What is DeFi?
DeFi, or Decentralized finance refers to a category of applications that aims to replace the traditional finance industry by using blockchain technology.
History of DeFi
Bitcoin gave inception to the blockchain, but its focus on security means the network is not very flexible nor scalable despite being incredibly robust.
These properties of Bitcoin work well in its assumed role as a store of value for the cryptocurrency industry but make it entirely unusable to perform complex transactions.
Inspired by Bitcoin, Vitalik Buterin co-founded the Ethereum foundation in 2013. Ethereum launched in 2015, aimed at being ‘programmable money’ where developers can use its open-source code to build on top of the Ethereum ecosystem – as highlighted in the whitepaper, which you can find here.
The flexibility of Ethereum quickly attracted developers to build decentralized applications (also known as Dapps) on the network.
Despite the questionable legality and vesting schedule of some ICOs, the speculative frenzy generated a large sum of capital that allowed committed DeFi teams to continue working on projects throughout the multi-year bear market that followed.
Later, the inception of Uniswap and Synthetix introduced concepts that other protocols would adopt. Rather than aiming to match buyers with sellers to facilitate trades, Uniswap enables trading via pooled liquidity in the protocol’s smart contracts.
Meanwhile, Synthetix was the first project that kick-started the idea of incentivizing providing liquidity to pools with rewards.
In February 2020, the total value locked (also known as TVL) in all DeFi protocols surpassed a huge milestone of $1 billion for the first time — through the March 12, 2020 global market crash caused the TVL to collapse.
However, decentralized finance saw a huge resurgence in the summer of 2020, now infamously dubbed ‘DeFi summer’. DeFi Pulse, an analytics platform shows the total value locked in DeFi surpassed $1 billion on June 1, 2020. For the rest of 2020, TVL (total value locked) grew at a dizzying pace, topping out at a whopping 80 billion dollars prior to the May 2021 crash, and now sits at approximately 60 billion dollars.
Why DeFi is eating Traditional Finance
Primarily built on Ethereum, DeFi offers some of the most common financial services found in the traditional financial system. Some of which include the following :
- Lending and borrowing
- Earning on your savings
- Spot trading
- Margin trading
- Derivatives trading
The magic of the DeFi is that since everything is done ‘on chain’ (meaning on the blockchain)— there is no need for any costly and opaque intermediaries found in the traditional financial sector. DeFi is built on smart contracts, where the code executes when predetermined conditions are met, removing the need for any human intermediary.
A smart contract’s code is permanently published to the public blockchain on which it is deployed. This allows DeFi to have some incredible properties that are simply not possible without the blockchain. Here are some examples :
- Permissionless: Anyone can interact with DeFi protocols without approval, authorization or scrutiny. This essentially removes all forms of discrimination or insider access – allowing a even playing field for all participants.
- Trustless: Being open-source, there is no need to trust whoever wrote and deployed a DeFi application. Any user can manually verify the code of the smart contract, as it is published on the blockchain for anyone to inspect. Hence, the term ‘don’t trust, verify’ is commonly used in the crypto community.
- Interoperability : DeFi protocols can interact with one another, allowing mutually beneficial relationships that are not possible within the walled gardens of traditional finance.
- Censorship resistance: DeFi applications cannot be censored, just like how the blockchain cannot be censored.
- Immutability: Once deployed, it is almost impossible to alter the original code for the application, though there are certain exceptions to this.
- Low cost: By removing bloated and expensive middlemen, transactions such as borrowing/lending, depositing to earn yields, and so on are cheaper and faster than traditional finance.
- Transparency: All transactions involving DeFi protocols are available to be scrutinized by the public. This contrasts with the largely opaque nature of traditional finance.
Here are some popular DeFi projects that are worth taking note of :
Borrowing and Lending: Aave
Aave is a blockchain-based borrowing and lending dapp — all done without any background checks, logging in and so forth.
You can deposit your cryptocurrencies on Aave and borrow against it; a common way for crypto investors to make their assets more productive is to borrow stablecoins against their cryptocurrencies and use those borrowed funds for yield farming.
The Aave contract automatically adjust borrowing and lending interest rates depending on demand.
Decentralized Exchange: Uniswap / Sushiswap / Pancakeswap
A decentralized exchange (also known as DEX) is a cryptocurrency exchange run entirely on smart contracts, letting you trade tokens from your wallet, such as Metamask.
This is different from a centralized exchange like Coinbase or Binance, which stores your crypto for you without you actually being in possession of your assets.
DEXs uses a mechanism known as Automated Market Making (also known as AMM) to automatically execute trades for the best prices.
On top of trading, anyone can become a liquidity provider, by supplying cryptocurrencies to the smart contract and earn trading fees depending on their share of the pool.
This can be highly lucrative if done right, as many projects will incentivize liquidity providers with rewards on top of the usual trading fees. This is also commonly known as yield farming, which you can learn more about here.
Synthetic Assets: Synthetix
Synthetix is a project that allows users to mint and exchange synthetic equivalents of assets like gold, silver, cryptocurrencies and traditional currencies like the Euro.
The synthetic assets are backed by excess collateral locked into the Synthetix contracts.
Being the first blockchain to introduce a programming language for smart contracts, Ethereum has been the de-facto platform for decentralized finance to thrive. Being the first mover, many developers started building the initial infrastructure that would power DeFi on Ethereum.
As network activity on the Ethernet network grew exponentially, so did network congestion. During the final months of 2020, DeFi projects were consuming so much computing power that gas fees skyrocketed to insane levels.
A simple swap on Uniswap went from costing $15-$30 in gas fees to $50-$100, effectively pricing out small trades and transactions, causing a huge bottleneck to DeFi.
The huge pain of expensive gas fees eventually gave way to cheaper alternatives, in the form of alternative blockchains that were built with similar code to Ethereum, also known as EVMs (Ethereum Virtual Machines). The chains were very easy for developers to port over from the main Ethereum network, and users soon followed as they could no longer afford the insane gas fees on the main Ethereum chain.
These alternative chains are often known as “Ethereum killers.” Such networks address Ethereum’s shortcomings, though they usually compromise in other ways.
The Etheruem network’s structure is designed to allow for the highest levels of decentralization, which means it must incentivize a large, diversified group of distributed and non-trusting transaction validators as possible.
To keep mining demands low, the number of transactions that are allowed on a single block is limited.
However, Ethereum’s increasing congestion — driven by DeFi itself — means that blocks are often completely full.
Therefore, users must outbid each other in gas fees to get their transactions processed by the network.
“Ethereum killers” often use a consensus mechanism that increases transaction processing speeds and offers far cheaper gas fees.
This allows the network to greatly increase transaction throughput than Ethereum, but compromise on decentralization in the process.
The dominant DeFi non-Ethereum blockchains that support DeFi ecosystems today include:
- BSC (Binance Smart Chain) : A cheap, fast, and nearly identical version of the Ethereum DeFi experience developed by one of the largest crypto exchanges, Binance.
- Polkadot: A blockchain that allows users to launch their own networks, known as parachains.
- Cardano: A proof-of-stake smart contract ecosystem.
- TRON: A blockchain with a small group of delegated validators with an emphasis on speed and low-cost transactions.
- Solana: A lightning-fast blockchain that uses Proof of History (PoH) as a consensus mechanism, allowing high throughput without the need for sharding.
- Polygon (formerly known as Matic) : A Layer 2 platform for building and connecting Ethereum-compatible blockchain networks.
Most of these alternative blockchains support the immediate deployment of Ethereum applications, similarly to how apps can be ported across multiple platforms. This means that developers can move projects from the highly congested Ethereum to a more economically viable blockchain that makes it far cheaper to transact on. For example, after launching on Ethereum, the popular decentralized exchange SushiSwap was relaunched on multiple sidechains, covering a wide spectrum of alternative blockchains.
The building blocks of DeFi
With the prevalence of DeFi, projects are mostly interoperable, meaning that they use bits and pieces of the wider DeFi ecosystem to perform as intended. Several of these DeFi building blocks are essential to the existence of DeFi and are worth understanding deeper.
Stablecoins are another vital backbone of the decentralized finance sector, as they allow for users to easily derisk from volatile assets.
Crucial DeFi activities such as borrowing, lending, trading, and so on could be severely impacted by high volatility, which is where stablecoins come into play.
Stablecoins are synthetic, digital assets that are supposed to be pegged to more consistently priced currencies, usually in the US dollar.
Originally created as a means for traders to easily convert volatile crypto assets into US dollars, stablecoins are just as important in DeFi.
There are three main types of stablecoins today:
- Fiat-collateralized: Fiat-backed stablecoins such as USDT and USDC are issued by a central authority and backed by real currency (such as US dollars) in a traditional bank account.
- Crypto-collateralized: A more decentralized take on stablecoins, DAI is a stablecoin pegged to the US dollars that is backed by crypto assets, such as Bitcoin. Due to the volatility of the underlying asset, these stablecoins are overcollateralized to ensure they hold their peg.
- Algorithmic: These stablecoins are a different take to the Crypto-collateralized stablecoin, in which they are inelastic in supply. Protocols of algorithmic stablecoins can change their supply based on the demand, which aims to be more efficient than the over-collateralized stablecoins such as DAI. That being said, some early incarnations of algo stablecoins such as ESD and DSD have failed to hold their peg, while partially collateralized iterations such as UST and FRAX have fared much better.
To function properly, smart contracts often need to accurately fetch the accurate price of volatile assets. Mispricing prices can quickly lead to devastating failures of smart contracts, which is where Oracles come into play.
Blockchain oracle services — with the most prominent one being Chainlink — fetch data that is not on the blockchain and relays it to smart contracts in a trustless manner.
This ensures that smart contracts are reacting properly to the accurate prices of assets before making any changes, such as increasing or decreasing interest rates, collateralization ratios, and so on.
Liquidity mining, also known as yield farming, is a term commonly used in the DeFi community as deploying capital to earn lucrative rewards from protocols.
Liquidity mining means to provide liquidity to protocols to receive a share of the trading fees as well as newly tokens issued from the DeFi project.
On the other hand, yield farming is the process of shifting capital between different applications to optimize the yields from liquidity mining.
Yield farming requires sophisticated know-how and carefully planned strategies to capture the best returns from different protocols.
With billions of dollars tied up in smart contracts, there has never been a greater incentive for malicious actors to exploit DeFi applications. After all, it can be rather difficult to trace stolen funds across the blockchain. Over DeFi’s short history, there have already been numerous hacks and exploits that have resulted in catastrophic losses.
Some of the most obvious risks presented by DeFi include:
- Protocol risk: DeFi smart contracts often store a large sum of capital. This inherently incentivizes bad actors to exploit protocols to drain the funds that are deployed in the smart contract.
- Composability risk: As DeFi applications crossover one another in their core functionality, exploits can be harder to sandbox if a key protocol is compromised.
- Rug pulls: Smaller projects with malicious developers can include secret backdoors to the project, where liquidity (composed of user’s funds) can be pulled from the main pool. This is also commonly known as a rug pull.
- Regulatory risk: As DeFi is completely unregulated, there is no way to know what will happen when law enforcement eventually decides to enact regulation on DeFi protocols.
- Centralization risk: Certain large DeFi applications might allow for the development team to control a huge part of the protocol, which raises centralization risks if the team behind the project is jeopardized.
- Volatility: Despite the use of oracles, extreme volatility might cause certain DeFi application to fail catastrophically, such as the infamous incident that happened to when DAI was momentarily unpegged, causing major issues with many other protocols.
A bright future for DeFi
DeFi is one of the most exciting and promising sectors of the wider cryptocurrency landscape. The use of smart contracts deployed on trustless networks allows for a completely inclusive financial system, which evens the playing field for everyone in the world.
Despite being in infancy, DeFi protocols have shown exponential growth in capturing billions and billions of dollars of capital.
Decentralized borrowing, lending, trading, and synthetics have already shown incredible adoption in the space and continues to innovate upon previous iterations.
Yet, users of these game-changing protocols should be aware of the risks posed by unknown vulnerabilities in the code of smart contracts, the possibility of regulatory concerns, and most importantly, the extreme volatility of crypto assets that could severely jeopardize these projects.
With that said, now that you are fully aware of how DeFi works, it up to you to explore this fascinating new paradigm of finance and learn how you can use it to stay ahead of the curve.
Jeremy has been running several online businesses behind his laptop for the past 5 years and he has worked as a freelance web developer previously. A trained marketer by profession, he also has Ruby on Rails and web development knowledge. His forte lies in eCommerce, SEO and content marketing. He’s been featured on Vice, Thrive Global, YFS Magazine, Forbes and several other publications. He prefers to connect with people on LinkedIn.