What is DeFi?

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Decentralized Finance (DeFi) represents a new vision of banking and financial services based on peer-to-peer transactions. Using blockchain technology removes the need for traditional financial intermediaries or third parties such as banks or brokers. This is your comprehensive DeFi guide.

Bitcoin (BTC), the pioneering decentralized payment network that allows global money transfers without intermediaries, was merely the beginning of the cryptocurrency revolution. The architects of DeFi aim to extend this accessibility even further to the average person. DeFi is increasingly seen as a way to lower the entry barriers for those who struggle to access traditional banking services. Lately, many crypto holders are turning to DeFi for a different reason: to increase their wealth. To best understand decentralized finance, let’s first look at centralized finance.

Centralized Financial System

Banks—entities primarily focused on profit—hold your funds in a centralized financial ecosystem. This system is rife with intermediaries facilitating monetary transactions between consumers, each charging service fees. For instance, the payment journey is complex if you purchase a soap using your credit card. It starts with the merchant and goes to their bank, which then forwards your card information to the credit card network. This network verifies the transaction and seeks approval from your bank. Once approved, the transaction is routed back through the acquiring bank to the merchant. Every party involved in this chain gets compensated, typically because merchants bear the cost of enabling credit and debit card transactions.

All other financial transactions are subject to a fee, loan applications can take several days to be approved, and you may not be able to use banking services abroad at all. That’s where DeFi comes in.

What is Decentralized Finance (DeFi)?

DeFi is an umbrella term for various decentralized financial applications based on blockchain technology, such as Ethereum. These products operate without authorization, meaning they do not use third parties. Instead of financial intermediaries (such as brokers and banks), everything is automated in a protocol via smart contracts. These are self-executing contracts with the terms directly written into code. They represent the building blocks that allow for the creation of decentralized applications (dApps).

DeFi draws inspiration from blockchain technology, which allows multiple entities to keep a copy of a transaction history, meaning it is not controlled by a single central source. This is important because centralized systems and human gatekeepers can limit the speed and complexity of transactions while giving users less direct control over their money. DeFi is different because it extends the use of blockchain from simple value transfer to more complex financial use cases.

  • Looking for a loan? Skip the bank; you can borrow directly from individuals.
  • Are you interested in speculating on Bitcoin futures or other financial derivatives? You don’t need a broker; the protocol covers you.
  • Want to swap one asset for another? Decentralized exchanges can handle the trade without hefty fees.

How Does DeFi Work?

So, decentralized financial systems use blockchain technology for their function. A blockchain is a distributed and secured database or ledger. Decentralized applications called dApps are used to process transactions and manage the blockchain. In a blockchain, transactions are recorded in blocks and then verified by other users. The block is closed and encrypted if these validators agree with the transaction. Then another block is created containing information about the previous block.

The blocks are “chained” via the information in each subsequent block, hence the name blockchain. The information in previous blocks cannot be changed without affecting subsequent blocks, so the blockchain cannot be changed. This concept, together with other security protocols, ensures the secure nature of this technology.

What are Smart Contracts?

In its most basic form, a smart contract is a self-executing contract where the terms are directly written into code. Consider it a digital agreement that doesn’t need a middleman to enforce. Developed on blockchain platforms like Ethereum, smart contracts are immutable and transparent, meaning once they’re deployed, they can’t be altered, and anyone can verify them. These contracts automatically execute actions like sending, receiving, and managing funds when certain conditions are met—no need for a notary, lawyer, or any other third party.

The obvious advantage of smart contracts is that they can be created to lend cryptocurrency without an intermediary, thus avoiding many of the risks associated with traditional lending. For example, if the borrower cannot meet his obligations under the loan, the lender can simply take back his funds, making collateral unnecessary. In addition, DeFi savings accounts could work the same way as bank savings accounts, but could offer higher interest rates or pay out daily, weekly or monthly, depending on the platform.

Who »Invented« DeFi?

DeFi has no single inventor, but DeFi applications first appeared on the Ethereum blockchain, invented by Vitalik Buterin. In 2013, the Russian-born Canadian, at the age of 19, wrote a white paper describing an alternative platform to Bitcoin that would allow programmers to develop their own apps using an embedded programming language. Thus, Ethereum was born. It has grown exponentially over the last nine years, and its native ETH is now the second largest cryptocurrency by market capitalization—right after Bitcoin.

While Ethereum provided the canvas, the early DeFi agents were platforms like MakerDAO, which introduced the concept of decentralized stablecoins, and Compound, which revolutionized decentralized lending and borrowing. These early projects proved that it was possible to recreate traditional financial services like lending, borrowing, and asset trading on the blockchain without intermediaries. Over time, a slew of innovators and developers have contributed to the DeFi landscape, making it a collaborative invention of the crypto community.

Brief History of DeFi

  • 2009: Birth of Bitcoin: Satoshi Nakamoto introduces Bitcoin, laying the foundational concept of decentralized, peer-to-peer transactions.
  • 2015: Ethereum Launch: Vitalik Buterin launches Ethereum, introducing smart contracts and setting the stage for decentralized applications (dApps).
  • 2017: MakerDAO Debuts: MakerDAO is launched, pioneering the concept of decentralized stablecoins with its DAI token.
  • 2018: Compound Finance: Compound goes live, revolutionizing decentralized lending and borrowing.
  • 2019: Uniswap’s Rise: Uniswap gains prominence, offering a decentralized exchange platform for token swaps.
  • 2020: Yield Farming Craze: The concept of yield farming takes off, popularized by platforms like Yearn.finance, leading to a surge in DeFi adoption.
  • 2020: Total Value Locked (TVL) Milestone: DeFi crosses $1 billion in Total Value Locked (TVL), marking its growing influence in crypto.
  • 2021: DeFi on Layer 2: Projects like Polygon and Optimism bring Layer 2 scaling solutions to DeFi, enhancing speed and reducing costs.
  • 2021: NFTs Meet DeFi: Non-Fungible Tokens (NFTs) integrate with DeFi platforms, creating new avenues for digital ownership and financialization.
  • 2021: Regulatory Attention: DeFi starts to attract regulatory scrutiny, signaling its growing importance and potential challenges ahead.
  • 2022: Multi-Chain Expansion: DeFi projects begin expanding to multiple blockchains like Binance Smart Chain and Solana, breaking free from Ethereum’s limitations.
  • 2023: Mainstream Adoption grows: DeFi starts to gain mainstream attention, with traditional financial institutions exploring decentralized finance solutions.

Ethereum, DeFi Engine

Most decentralized financial applications are, therefore, built on the Ethereum blockchain, which is, unlike Bitcoin, easier to use to build other types of decentralized applications that go beyond simple transactions.

Indeed, Ethereum’s smart contract platform, which automatically executes transactions if certain conditions are met, offers much more flexibility. Ethereum programming languages such as Solidity are specifically designed to create and execute such smart contracts.

Imagine a user wishes to transfer money to a friend next Tuesday, but only if the temperature exceeds 25 degrees Celsius, as reported by BBC. Such conditions can be encoded into a smart contract.

Ethereum also introduced the ERC-20 token standard, which has become the de facto standard for creating new tokens in the DeFi space. Whether it’s governance tokens, utility tokens, or even stablecoins like DAI, the ERC-20 standard has made it incredibly easy for developers to launch new tokens, enriching the DeFi ecosystem.

Ethereum Challenges Prompted New Defi Blockchains

While Ethereum has been instrumental in the rise of DeFi, it’s not without its challenges. The platform has faced issues with scalability, leading to high gas fees, especially during peak usage times. This has opened the door for competitors like Binance Smart Chain and Solana, which offer faster transactions at lower costs. However, Ethereum is not sitting idle; with upgrades like Ethereum 2.0 and Layer 2 solutions like Polygon, the platform is gearing up to meet these challenges head-on.

What Makes Defi So Special?

  • Democratization of finance: One of the most compelling aspects of DeFi is its potential to democratize access to financial services. Traditional financial systems are often riddled with barriers—be it geographical limitations, credit checks, or minimum balance requirements. DeFi shatters these barriers by offering financial services on a public blockchain, accessible to anyone with an internet connection. No middlemen, no gatekeepers, just pure, unadulterated financial freedom. This opens the door for financial inclusion, bringing essential services to the billions who are unbanked or underbanked.
  • Transparency and security: In a world where data breaches and financial scandals make headlines, the transparency and security offered by DeFi platforms are nothing short of revolutionary. Built on blockchain technology, DeFi applications are transparent by design. Every transaction is recorded on a public ledger, providing an unprecedented level of transparency. Moreover, the decentralized nature of these platforms makes them highly resistant to censorship and fraud. Your funds are secured by cryptographic algorithms, not by a bank with questionable security measures.
  • Cost efficiency and innovation: DeFi’s smart contracts automate complex financial transactions, from lending and borrowing to asset trading. This automation eliminates the need for intermediaries, slashing transaction fees and reducing the cost of financial services. But the magic doesn’t stop there. The open-source nature of most DeFi projects fosters a culture of innovation. Anyone can audit, fork, or build upon existing protocols, leading to an explosion of financial products and services that are more aligned with the users’ needs rather than profit-driven financial institutions.

What Can We Do inside Defi? Top Use Cases:

Lending and Borrowing

One of the most fundamental services offered in the DeFi space is lending and borrowing. Platforms like Aave and Compound have revolutionized the way we think about loans. Forget about credit checks, paperwork, or waiting in line at the bank. With DeFi, you can lend or borrow assets directly from a liquidity pool. Lenders earn interest by providing liquidity, while borrowers pay interest to access it. And the best part? It’s all automated through smart contracts, making the process seamless and efficient.

Decentralized exchanges (DEX)

If you’ve ever used a centralized exchange like Binance, you know the drill—sign up, go through KYC, deposit funds, and then trade. But what if you could trade directly from your wallet without any of these hassles? Welcome to the world of decentralized exchanges (DEXs) like Uniswap and SushiSwap. These platforms allow for peer-to-peer trading, facilitated by smart contracts. No middlemen, no withdrawal fees, just pure trading freedom.

Yield farming

DeFi offers the adrenaline-pumping activities of yield farming and liquidity mining for those who like to live on the edge. By providing liquidity or participating in a dApp’s ecosystem, you can earn rewards through tokens. Platforms like Yearn.finance have even automated the yield farming process, shifting your funds between different protocols to maximize returns. It’s like having a robo-advisor for your crypto investments.

Insurance, derivatives

The DeFi ecosystem is rapidly evolving, and new services are popping up like mushrooms after a rainstorm. You can now buy decentralized insurance through platforms like Nexus Mutual, trade derivatives on Synthetix, or even participate in decentralized governance through DAOs (Decentralized Autonomous Organizations). The possibilities are virtually endless, limited only by the imagination of the crypto community.

How Are Decentralized Applications (Dapps) Created?

DeFi apps can be created by anyone who can write smart contracts. It does require a deep understanding of blockchain-specific programming languages and development frameworks. Solidity is the language of choice for Ethereum-based DeFi apps, while other blockchains like Binance Smart Chain or Solana may use languages like Go or Rust. Development frameworks like Truffle or Hardhat offer a suite of tools that streamline the development process, from compiling and deploying smart contracts to running tests and front-end development.

A DeFi app typically consists of two main components: the front-end and the back-end. The front-end is the user interface, built using standard web technologies like HTML, CSS, and JavaScript. The back-end is where the magic happens; it’s composed of smart contracts that interact with the blockchain to execute various financial functions. These two components are bridged by Web3 libraries, which enable seamless interaction between the blockchain and the user interface.

Before a DeFi app goes live, it undergoes rigorous testing on a testnet—a simulated blockchain environment. This is crucial for identifying bugs and vulnerabilities. Once the app passes the testnet phase, it’s often audited by third-party firms to ensure security and compliance. Finally, the smart contracts are deployed to the mainnet, and the DeFi app is officially launched.

How Can We Use DeFi Products?

Anyone can use them by visiting the app’s website and connecting to a DeFi-enabled crypto wallet, such as MetaMask on Ethereum or Phantom on Solana. Most DeFi apps do not require users to provide personal data or register. However, as the applications are built on a blockchain, you must use coins from that blockchain to pay for transactions. ETH is required to pay for transactions on the Ethereum network, SOL on the Solana blockchain, and so on.

How Can I Start My Defi Journey?

Firstly, set up a wallet compatible with Ethereum to interact with various DeFi platforms through your web browser. MetaMask is a popular option for this. Next, acquire the specific cryptocurrency that the DeFi protocol you’re interested in uses. Many protocols are Ethereum-based, so you’ll likely need to purchase ETH or an ERC-20 token. If you want to use Bitcoin, convert it to an Ethereum-compatible version like Wrapped BTC. Once you’re set up, decide on your DeFi activity: options include lending your crypto, earning interest by depositing it on a decentralized exchange (DEX), or investing in high-risk, high-reward projects. The choices are abundant.

Caution: The DeFi landscape has hazards, including scams and technical flaws. It’s a highly speculative and volatile sector within the already risky world of cryptocurrencies. Scams, including exit scams and rug pulls, are quite common. Additionally, smart contract vulnerabilities often expose centralized control by token creators, contradicting the supposed decentralization of the project. So approach carefully.

DeFi: Cons

  • Complexity: One of the most glaring issues with DeFi is its complexity. While traditional finance has its own set of complexities, DeFi takes it to a whole new level. From yield farming strategies to liquidity pools, the learning curve can be steep. This complexity not only makes DeFi intimidating for newcomers but also increases the risk of making costly mistakes. One wrong move, and you could find yourself in a financial quagmire.
  • Security risk: DeFi’s backbone is smart contracts—automated, self-executing contracts that run on a blockchain. While these contracts offer unprecedented transparency and automation, they are also prone to bugs and vulnerabilities. A single coding error can lead to massive financial losses, as we’ve seen with infamous hacks like the DAO incident. And let’s not forget, once a smart contract is deployed, it’s immutable, meaning errors can’t be easily fixed.
  • Regulations: DeFi operates in a regulatory gray area, and this lack of oversight can be both a blessing and a curse. On one hand, it allows for financial innovation and inclusion. On the other, it opens the door to fraudulent schemes and money laundering. Regulatory crackdowns could pose a significant risk to DeFi platforms and their users, leading to frozen assets or even complete shutdowns.
  • Impermenent loss: For those who venture into providing liquidity or yield farming, impermanent loss is a term you’ll become intimately familiar with. In simple terms, impermanent loss occurs when the price of your deposited assets changes compared to when you deposited them, leading to less value when you withdraw them. This risk is often not well-understood by newcomers, leading to unexpected losses.

The Future of DeFi

In November 2020 (when the 2020-2021 crypto bull run was heating up), less than $20 billion of value was locked in various DeFi platforms, mostly on Ethereum. By the following year, this value was already over $260 billion, with $19 billion coming from the Binance Smart Chain alone. At the time of writing, the market has cooled somewhat in terms of astronomical values, but technology and space continue to evolve. If the trend eventually continues and the DeFi maximalists are right, this is just the beginning of a big DeFi wave. The ardent preparers argue that the benefits of an open and decentralised financial system are simply too compelling not to capture trillions of dollars in value.

But as DeFi gains momentum, it’s bound to attract regulatory scrutiny. How DeFi platforms navigate this regulatory maze will be crucial for their long-term viability. Compliance could bring legitimacy, but excessive regulation could stifle innovation. Security is another significant concern. As DeFi platforms handle more value, they become lucrative targets for hackers. Advances in cryptographic techniques and decentralized governance models will be essential in fortifying the DeFi ecosystem.

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