructure—like banks, remittance platforms, and government-issued currencies.
It’s a brand new monetary system that seems to empower users, by offering an alternative to the old and outdated traditional financial system, or by providing access to crucial financial services where it is lacking. This new monetary system is powered by open, transparent smart contracts that can be used to complete a wide variety of tasks and are accessed through simple user interfaces, much like standard applications.
Built on top of decentralized blockchains, these DeFi applications operate without any centralized governing entity and enable users to interact with each other in a completely trustless manner, since the underlying smart contracts automatically keep counterparties involved in a transaction safe.
Benefits for DeFi Users
Arguably the most significant benefit of DeFi applications is their accessibility. Since there is no governing entity at the helm, and there are no regulations or rules to adhere to. DeFi applications can be accessed by anyone—no matter where in the world they reside. Anybody with a cryptocurrency wallet and an internet connection can interact with the world of Decentralized Finance—with no credit checks, KYC, or other barriers to entry.
This is of particular importance for the 1.7 billion adults worldwide that lack access to a bank account. Through DeFi, these individuals, and everybody else now have access to a wide range of permissionless protocols that provide many of the same features as banks.
But DeFi goes well beyond providing standard financial services to those that need them. It presents an entirely original system based around openness and transparency, ensuring participants can check exactly what is going on behind the scenes should they wish to. It achieves this while dispensing with trusted third parties and costly intermediaries—driving access costs down to the bare minimum.
Moreover, DeFi gives individuals a way to easily turn a profit on their digital assets by contributing to lending pools which are used for providing collateral-backed loans to borrowers, and depositing assets to liquidity pools, which allow traders to swap their assets on decentralized exchange platforms. Both lending pools and liquidity pool investments can provide returns that far exceed those provided by even the most generous banks.
Most Common Use-Cases of DeFi
Despite being a relatively new industry, Decentralized Finance has grown considerably in recent years, and both the number and variety of DeFi applications has also multiplied.
Nowadays, there is a DeFi alternative to practically every major financial service you already use, while some applications for DeFi technology are completely unique—and are made possible thanks to peer-to-peer blockchain technology.
We’ll cover some of the most common DeFi use-cases below.
Open Lending Protocols:
DeFi lending protocols like Compound and Aave allow users to lend and borrow digital assets in a secure, trustless manner. Borrowers deposit funds as collateral and typically pay a fixed interest rate, while lenders earn a variable return on their assets.
Note: Most popular DeFi apps have had their smart contracts audited and are generally considered safe to use. However, less well-established or newer apps may not necessarily be safe to use. As always, your tokens may be at risk whenever they leave your wallet.
Automatic Market Makers (AMMs):
AMMs are DeFi applications that automatically create markets by using mathematical formulas to set the price of a token based on ratio of assets stored in the platform’s liquidity pools, rather than supply and demand like most centralized exchanges. For example, if there are 10 ETH and 100 UNI in the ETH/UNI pool, then each ETH is worth 10 UNI. This ratio can change over time as traders swap their ETH and UNI, changing the amount of either token in the pool. Ross Bulat explains in depth how this system affects the value of each token in a Uniswap pool in a recent Medium post.
Decentralized insurance protocols like Nexus Mutual allow users to protect themselves against a wide range of risks in the DeFi sector, such as hacks, theft, flash crashes, and almost anything else. Anybody can also contribute to insurance pools to earn a return for taking on risk.
Synthetic Asset Issuance:
Synthetic Asset issuance platforms allow users to create a variety of crypto tokens that mimic the price or characteristics of another digital currency, real-world asset, or financial product. For example, a synthetic token that tracks the price of a major stock like Amazon (NASDAQ: AMZN) or Google (NASDAQ: GOOGL). Synthetics give cryptocurrency users a way to trade and gain exposure to complex financial products through a single token (like ETFs, options, and basket funds) and participate in markets that might otherwise be difficult to access.
In the last two years, the total value of tokens locked up in DeFi tools and protocols increased from $203 million to $9.53 billion—representing growth of more than 4,500%. During this time, the DeFi industry has skyrocketed in interest among developers and established crypto companies, and more firms than ever before are now developing and launching their own DeFi applications.
However, while many DeFi platforms genuinely act to return financial independence to users and provide access to new, potentially liberating or profitable opportunities, not all are safe to use, and some are outright scams. With that in mind, it’s important to do your due diligence before investing in or using any DeFi platforms, and only risk what you can afford to lose.