What is DeFi (decentralized finance)

Key Takeaways

Decentralized Finance (DeFi) is exactly what it sounds like—financial services without centralized control. That’s it—financial services without a central authority. There is no intermediary, no central bank, and no brokers. Blockchain protocols enable regular people to access financial services without a bank and offer traders a chance to build their portfolio across 10,000 cryptocurrencies. 

But what are these financial services and how do they work? In this article, we’ll discuss decentralized finance in the following sections:

• How DeFi works
• DeFi services
• Why DeFi is important
• DeFi protocols
• And more!

Let’s dive in.

What Is Decentralized Finance (DeFi)?

DeFi is a financial system built on blockchain that bypasses traditional financial intermediaries. On DeFi platforms, you can lend, borrow, trade, and earn interest. Through smart contracts, DeFi ensures transaction transparency, security, and accessibility, making financial services available to anyone with an internet connection. Whether you are a seasoned investor or a beginner, DeFi opens the door to numerous financial services that were once only accessible through traditional banking systems.

The History of DeFi

Ethereum’s arrival on the scene back in 2015 was the spark that ignited DeFi. It allowed for transactions with specific conditions, making it perfect for DeFi. Ethereum then introduced token standards, creating a universal token language to work across platforms. Hot on the heels of these Ethereum came the first DeFi protocol in 2014: MakerDAO

Then came what we now fondly remember as DeFi Summer—a period of explosive growth and wild experimentation that gave birth to projects like Compound, Aave, and Yearn. Even today, most DeFi activity still happens on Ethereum, a testament to the platform’s foundational role. While DeFi has branched out and isn’t solely confined to Ethereum anymore, there’s no denying Ethereum’s impact on DeFi’s rise and success.

How does Decentralized Finance (DeFi) Work

DeFi flips the script on traditional finance using blockchain, smart contracts, and decentralized applications. Here’s how these three technologies work together to enable trustless financial services without a bank account:

Blockchain

Blockchain is at the core of DeFi, underpinning and recording every transaction, trade, and interaction. It records every transaction made in the DeFi space and provides the infrastructure for sending value between different players. 

Transaction blocks are encrypted with a highly sophisticated algorithm and therefore, impossible to tamper with. Because each block contains information about the previous block, altering any information in a blockchain is practically impossible, ensuring immutability and security.

This trustless system enables blockchain networks to provide the foundation of DeFi’s multi-billion dollar ecosystem.

Smart contracts

A smart contract is a self-executing program on a blockchain network that governs the terms and conditions of a transaction.  Smart contracts execute automatically, according to an “if x then y” formula. In other words, if certain conditions are met, a transaction will automatically execute. Let’s look at how this enables crypto lending:

You’ve organized a crypto loan using a lending protocol. You deposit your loan security, a token, into the smart contract. If you repay the loan on time per the agreement, the contract automatically releases your tokens. But if you default, the smart contract transfers your tokens to the lender. This simple logic is at the heart of DeFi smart contracts, enabling trustless and automated financial transactions in a whole new way.

Smart contracts automatically enforce agreements without intermediaries, reducing costs and increasing efficiency. They’re pivotal to DeFi, enabling programmable financial instruments and services.

Decentralized Applications

Think of DeFi’s backend as the engine room, packed with complex machinery like blockchains and smart contracts. It’s powerful stuff but could be more user-friendly. That’s where dApps come in.

dApps are software programs built on top of that blockchain engine. They are the bridge connecting you to the blockchain and smart contracts powering the DeFi ecosystem. dApps provide user-friendly interfaces for interacting with all those blockchain-based financial services we mentioned earlier – lending, borrowing, swapping, and earning interest. 

DeFi services 

The DeFi ecosystem features a profusion of different services and options. One thing that sets DeFi apart from traditional finance is that you don’t need to provide any personal data to access them. 

Here are a few of the financial services you can access via DeFi:

Lending

DeFi lending is like traditional lending; however, you use dApps to access lending services on DeFi platforms. Instead of relying on banks, users lend and borrow directly from one another using smart contracts to automate and secure the lending agreement. Smart contracts ensure lending transparency and efficiency.   

With DeFi lending, you can become a crypto lender, providing liquidity to liquidity pools managed by smart contracts. In return, you’ll receive rewards from the transaction fees or interest charged to the borrower.

As a borrower, you can tap into this pool to access liquidity. Borrowers pay interest on what they borrow. Lenders then receive a portion of the interest based on their contribution to the pool. Smart contracts control the interactions between borrowers and lenders, ensuring each party meets their obligations per the agreements.

Borrowing

You can deposit your cryptocurrency as collateral to secure loans, allowing you to access additional funds while retaining ownership of your assets. DeFi borrowing lets you borrow flexibly and instantly, which is perfect if you want to use your cryptocurrencies without selling them.

Staking

Another compelling service within DeFi is staking. Staking allows you to earn rewards by locking up your crypto assets in a smart contract to support a blockchain network. Smart contracts automate the staking process. By staking your crypto, you help verify transactions and secure the network. In return, you earn rewards, usually the project’s tokens. The reward amount depends on the staking duration and amount. 

For instance, you can stake or lock up 100 tokens, with 10% monthly returns. The smart contract will record these parameters, ensuring you receive 10% of your 100 tokens monthly as long as you continue to stake your tokens. 

Platforms like Coinbase and Lido are renowned for their staking services, offering users a reliable way to generate passive income. Staking is an attractive option for investors looking to grow their holdings while supporting the blockchain network.

Yield Farming

You can also earn interest on your cryptocurrency holdings through yield. Here’s how it works: Instead of letting your crypto sit idle, you can lend it to liquidity pools. These pools fuel DeFi transactions, like borrowing and swapping tokens. By contributing your crypto, you’re helping the DeFi ecosystem function smoothly. In return for your contribution, you’ll earn rewards, often as additional cryptocurrency. 

DEX Trading

Decentralized exchanges, or DEXs, are a vital part of the DeFi ecosystem. They intersect the thousands of different cryptocurrencies and tokens within the system. Say you have some Avax tokens (AVAX) and you’d like to swap them for Maker (MKR) – you can use a DEX to facilitate that swap and access more complicated financial instruments too.

Trading digital assets through DeFi protocols offers a decentralized alternative to traditional exchanges. This means there’s no onboarding process or personal data required and you can simply plug and play. This is why DEXs are an important and popular feature of the DeFi system.

Providing Liquidity

Want to earn passive income? Become a liquidity provider! Liquidity provision is a cornerstone of the DeFi ecosystem. Contribute your crypto to liquidity pools to facilitate borrowing in your DeFi platform. In return, you’ll receive a share of transaction fees or governance tokens.

Why does Decentralized Finance matter?

DeFi’s significance becomes clear through its applications and services, particularly in democratizing financial services. Let’s explore its major contributions.

Banking the Unbanked

Imagine living where you can’t open a bank account or receive a loan simply because traditional financial services aren’t accessible. This is the reality for millions worldwide. DeFi bridges this gap, allowing anyone with an internet connection to access financial services. No more paperwork or lengthy approval processes – just simple access to banking, lending, and investing.

Privacy

With data breaches and privacy concerns becoming more common, DeFi provides a welcome alternative. Traditional financial systems often require a lot of personal information, which can be vulnerable to hacking and misuse. 

DeFi platforms prioritize user privacy. Blockchain technology encrypts and secures your financial activities on the blockchain, acting like a personal vault with ironclad security. It’s like having a secure vault for your money that you can only access.

Fairer rewards

Ever feel like your savings account isn’t earning much interest? With DeFi, the rewards may be more attractive. Traditional banks often have overhead costs and pay minimal interest rates. DeFi protocols, however, give higher yields by removing intermediaries and connecting borrowers directly with lenders. The peer-to-peer system means more profits go back to the users, providing better returns on your investments.

Composability 

Remember we discussed the ERC20 Ethereum token standard? This is a central part of the DeFi space because it ensures all tokens are interoperable, and can interact. We call this composability. 

Think of DeFi as a box of financial Lego. Each protocol and application is a piece that may combine with others to build something unique. This allows developers to create financial products by stacking different DeFi components. For example, you can use a lending platform with a decentralized exchange to maximize your investment strategies. 

The flexibility leads to a constantly developing ecosystem, where new opportunities are always around the corner.

DeFi Protocols Guide

Which protocols do most people prefer? We sample a few of the popular DeFi protocols in the ecosystem. 

Aave

Aave, a leading DeFi platform, lets you lend and borrow crypto. Deposit your holdings to earn interest or borrow funds for various needs. Aave offers flexible interest rates that adjust with supply and demand. Beyond the basics, Aave has unique features. You can use smart contracts to lend or borrow cryptocurrencies.

Need a quick boost? Aave’s flash loans let you borrow large sums without collateral, if you repay them within the same transaction. Such features enable advanced strategies for experienced traders. Aave’s interest rate model also considers all risk preferences with fixed and variable options.

Uniswap

Uniswap is a DEX that changes how we trade. It lets you trade directly from your crypto wallet using automated market makers (AMMs).

Liquidity providers contribute to crypto pools, earning fees from every trade on the platform. Uniswap’s AMM system relies on smart contracts, self-executing programs on the blockchain, to determine prices and complete trades. 

Uniswap’s decentralized trading depends on users providing liquidity. The platform takes a small fee from each transaction and shares it with liquidity providers, creating a win-win situation. Uniswap gets a functional marketplace, and providers earn a passive income stream.

Curve

Launched on Ethereum, Curve is a DEX offering efficient stablecoin and low-volatility token trading. Due to its optimized exchange mechanics, it excels in stablecoin swaps. This focus makes Curve ideal for active stablecoin traders and those seeking stable portfolio exposure. Curve also integrates with other DeFi platforms, boosting liquidity and ecosystem value.

Curve functions through asset pools, each containing cryptocurrencies with similar values. These pools, especially the stablecoin ones, generate high interest for liquidity providers. Curve achieves this by using deposits to provide liquidity to other DeFi protocols and sharing the generated interest and platform fees with providers.

How to access DeFi

You can access DeFi services in 4 steps: 

• Create a compatible crypto wallet
• Buy Ether
• Choose a protocol or service
• Connect your wallet

Let’s explore these four steps. 

1. Create a compatible crypto wallet

A crypto wallet manages your private and public keys, tracks your assets, and lets you make digital transactions. There are two types: hot wallets (online) and cold wallets (offline). Hot wallets like Coinbase Wallet, MetaMask, and Trust Wallet are easy to use but may be vulnerable to hacking. Cold wallets are more secure since they are offline but require more effort to manage.

2. Buy Ether (ETH)

Next, you need to purchase Ether (ETH). Most DeFi applications run on the Ethereum network, so Ether is the gateway to enjoy DeFi functionality. You can buy Ether via several ways, such as using a credit or debit card, a bank transfer, PayPal, or swapping other cryptocurrencies like Bitcoin on an exchange platform.

3. Choose a protocol or service

With Ether in your wallet, it’s time to pick a DeFi protocol or service. There are plenty to choose from, depending on what you want to do. For lending and borrowing, Aave is a popular choice. If you’re looking to trade cryptocurrencies, many traders prefer Uniswap. For stablecoin-focused DeFi solutions, Curve is a great option. Your choice will depend on your investment goals and trading preferences.

4. Connect your wallet

Finally, you’ll need to connect your wallet to the DeFi protocol. This usually involves clicking the Connect button on the platform, selecting your wallet, and following the prompts. If your wallet isn’t listed, you can often use WalletConnect to link it. After connecting your wallet, you can start interacting with the DeFi application. 

Concerns About DeFi

While DeFi offers many opportunities, it’s important to approach DeFi with an understanding of its inherent risks. Here are key areas of concern:

Rugpulls

DeFi projects can vanish overnight, leaving investors with worthless tokens. Before you invest in DeFi, meticulous research into a project’s team, code audits, and community engagement are essential.

Unregulated

DeFi’s unclear regulations can be a double-edged sword. While they allow developers and finance experts to provide novel or improved financial instruments, they may also lead to fraud, hacking, and other forms of exploitation. Additionally, laws in various countries need to be clearer about participating in DeFi.

Volatile marketplace

Lastly, let’s talk about volatility. DeFi markets can be volatile, taking you to the top of the world before crashing down at full speed and giving you hope with a slight increase. This volatility can trigger liquidations, a process where a DeFi platform sells off a borrower’s collateralized crypto holdings to cover a loan if the value dips below a certain threshold.

How to stay safe in decentralized finance

You may have heard DeFi referred to as “the wild west of finance”. While the DeFi space is a vibrant showcase of clever technology, equitable rewards and accessible financial services, it is also largely unchecked. Since a protocol is not a legal entity like a company, there is no customer service team, and no way of regulating DeFi platforms. Anyone with technical knowledge can launch their own, crypto-powered DeFi protocol. If it turns out to be fake, or poorly managed, it’s your crypto on the line.

In short: you are your own last line of defence when it comes to interacting with DeFi. Luckily, the space has a number of very valuable data sources where you can do your own research, as well as some simple security measures.

Read project white papers

Say you identify a project and you’re keen on purchasing their tokens. Before you make this decision, confirm that they have an official channel where you can access their documentation, like the whitepaper. Go through the whitepaper, understand the project, and make a choice based on your own assessment.

Check out Etherscan

Tokenomics give key insight into protocols that catch your eye. The official supply and distribution roadmap will generally be set out in the White Paper, but you can also go a bit deeper with your research using a blockchain explorer like Etherscan. On Ethrescan, simply search for the project’s smart contract, and you’ll be able to see exactly how many tokens it contains, a full list of transactions on that smart contract and detail about exactly how and where tokens are distributed. This can help yoou identify threats like rug pulls and crypto whales.

Understand smart contracts

Smart contracts dictate how DeFi services operate. They contain all the code determining your crypto’s safety while staked, in a pool, or when you lend it to the platform.

Review the smart contract codes to ensure they work. Additionally, confirm that a reputable firm audited the project’s code.

Segregate your crypto assets

As the old saying goes, never put all your eggs in one basket. Diversify and spread your portfolio across many platforms and projects. This way, you’ll never lose 100% of your crypto.

How to use Bitcoin in Decentralized Finance

Bitcoin is the most well-known cryptocurrency, but its protocol doesn’t support smart contracts, limiting its use in DeFi. Wrapped Bitcoin (wBTC) addresses this limitation. 

Wrapped Bitcoin (wBTC) explained

wBTC is an ERC-20 token on the Ethereum blockchain, pegged 1:1 with Bitcoin. With wBTC, you can use a synthetic representation of your BTC on DeFi applications, such as DEXs and lending platforms, by wrapping Bitcoin into a compatible format.

To mint wBTC, you can use a custodian or a bridge protocol. Once you lock up the amount of BTC you want to wrap, you’ll be issued with the equivalent amount of wBTC on the Ethereum blockchain, ensuring that one Bitcoin backs one WBTC token. 

Closing Thoughts

DeFi highlights the move to a more open and inclusive financial system. While it is still in its early stages, DeFi has shown its potential to simplify and improve financial interactions globally. What remains is harmonizing its regulatory uncertainties with its decentralized ethos. 

Frequently asked questions

Can I use BTC for DeFi?

Yes and no. While you can’t directly use Bitcoin (BTC) in DeFi applications, there is a very popular workaround. You can wrap your BTC to produce a synthetic asset called wBTC, capable of interacting with DeFi’s underlying protocols.

What is a DEX?

DEX stands for Decentralized Exchange. DEXes operate on a peer-to-peer (P2P) basis. Users connect directly to trade cryptocurrencies without relying on intermediaries. Decentralization ensures transparency and potentially faster trade execution, but DEXes may have lower trading volumes and higher transaction fees compared to centralized exchanges (CEX).

What is a rug pull?

A rug pull is a malicious DeFi scam where developers create an attractive DeFi project, like a new token or yield farming opportunity. They hype it up, attracting investors, and then abruptly abandon the project, taking all the funds. Rug pulls are a risk in DeFi, highlighting the importance of thorough research before investing in any DeFi project. Be wary of unrealistic returns or projects with anonymous teams.