What is Decentralized Finance? (DeFi)

Although it didn’t go by the name “DeFi” at the time, Bitcoin introduced the idea of electronic peer-to-peer money to the world in 2009. As a simple medium of exchange and store of value, Bitcoin pioneered the idea of digital assets as money. The trustless nature of the network removed third party institutions like central banks and Wall Street capitalists from this new idea: cryptocurrency.

With the creation of Ethereum came smart contract functionality. Digital assets can not only be transferred but, through immutable code, developers can also simulate more features of the traditional finance system without the need to use traditional intermediaries.

This opened the doors to the use of cryptocurrencies for financial services like lending and borrowing, trading, insurance, venture funding, and participating in derivatives markets. Other smart contract platforms like Solana and Avalanche soon saw similar growth in their DeFi ecosystems after their respective launches.

By the numbers

During the summer months of 2020, a number of DeFi applications launched and saw massive community adoption, including Compound (a lending and borrowing decentralized application), Yearn Finance (offering a suite of tools for users to maximize their earnings), Sushiswap (a decentralized exchange), and many others.

This initial surge drove the total value locked (TVL) in DeFi protocols across all blockchains to nearly $10 billion by September of that year. After a short cooling-off period, more and more money found its way into DeFi protocols, and by the end of 2021, the TVL measured over $180 billion.

What is the role for DeFi?

DeFi’s alternative financial system offers users the ability to have full control over their assets and how they interact with other parties, making it a core element of Web3. It has seen an exponential rise in popularity due to it removing the many impediments and frictions of traditional finance.

Take, for instance, the process of borrowing from a traditional bank. First, you need to apply and be approved for a loan. The rate is set by the bank, and they charge a fee to manage the loan for you. If they want to transfer your loan to another servicer, you are not in a position to change their decision.

This one example highlights only a few of the benefits provided by the decentralization of finance. There is no “gatekeeping” in DeFi; its services are open to everyone, and there is no application process requirement to use its decentralized applications (dapps). Rates are set by market factors such as supply and demand, which generally makes them fairer. The fees needed to run dapps are not as significant as those used to support a third party (i.e. bank). Further, you have the freedom to move your funds from one platform to another if it offers you a better deal.

Lastly, while a bank only operates for 8 hours on business days, DeFi is always open, providing quick, efficient, and transparent means of executing financial transactions.

Limits of DeFi

First, it is worth noting that not all platforms that claim decentralization are truly decentralized. In some cases, the stakes in a platform are heavily weighted toward the founding team or a small group of participants.

This was perhaps best highlighted by a governance vote on the Solana-based platform Solend, where a major vote was dominated by just one user in June 2022. This vote was quickly reversed due to the blowback of the initial decision.

Another limitation is the susceptibility to hacks. Any weakness in the back-end programming of a DeFi platform can be exploited by a hacker, in which case funds are irreversibly drained from the protocol. This can also happen on the front-end of a platform—like a website—which led to users losing almost $600,000 from Curve Finance in August 2022.

Because it is based on blockchain technology, decentralized finance is governed by different rules than traditional finance. Users must be aware of these when they participate in its expansive offerings, and it is important to do your own research before using a platform.

What are some examples of DeFi in action?

Since its inception, DeFi has grown exponentially to offer a wide selection of services. It is difficult to include every aspect of decentralized finance, but here are some of the most popular examples:

• Decentralized stablecoins: Give crypto holders an asset with a constant value so they don’t have to trade back and forth to fiat currency through centralized exchanges.

Example: MakerDAO introduced the idea of a decentralized, overcollateralized stablecoin in 2017. This new token (DAI) was backed by other cryptocurrencies and promises a stable value of $1.

• Lending and borrowing: Just like taking a loan from a bank, some platforms provide opportunities for users to borrow assets to be used in alternative DeFi applications or for other investments. Users can also lend their own assets through smart contracts and collect interest and rewards, also known as yield farming.

Example: Aave is a lending/borrowing platform originally built on Ethereum that is now hosted on a variety of blockchains and layer 2 solutions like Avalanche, Fantom, Optimism, and Polygon.

• Asset trading: Trading stocks requires a buyer and a seller and traditionally large investors or institutions act as “market makers” that provide liquidity to asset markets. Many decentralized exchanges (DEX) use an automated market maker (AMM) smart contract that sees users combine their assets into liquidity pools. Those wishing to swap tokens trade into the pool, and liquidity providers collect a fee for their service.

Example: Uniswap is the most famous AMM-based DEX and has processed over $1 trillion in all-time trading volume. Curve Finance is a stablecoin-based DEX that is regularly one of the most popular platforms for swapping tokens.

• Derivatives: Traditional markets for securities and commodities include not only the trading of fundamental assets, but also derivatives of those assets. In other words, investors can trade in contracts that predict future prices (such as futures and options contracts). There are similar crypto-based DeFi markets that allow for trading in these derivatives.

Example: dYdX is a platform that allows for trading of perpetual futures contracts, which are future contracts with no expiration dates.

• Insurance: Because of the inherent risks that come with DeFi, such as hacks and smart contract exploits, decentralized insurance has become a popular way to protect funds. By paying a premium, users can submit claims to recover assets lost in DeFi protocols.

Example: Nexus is a decentralized insurance protocol governed by its own NXM token. Holders of the token get a portion of the premiums paid by those taking out policies on their DeFi funds.

• Venture funding: The idea of using cryptocurrency to fund projects saw a boom in popularity during the 2017 boom of initial coin offerings (ICOs). However, more recent crowdfunding efforts have become prominent ways to ensure projects have the support they need to succeed.

Example: Parachain crowdloans are used to build support behind blockchain projects that must bid on parachain slots to be included in the Polkadot network. Users agree to lock up their DOT for a predetermined amount of time and often receive a project’s token in return.

Decentralized finance essentials

• Decentralized Finance (DeFi) encompasses many financial services that bypass the need for intermediaries that traditional finance has become reliant on.
• Since 2020, the adoption of DeFi has exploded. Billions of dollars have been infused into the innumerable dapps that make up the DeFi ecosystem, though not without the growing pains of protocol hacks and smart contract exploits.
• Some of the important services provided by DeFi applications include the establishment of decentralized stablecoins, lending and borrowing, asset trading, derivatives trading, insurance, and venture funding.