If you’ve invested in Bitcoin or done any research into cryptocurrency, you’ve probably heard the term decentralized finance (DeFi) brought up a time or two.
One of the most significant promises of cryptocurrencies is to give everyone in the world access to payments and finance, regardless of where they are. As a result, proponents of DeFi see it as a superior alternative to the traditional finance services now in place.
But what is decentralized finance? How does it stack up against the traditional financial system? In this beginner’s guide, we’ll go over everything you need to know about this new financial system that could change the world.
What is Decentralized Finance (DeFi)?
Viewed as a subcategory within the broader crypto space, DeFi has the potential to be majorly disruptive. Short for decentralized finance, DeFi is a term used to describe the vast system of financial tools that run freely on the internet without the control of intermediaries.
The decentralized finance world consists of many non-custodial, decentralized finance products. Non-custodial means that there is no team managing your crypto assets on your behalf. Unlike, say, when you deposit your money into a bank or lend out your crypto through a crypto loans company. With DeFi, you always have control over your assets.
Furthermore, decentralized means that the DeFi protocol creators have voted themselves out of power to give users control over the network. In practice, DeFi is a network of smart contracts and decentralized applications (DApps) that run on the Ethereum blockchain and focus on financial services such as loans, exchanges, derivatives, trading, and more.
If you’ve ever experienced the horrendous process of applying for a loan or been in a situation where a bank restricted access to your money, then you surely understand that the current financial system is not always on the side of ordinary citizens.
Instead, it favors those who are centrally controlling the funds, leaving customers with little control. This is where DeFi comes in, as it creates a people-focused financial system with little room for corruption or mismanagement. Under the DeFi system, every user has equal rights, and the system provides users with the freedom to control their funds and make transactions as they wish.
There are already DeFi applications that enable you to take out instant loans, lend your extra funds to others and earn passive income, and trade and exchange assets without having to go through a third-party institution. If the vast majority of people adapt to DeFi systems, it could potentially eliminate the need for third-party institutions and create a more accessible financial world for millions of people across the globe.
DeFi vs. Traditional Finance
One of the best ways to understand DeFi is to compare it to the traditional finance system (TradFi) now in place. While both DeFi and traditional finance are systems that aim to help people manage their money and make transactions, they operate very differently.
In centralized finance, asset classes and processes are managed by companies or people. In decentralized finance, assets are managed by a set of smart protocols.
Here are some of the main ways DeFi differentiates itself from its traditional counterparts:
Unlike traditional finance, DeFi apps are not managed by institutions and their employees. Instead, the rules are written into codes, also known as smart contracts.
Smart contracts are programs that run on the blockchain and execute automatically when certain conditions have been met. Once a smart contract is deployed to the blockchain, the DeFi apps can run themselves with little to no human intervention. In practice, however, the DApps are usually maintained by developers with bug fixes and upgrades.
Obviously, this contrasts with traditional finance, which involves much human interaction for processes to take place.
The code on the blockchain is transparent, and anyone can audit it. Since anyone can find bugs and understand the smart contract’s functionality, a higher level of trust is built with users.
Transactions are also public and can be viewed by anyone. While this may raise privacy concerns, transactions are pseudonyms and not directly tied to your real-life identity.
This contrasts with the traditional banking system, where customers have no control over how financial products are built or maintained.
The accessibility of traditional financial products varies depending on the institution. While domestic transactions can typically be done with ease, international transactions are another story. For example, if you live in the U.S. and want to send money to someone in Denmark, you’ll likely need to use a third-party service that charges transaction fees and conversion fees.
DeFi is designed to be globally accessible from day one, meaning you’ll get access to the same services no matter where you’re located. While local regulations may apply, most DeFi apps are accessible to anyone with an internet connection.
DeFi apps are permissionless, meaning anyone can create them and use them. This also contradicts traditional finance systems, which have many gatekeepers and account sign-up requirements with lengthy forms. With DeFi, users can directly interact with smart contracts through their crypto wallets.
If you don’t like the interface of your bank’s mobile app, there’s not much you can do outside of contacting customer service with your concerns or switching banks. However, if you don’t like the interface of a DeFi app, you can use a third-party interface or even build your own app.
What are DeFi Protocols?
To better understand the DeFi universe, you also need to understand DeFi protocols. On a basic level, protocols are rules or standards created to govern particular tasks or activities. DeFi protocols are autonomous programs that feature rules and principles that help resolve some of the conventional pitfalls found in the traditional finance world.
There are already many DeFi protocols that have gained popularity recently. These include:
- AAVE: This lending protocol in the DeFi space offers the AAVE token to those who support the protocol’s security and participate in its governance.
- Maker: This is a popular lending protocol that helps develop the DAI stablecoin. The native token of Maker, MKR, is essential for protocol decisions.
- Uniswap: The leading decentralized exchange (DEX) with its native token, UNI, encourages liquidity for specific pools.
In addition to understanding protocols, here are some other elements of the DeFi ecosystem that you may want to familiarize yourself with:
All projects in the DeFi ecosystem can be layered on top of one another or work parallel to one another. This layering process is where the terms Layer 1 and Layer 2 come into play.
Layer 1 solutions refer to the primary and foundational working parts of the DeFi network. These solutions serve as the pillar structures with which the entire ecosystem benefits and communicates. These structures also hold integrity so other projects can perform more advanced applications that could otherwise not be done.
Layer 1 blockchains include Ethereum, Bitcoin, Litecoin, Avalanche, and Binance Smart Chain.
These protocols need to be secure, scalable, and decentralized. Networks use different methodologies to improve overall scalability.
Common methodologies used include:
- Consensus protocol: This includes Proof of Work (PoW) and Proof of Stake (PoS). Proof of Work aims to achieve security and consensus by having miners decode complex crypto algorithms. Proof of Stake allows users to authenticate blockchain transactions based on their stake. While PoS has quicker transaction speeds, it’s considered less secure than PoW.
- Sharding: This methodology involves breaking up the network into database blocks (known as shards) to make the blockchain more manageable. Sharding is still in the experimental phase.
To further improve the use of smart contracts, so-called oracles are used. Oracles are third-party services that provide external data to smart contracts and allow the smart contracts that exist within blockchains to receive external data from outside of their domain.
Oracles act as data sources that can be fed into smart contracts, enabling them to access real-time data that’s not on the blockchain. For example, it allows them to access the real-time price of assets. While oracles aren’t data sources themselves, they’re layers that verify on-chain data related to real-world events. The cumulative data they verify is then sent to the smart contracts.
By far the most well-known oracle blockchain is Chainlink. As one of the first to offer integration of off-chain data into smart contracts Chainlink has been able to leverage its first-mover advantage. The protocol currently includes over 1 billion data points, delivering value to more than 1,000 project integrations and 700 oracle networks.
DeFi Use Cases
DeFi is a rapidly changing ecosystem that has the potential to develop into something well-beyond what’s offered by the traditional finance world. The following are some of the main use cases for DeFi:
Decentralized Exchanges (DEX)
Very important in DeFi are decentralized exchanges. A decentralized exchange (DEX) is a peer-to-peer marketplace where crypto traders can make direct transactions without handing over the management of their funds to a custodian or intermediary.
Instead, the transactions are facilitated with the use of smart contracts. These exchanges were created to remove any sort of centralized authority from overseeing and authorizing trades. They allow for peer-to-peer buying and selling of crypto. They’re also typically non-custodial, meaning users maintain complete control over their wallet’s private keys.
The very first decentralized exchange was NXT in 2014, however since then a large number of competing DEXs have emerged. Uniswap is one of the best known DEX, and many other projects used their codebase to create similar decentralized exchanges. As of March 2022 the largest DEX by transaction volume is DyDx.
Decentralized marketplaces refer to the spaces where people can trade and invest digital assets without the involvement of middlemen. These spaces are available globally, and they don’t require intermediaries to make trades possible.
The purchasing of NFTs (non-fungible tokens) occurs in decentralized marketplaces. NFT marketplaces are platforms where digital collectors can store, display, buy, sell, and create tokens that represent ownership of unique, tangible, and intangible items. To access an NFT marketplace, you’ll need a pre-funded crypto wallet and a user account.
As NFTs gain in popularity the number of decentralized marketplaces has also been growing. One of the most well-known is OpenSea, and it is also the top marketplace by transaction volume. Other popular platforms include Rarible, SuperRare, and District0x, a network of decentralized marketplaces and communities.
Currently, decentralized finance is spread out across multiple blockchains, including Ethereum and Binance Smart Chain. Each blockchain is its own ecosystem of unique and siloed financial protocols. This is where decentralized aggregators come in, bringing trades across multiple exchanges to one place, saving users time and increasing efficiency for better trades. Perhaps the best known aggregator is 1inch. Others include ParaSwap and Matcha by 0x.
Lending and Borrowing
Lending and borrowing are some of the most popular use cases for DeFi. Many open lending platforms already exist that allow you to lend out your digital assets to other users and earn interest or borrow digital assets from other users and pay some interest.
Yield Farming and Liquidity Providers
Yield farming is a practice that involves locking up digital assets in return for rewards that are typically automatically delivered via smart contract. In most cases, yield farming projects require users to stake provider tokens that they receive after providing liquidity on certain exchanges, such as AAVE. These tokens then mint a new type of token, which can either be used or sold. Yield farms are considered a high-risk/high-reward use case, as locked assets can sometimes be lost if there are loopholes in the smart contracts.
Stablecoins and Synthetics
An important digital asset in the DeFi space are Stablecoins. These cryptocurrencies have their value pegged to another asset to reduce volatility and keep prices stable. Often, they’re pegged to fiat currencies like the US dollar or other assets like gold. Because of their characteristic to offer price stability and the possibility of faster money transfers, these coins are popular among lenders, borrowers, traders, and liquidity providers.
Synthetic asset issuance is a sort of a subdivision of stablecoins. It is one of the most complex use cases for DeFi. With synthetic asset issuance, digital asset tokens are created that mimic the properties of something else, similar to how stablecoins closely match the value of the currency or asset they’re tied to.These synthetic assets can represent anything from precious metals to digital assets to stocks or derivatives. Moreover, they can be bought, sold, or traded, allowing users to access previously illiquid or hard-to-obtain assets.
One of the most significant benefits of DeFi is that it allows you to manage your digital asset finances without relying on a centralized institution. However, DeFi does have its fair share of potential risks. But there are several ways to invest in DeFi. To lower the risks you could consider a strategy of investing in the tokens for promising projects.
And as with all kinds of investments, it’s important to do your due diligence before interacting with a DeFi platform or protocol. DeFi has many exciting use-cases, and there are already some promising DeFi protocols in existence.
To get a stake in this exciting, rapidly growing industry, join SMART VALOR and check out our DeFi section.