Decentralized Finance (DeFi) Definition
Decentralized Finance, DeFi (pronounced as dee-fye), is a general term for an emerging monetary system that seeks to develop an internet native financial age backed by blockchain technology. It’s hosted by a distributed network of computers rather than a single server. DeFi’s primary motivation is to eliminate third-party intermediaries in finance to solve trust issues lingering around the traditional financial sector. It also intends to make anyone and everyone from whichever part of the world eligible for banking through the internet. Over 1.5 billion people around the world lack access to essential financial services. DeFi participants can partake in most functions found in a typical bank, such as saving, investing, borrowing, and even lending. You can also buy insurance, trade contracts for difference (CFDs), and much more. And it’s faster as you don’t have to go through intermediaries. DeFi transactions are of a peer-to-peer nature.
What Is Decentralized Finance?
DeFi is an open financial system. Its main building blocks are digital assets, decentralized applications (dApps), smart contracts, and protocols. Blockchain technology makes it trustless, decentralized, programmable, permissionless (open to everyone), and censorship-resistant. Most of what can be defined as DeFi operates from the Ethereum ecosystem. While Bitcoin is the largest crypto, it’s mainly used as a store of value. Ethereum has an extra feature. It’s a “world computer” with a whole permissionless computing platform, explaining why most DeFi projects use the Ethereum network.
Digital currencies and smart contracts eliminate the need for intermediaries, even in services like lending and borrowing. Unlike traditional banks, this decentralized model offers platforms where one can lend out crypto and earn interest in a matter of minutes. The interest is better than what banks offer. DeFi uses dApps to facilitate peer-to-peer businesses. Ethereum is the most widely tested and successful dApps network; no wonder it’s attractive to DeFi. DeFi has several coins for payment, including Ether, Polkadot, and USD-pegged stable coins. Anyone with programming skills can create a new app or add to the development of DeFi since it’s open source.
Understanding Decentralized Finance (DeFi) & Centralized Finance(CeFi)
Centralized finance is the opposite of DeFi. Both offer services like savings, lending, and investment, except that CeFi does so through a third party. Traditional banks are the best example. They control every aspect of their clients’ lives, from receiving their money to sending it. They decide when you can access your funds and even implement government regulations on your money. Customers pay a fee for each service rendered to them. There is no way to bypass these middlemen as long as you are using their services. Regulatory authorities like FED and SEC in the US enforce laws that govern how money moves in centralized finance. Decentralized finance, on the other hand, promotes freedom and democracy in the way transactions are done. It takes away power from monopolies and hands it over to the people. The commoner is exploited in traditional finance. Today if you have money in your savings account, you’re probably earning an interest of, say, 0.5%. You may not know that the bank uses your money to do business. It lends it, to other customers, at a high rate, like 3%, and only pays 0.5%, which is only about 15% of the profits they made with your money. DeFi gives you a platform where you can lend to borrowers directly and earn the entire 3% profit.
Traditional vs. Decentralized Finance: How Different is DeFi From Other Banking Products?
- Management: Employees manage normal banking products in an institutional setup. These are the people responsible for ensuring that transactions are fulfilled as they should. DeFi is an algo-managed environment in conjunction with smart contracts. Once a smart contract is deployed, the DeFi app handles the entire transaction according to the rules of the agreement without requiring human intervention.
- Trustless: Transparency is one of the founding principles of blockchain technology. It’s, in fact, among the vital differences between DeFi products and traditional banking products. Blockchain transactions are available to everyone at any time, something that creates trust among the community. In addition, there are no privacy concerns since transactions happen in a pseudonymous fashion.
- Accessibility: Traditional banks are geographically limited. Even for those with online banking, clients are still required to visit the banking hall for certain transactions. DeFi is 100% online and can be accessed from any part of the world.
- Permissionless: Present-day bank accounts have specific requirements that may limit people of certain categories from using them. DeFi is permissionless. There are no KYC requirements or credit history audits. It’s open to everyone. Since there are no gatekeepers, anyone is free to build new DeFi apps or use existing ones. All this is enabled by the power of smart contracts.
- Quick Innovation: The open-source nature of DeFi makes it programmable. Since it’s trustless, any programmer can add new ideas. Of course, some never see the light, but the ecosystem is always filled with new products from all angles of creativity. That is why DeFi is growing at a tremendous speed.
CeFi Vs DeFi
| CeFi | DeFi | |
| Funds Custody | The exchange has custody | User has complete custody |
| Security | Exchange can be hacked | No funds in the exchange to hack |
| Customer Service | Easily available | Hardly offered |
| Costs | Higher fees and commissions | Low fees |
| Access | KYC verification required | Permissionless |
| Anonymity | Very little | High anonymity |
The most important DeFi terms explained.
- AMM: Automated Market Makers (AMMs) facilitate transactions between buyers and sellers via smart contracts. So they eliminate the need for third parties or direct meetings between transacting parties.
- Bitcoin Maximalist: Also called “Bitcoin Maxis.” They are notorious supporters of Bitcoin who believe it’s the Bitcoin is the only true crypto, and the rest are pump and dump schemes.
- Black Swan: Black swans refer to catastrophic occurrences in DeFi. These are events that are normally unseen yet leave a widespread effect across the entire market.
- Censorship Resistant: These are protocols whose transactions can’t be invalidated or interfered with. DeFi is censorship resistant because no one can stop its transactions.
- DAO: Members create Decentralized Autonomous Organizations (DAOs) to automate decision-making through a governance token.
- Deflationary Token: Tokens are “deflationary” if their supply is constantly reduced from the market to cause scarcity and raise prices.
- dApps: Decentralized applications (dApps) are digital apps that run on the decentralized blockchain.
- Derivatives: Derivatives are securities whose value reflects the price of an underlying asset or group of assets. Therefore they don’t have an intrinsic value.
- ERC-20: This is an Ethereum network standard for running smart contracts. It carries the rules that govern all Ethereum tokens.
- Flash Loan: Flash Loans are a type of uncollateralized or unsecured loans accessible through DeFi platforms. They are governed by smart contracts and are paid back within seconds.
- Gas: Gas is the cost of performing transactions on a network. It’s normally determined by the miners according to the demand and supply of computing resources. Gas fees are higher when the network is congested and vice-versa.
- Governance Tokens: These tokens allow DAO members to vote. The weight of a vote is determined by the number of tokens held by the voter.
- Liquidity: Liquidity is the availability of liquid assets in DeFi.
- Liquidity Pools: Liquidity pools are made up of pooled assets locked in by smart contracts and are meant to facilitate trading.
- Off-Chain & On-chain: Off-chain transactions occur “off” the blockchain network. They are mostly free. While on-chain transactions take place take place on the Ethereum network, hence subject to gas fees.
- Web 3.0: This is an internet built on the blockchain and gives users autonomy over information. It’s decentralized and benefits both builders and users.
- Yield Farming: Refers to the act of investing tokens in DeFi to earn interest.
How Does DeFi Work?
DeFi is enabled by the blockchain network and crypto. In traditional finance, there’s a physical ledger book or computer ledger software that banks use to record transactions. This is called a private ledge. It can only be accessed by the institution in charge. DeFi has a ledger too. All transactions are recorded in a coded format. The difference with your bank is that DeFi uses a public ledger. Anyone can check the ledger and view all the recorded transactions. The addresses involved, which are like bank accounts, are also visible. However, personal information such as the owners of the address is kept private. DeFi ledgers are also said to be distributed, meaning that anyone using the platform has the same copy of records in encrypted codes. It’s theoretically impossible to alter a transaction that has already been recorded. That’s why it’s said that blockchain activities are immutable. Immutability guarantees security and increases trust between users and the system.
As already discussed, DeFi takes advantage of smart contracts to offer all traditional banking services without third parties and central governing authorities. It hence makes it possible for anyone to access services such as banking, money transfer, and saving from any part of the world. All that’s needed is a connection to the internet.
Smart contracts are also eliminating banking instruments such as documentary letters of credit and the costs involved. You can perform a complex sales transaction such as the purchase of real estate automatically by simply setting up or following a smart contract. The smart contract executor protocols will transfer the titles of ownership and money when the required conditions are fulfilled. DeFi is not yet complete, even though its fruits are already being harvested. It’s a continuous work in progress. Keep in mind that it’s not owned by anyone, just like the internet.
What can you do with DeFi?
You can engage in DeFi via blockchain software called dApps (decentralized applications), or simply called DeFi projects. Most dApps / DeFi projects currently run on the Ethereum blockchain. Here are some of the ways people are participating in DeFi
- Lending: Instead of holding your crypto tokens in your wallet with no use, you can lend them out to the network. In return, you get rewards in the form of more crypto (interest). Unlike traditional banking, DeFi rewards can start streaming in almost as soon as you lend your crypto.
- Borrow: Since there is a lending function, borrowing is also part of DeFi. You can obtain a loan instantly without following lengthy application processes. DeFi offers extremely short-period unsecured loans called flash loans to longer-term collateral-based loans. Your credit history is not important.
- Trading: DeFi’s automated market maker system allows you to engage in peer-to-peer trading of financial assets. You can also take part in derivative trading and earn quick leveraged returns.
- Savings: You’ll come across attractive saving plans in the DeFi environment. Here you can put your crypto in a saving dApp and earn better interest than what your bank gives you.
- Gambling: Gamblers are never left out of any new technology. Casinos and other gambling operators have already joined DeFi. This has promoted the development of a decentralized betting ecosystem like LunaFi, where anyone can invest and become the house.
What are yield farms?
Yield farming is an umbrella word for different ways of earning interest from your crypto. It can be compared to how you can earn from saving in the bank or even taking an insurance investment policy. Most of it requires you to lock up your crypto for a while and in the end, take away rewards in the form of more crypto. In Defi, investors put their money/tokens/coins in dApps such as crypto wallets and decentralized exchanges to earn interest. Yield farming is a function of smart contracts.
There are several ways to participate in yield farms with your digital assets. Staking is one of the most common ways. Proof-of-stake blockchain networks like Solana and Polkadot will reward you for verifying transactions on the network. You may also invest in a lending protocol app like Compound and earn dynamic interest rates. Lastly, you can become a liquidity provider for decentralized exchanges like Uniswap. This involves investing a pair of crypto tokens in equal measure to facilitate digital assets swaps in decentralized exchanges. By doing so, you’ll share in the platform’s profits for fees collected from investors exchanging one currency for another.
Degen vs. Stable Yield Farming
There are always two types of investors; aggressive high risk, and low risk, also called conservative type investors. Degen and stable yield farming represent these two types of investors, respectively. Let’s dig deeper.
Degen yield farms take outrageous risks far from normal risk protocols and target extremely high returns, therefore it is also considered as DeFi gambling. While the chances of catastrophic outcomes are high, investors can take home double or even triple their returns when things go right. Unfortunately, most yield farming tokens have weak use cases and are simply backed by investor speculations and hype. They hardly have proper documents or undergo code audits. These are zero-sum games where you either win big or lose big. Outcomes can be determined starting from a few hours, days to weeks. Successful degen farm investors get in early and exist quickly too.
On the other hand, stable yield farming involves taking low risks and targeting relatively low to moderate returns. They are usually backed by reputable teams and have a proper project behind them. The annual percentage returns (APRs/APYs) are never anywhere close to 100%
How you can start using DeFi - Step by Step Guide
Step 1 — Decide your initial investment.
The best way to get started is to get involved. After reading and doing tons of research, you still can’t get better at it if you’re not a participant. Beginners should start with a small amount that they are willing to risk. Remember, profits and losses are part of business, so don’t put in your entire savings. You may also not want to start with borrowed capital unless it’s money that can’t strain you if it fails to pay off.
Step 2 — Converting Fiat to Crypto/USD (Stablecoins)
You’re going to require crypto ownership to take part in DeFi. You can begin by buying major digital coins like BT, ETC, or stablecoins. Stablecoins are pegged on the dollar and are meant to exchange at a rate of 1 dollar per coin. You will need a crypto exchange account to buy digital assets. We recommend Coinbase for beginners, although you’re free to go for any exchange that appeals to you. It’s user-friendly and secure.
Step 3- CeFi or DeFi?
Now that you have bought crypto, you need to decide whether you will stick to Centralized exchanges or Decentralized exchange platforms. DeFi platforms are the best if you want to have the full experience of decentralized finance. While CeFi platforms are easy to use, and you don’t have to worry about your private keys, they have fewer features. You can’t stake or borrow in CeFi exchanges.
Step 4 — Get a Crypto Wallet
You would need a crypto wallet if you picked DeFi. Crypto wallets were developed to provide all DeFi functions under one roof. Non-custodial wallets are the most preferred by investors. They are more secure and hard to hack. Users have full control of access keys. Coinbase Wallet, MetaMask, and TrustWallet are among the most common crypto wallets.
DeFi in Gambling
Gambling is one of the most progressive industries. The internet became popular towards the end of 1991, and by 1994, the first online casino was launched. Ever since, the sector has continued to explore every new technology that comes up. DeFi is the new darling on the block, so gamblers couldn’t be left out. We are not just talking about land-based casinos. Covid 19 lockdowns forced casinos to seek alternatives online. Blockchain technology offers transparent and secure ways of betting. Many gambling providers started adopting cryptocurrencies, and today there is clear evidence that the future of casinos and sports betting is in DeFi.
There are several benefits of DeFi gambling. Let’s look at them.
- Transparency
Trust is the biggest issue in gambling. DeFi gambling is blockchain-based, so it’s transparent, and bettors have no illusions that they will be rigged out. Of course, the house may still win in the long run because that’s the nature of gambling. However, when players use DeFi or dApps, they are sure that all losses and wins are 100% genuine. Meaning participants can now enjoy a plethora of gambling options without worrying about losing their money to dishonest operators. This is because blockchain records everything immutably, including losses, wins, and payouts.
- Provably Fair Games
Another significant benefit of DeFi is the introduction of provably fair games. Nothing worries a gambler more than being cheated. Speculators are willing to take substantial stakes as long as they are sure there is fairness. Provably fair games are a surefire way of proving fairness in gambling. They remove third parties and introduce a fairness verification system between casino operators and bettors. The fairness verification system is irrevokable and undisputable. For example, after playing a given spin in a slot machine, you can key in seed numbers into a hashing tool to find out whether the casino tampered with the outcome or not.
- DeFi Games
DeFi games are hosted and played on the blockchain. What’s most attractive about them is that they offer players numerous rewards to players. You can earn real money by taking part in DeFi games. There’s nothing better than making money while being entertained. That’s why play-to-earn games have become so popular.
- Metaverse Casinos
The metaverse is a futuristic immersive virtual world. Members can buy land, own houses, operate shops and even play games. It works like the real world. All you need is an avatar that represents you to get started. Casinos have already begun creeping into the metaverse as they seek to provide immersive betting environments to their clients. Metaverse casinos rely on smart contracts and cryptocurrencies to implement their functions.
DeFi Financial Products
Uniswap: Token exchange
UniSwap is one of the oldest and largest decentralized exchanges. Its Native and governance token is UNI. The platform uses a permissionless model allowing accessibility to anodyne over the internet with zero restrictions. It’s 100% governed by smart contracts and lets users trade all major tokens from the wallet. It supports more than 1800 tokens and 2000 coins. As the name indicates, UniSwap doesn’t accept fiat transactions. It’s a crypto-to-crypto trading platform. If you’re just getting started, buy BTC, ETH, or a coin of your preference from a fiat compatible exchange and send it to your UniSwap wallet. UniSwap enables peer-to-peer market making. It runs on the Ethereum blockchain network, which uses the proof-of-work operating model. As a UniSwap DeFi user, you can create new markets with smart contracts, use current markets to swap digital coins, stake to earn rewards, or participate in voting through UNI tokens.
Augur: Market prediction platform
Augur is a trustless DeFi platform for market prediction. Users can stake in the outcome of a real-world event. Like betting or binary options, users place bets and earn rewards when they win. The less likely the event, the higher the premium. More likely, events have fewer rewards. It offers several markets, including non-finance-related options such as gossip and even weather updates. For example, you can bet on a question like, “Will Donald Trump regain his Twitter account on 5th July 2022?” Your bet, in this case, is a simple yes or no. You’ll come across three main types of predictions, yes/no, multiple-choice, and scalar ( predictions with lower and upper bands). The platform founders believe that Augur will help tap into the crowd’s wisdom to spread quick and easy-to-read information in every sector. Augur is built on Ethereum. Its native token REP is used to place bets and participate in Augur competitions.
PoolTogether: Zero loss savings platform
Not everyone who participates in a lottery wins. But what if there were no losers? This is what DeFi service provider PoolTogether offers. It allows users to stake crypto into a lottery programmer for a chance to win attractive weekly and monthly prizes. There is a weekly or monthly winner but no losers. Yes, there are absolutely no losers because everyone else who didn’t win gets back their initial investment at the end of the bet. So your only cost will be trading fees, but you don’t lose your money. It’s an Ethereum-based platform that describes itself as “prize savings,” meaning you get rewarded for saving. Instead of holding your crypto elsewhere, you could keep it and bet with it at PoolTogether since there are no risks, yet if you win the draw, you could potentially take home a huge price. The best part is that there are no lengthy account opening procedures. Simply go to the PoolTogether website, connect to your Web3 wallet, and get started.
Compound: Borrow and lend
Compound is a sophisticated blockchain-built borrowing and lending app that’s the DeFi version of what we call money markets in traditional finance. The protocol allows users to borrow and lend in crypto, just like you can take loans from a bank or save to earn interest. Supported cryptos include Ether, Tether, USD Coin, Augur, Wrapped BTC, Dai, Basic Attention Token, True USD, Sai, Sushi Token, Oz, Maker, Uniswap, ChainLink Token, Aave Token, and Yearn Finance. Lenders stake their crypto into different liquidity pools to earn dynamic interest rates annually. Interest is paid to lenders in the same crypto-token they use to stake. Like banks, Compound loans are secured by the crypto savings balance of a borrower. So you must open an account and start saving to qualify for a loan. DeFi is anonymous, and there are no credit score checks, so borrowers qualify for a percentage of their savings according to several determining factors. Loans are paid with compound interest rather than a fixed rate. So the cost of borrowing keeps varying with your loan balance. Keep in mind that Compound itself doesn’t offer loans but instead matches lenders and borrowers in a peer-to-peer fashion.
MakerDAO: Decentralized reserve bank and stablecoin
Maker is stablecoin and lending DeFi lending project. However, the concept is very different from lending dApps like Compound in that it is like a central bank but decentralized. It’s an Ethereum-based project governed by MakerDAO through Maker token (MKR) and uses DAI for transactions. These are its two native coins. DAI is a USD-pegged stablecoin backed by crypto collateral from user deposits and is kept stable by MKR. Maker strives to operate pretty much like the Fed without breaking the founding tenets of DeFi. Holders of DAI can even vote just like the Fed community votes on interest rates. Holders of MKR can take collateralized loans in DAI stable coin, with MKR as the security. The borrower’s collateral is automatically sold when they fail to repay their loans accordingly. Everything is governed by Ethereum protocol smart contracts.
DeFi Currency
There is no single currency that works best in DeFi. The ecosystem is designed to work with cryptocurrencies. DeFi products work with a variety of cryptos, from major ones to tokens. Tokens are so far the most actively used currencies as most platforms have their own native coins. The technology is, however, still new, so it’s not possible to determine which coins will dominate in the future. The common denominator is that all DeFi currencies are compatible with smart contracts. While the entire crypto sector is currently valued at over $1.5 trillion, DeFi native tokens make up about $124 billion in market cap, slightly less than 10% of the entire digital coins market cap. Most DeFi platforms are DAOs, meaning they are governed by their members through a democratic voting system, in which case, the ecosystems’ native tokens give holders special voting rights. Users with more tokens have more voting rights based on the assumption that a member’s interest in the success of a project can be measured by how much they are willing to invest in it. Uniswap is so far the largest native token with governance rights. It had a fully diluted market cap of $5.3 billion as of writing this.
DeFi’s future looks bright. We can call it the innovation of the century. The technology behind it offers solutions to many problems of traditional finance. Just like the wealth management space is being disrupted by artificial intelligence, DeFi is the next significant disruption in the banking sector. From giving out unsecured loans in seconds to taking out the middle man, DeFi’s potential is far-reaching. Numerous use cases can be developed simultaneously. And since it’s an open-source platform, DeFis will continue to experience tremendous growth with new functionalities being launched daily. And we are not talking just about finance. DeFi is finding use cases in governance, transport, entertainment, energy, and even in the health sector.
We are heading into a future of self-driving cars, meaning there will be self-driving taxis too. Picture a world where all taxis have a DeFi wallet, and all you have to do it to activate your journey with a smart contract. The future of DeFi is independence for all. That said, the journey will not be without hurdles. Government regulations are the main challenges that lie ahead. Regulators are hardly up to speed with technology. This could mean the introduction of unfavorable, poorly structured laws, especially for the smart contract sector that feels it doesn’t need regulation. The ongoing lawsuit between SEC and XRP is a perfect example of regulatory problems that emerging technologies encounter. In the end, technology always wins, so DeFi is here to stay and lead us to a future of integrated value exchange.
Conclusion
DeFi is a new experience with a world of possibilities. It’s not just different from traditional finance but is also exciting. Although it’s still in its infancy days, participants are already reaping huge rewards. From provably fair gambling to earning massive returns from yield farms to individuals taking loans on the blockchain. The potential that DeFi carries can’t be ignored. The best part is that it’s permissionless, so anyone can join without restrictions. Simply get a Web3 or DeFi wallet to get started. If you’re interested in staking, a rule of the thumb is to invest your risk capital only. Cryptocurrencies are volatile, and they can lose value at any time.
FAQs
Decentralized Finance (also known as DeFi) is a form of blockchain-based finance that doesn’t rely on a central financial intermediary like an exchange, brokerages, or banks to offer traditional financial instruments. Rather, DeFi relies on smart contracts on blockchains like Ethereum and therefore massively improves traditional finance.
Through DLT Users can access financial products directly on the blockchain, without the need for any middlemen like banks. In other words, users can trade crypto currencies, acquire insurances, borrow or lend funds, invest in different assets using derivatives and NFTs and earn interest in saving accounts through DeFi platforms.
DeFi democratizes finance and brings financial opportunities to the unbanked and underbanked. DeFi connects users directly via blockchain technology, commonly known as the DeFi protocol, creating a peer to peer financial network. Its products and smart contracts ensure that all agreements are fulfilled and therefore eliminate the need for intermediaries.
Bitcoin is a cryptocurrency running on a decentralized Blockchain. DeFi doesn’t refer to any specific coin but rather the entire concept of a financial system built on a decentralized distributed blockchain like the technology behind Bitcoin and Ethereum. DeFi enables users to borrow, lend and even trade. Bitcoin is simply a store of value, so it’s not decentralized finance.
Total Value Locked (TVL) in DeFi is simply the total amount of staked or invested cryptocurrency earning rewards.
No one created DeFi. Neither is owned by any single person. It’s a concept that was inspired by Bitcoin but built on smart contract blockchains like the Ethereum network. It’s programmable, so anyone with coding skills can take part in developing DeFi.
Reviewed and Fact Checked by Kevin O'Brien , Web3 & DeFi Writer