As of January 2022, an astounding $100 billion in crypto assets are locked into decentralized finance applications, according to DefiPulse.
Decentralized finance — known as “DeFi”— is a sector within the blockchain industry that includes a number of applications that aim to disrupt and displace the world of traditional finance.
DeFi uses digital currencies for financial activities such as lending and borrowing, trading, and earning yield on assets.
What Is DeFi? — Origin Story
The origins of DeFi can be traced back to the launch of the Bitcoin blockchain, mainnet, in January 2009. Bitcoin is the world’s first blockchain — a digital ledger technology that allows people from around the world to share a unified copy of data (e.g., financial transactions).
In this way, Bitcoin first helped to “decentralize” the financial world since no single person or entity is responsible for verifying transactions or maintaining a copy.
However, the DeFi industry we know today isn’t just limited to basic transactions. Most experts point to the launch of the Ethereum blockchain in July 2015 as the biggest catalyst for DeFi’s ascent.
Ethereum is the first blockchain to introduce smart contracts — programming logic that creates automated rules for crypto transactions. The invention of smart contracts led to the development of several innovative apps built on the Ethereum blockchain.
Following Ethereum’s DeFi boom, new blockchains emerged with smart contract technology and DeFi applications. With Ethereum, users need to pay a gas fee for each transaction on the network. Gas fees ensure that validators process user transactions. Due to Ethereum’s limited scalability, the gas fee for a single transaction is often $100-$200 as of early 2022.
Ethereum aims to improve scalability with Ethereum 2.0 to reduce gas fees. In fact, very few blockchain ecosystems rival Ethereum in terms of the number of DeFi developers, applications, or active users.
Types of DeFi Applications
There are a growing number of DeFi applications that play an important role in the cryptocurrency market today. Many applications have the potential to disrupt the banking industry and foster greater financial inclusion. Let’s look at a few types of DeFi applications to help us understand DeFi.
Lending/borrowing is the original use case of DeFi and still remains the most popular type of application by far. Lending protocols allow users to either lend out their assets and earn interest in crypto or borrow funds by using their existing crypto holdings as collateral.
DeFi relies on overcollateralized loans, so it eliminates the requirement to wait for loan approvals. For example, a user who wants to borrow $100 might have to supply $500 in collateral. The loan is then distributed immediately in the form of a stablecoin. Borrowers only need to maintain a standard collateral ratio to keep their loans open.
Examples of DeFi lending protocols include Marker, Aave, and InstaDApp.
Decentralized exchanges (DEXs) are applications that allow crypto holders to trade one crypto for another. For example, users can trade ETH for USDC or vice versa via a DEX. Most decentralized exchanges consist of two user types: liquidity providers and traders.
Liquidity providers act as market makers for DEXs by locking capital in smart contracts. They are then rewarded by receiving a portion of exchange fees accumulated for a specific trading pair.
For most DEXs, each trading pair has a liquidity pool that makes it easier to fill orders. As an example, ETH/USDC has its own pool while WBTC/ETH has its own pool.
DEX traders are market takers, meaning they take liquidity from a specific pool by placing trades that reflect real-time market prices. They typically pay a fee to the DEX platform for each order.
Examples include Curve Finance, Uniswap, and Pancakeswap.
Derivatives platforms enable traders to create financial contracts related to futures. For example, users can bet whether they think the price of a certain cryptocurrency will go up (create a long position) or down (create a short position).
Futures trading platforms allow users to trade with leverage. The benefit of leverage is that users can potentially 5x their profits without having to hold the underlying asset they wish to trade. The downside is that they can also lose five times the amount if they are liquidated.
Examples of DeFi derivatives platforms include dYdX, Synthetix, and Nexus Mutual.
Yield Farming Aggregators
When most people define what is DeFi, yield farming is usually the first thing that comes to mind. Yield farming generally refers to earning interest by depositing crypto into a smart contract. The smart contract lends out crypto to borrowers and traders. Lending crypto on lending/borrowing protocols and providing liquidity on DEXs are two examples of yield farming.
Some platforms, known as yield farming aggregators, take this a step further. Instead of making the user select a single DeFi application, aggregators automate the process of optimizing yield by depositing funds across multiple platforms.
For example, yearn.finance users deposit tokens into the protocol. Then, the protocol converts their tokens into yTokens (such as yDAI, yUSDC, and yUSDT). The protocol’s smart contract searches DeFi applications with the highest APY for farming, and then sends the tokens to them.
Risks of DeFi
As with most things in the world, high rewards involve high risks. Compared to crypto banking platforms or exchanges, DeFi platforms are quite risky. Even the most experienced DeFi users find it difficult to avoid financial setbacks that are largely outside of their control.
Smart Contract Flaws
Smart contract technology is still relatively new, and many DeFi applications, use smart contracts that aren’t completely secure.
Although it’s practically impossible to hack blockchains themselves, smart contracts code often contains flaws. If a hacker finds a smart contract exploit and manages to steal funds, there’s little to no recourse for impacted investors.
When liquidity providers supply funds to decentralized exchanges to try and earn high yields, they risk losing potential profits. Let’s say a user locks in ETH and USDC in a liquidity pool. Typically, they must supply 50% of each asset. The liquidity provider will get profits paid in USDC as more traders buy ETH.
But let’s say the price of ETH doubles. In this case, the profits from simply HODLing ETH and not locking funds in the liquidity pool would be much higher. The loss is considered “impermanent” when funds are locked into a liquidity pool. However, the loss becomes permanent (realized) when the liquidity provider decides to withdraw funds from the liquidity pool.
Liquidation is a great risk for users who borrow funds via a DeFi platform. Even if the user supplies collateral well above the minimum collateral ratio, crypto market crashes can happen suddenly and lead to mass liquidations. The risk of liquidation is also quite high on derivatives platforms.
For many cryptocurrencies, it’s common to see days where prices decrease more than 20%. Such volatile price swings make it impossible to accurately determine how much collateral is sufficient to avoid liquidation. For this reason, many users question whether generating a DeFi loan or participating in futures trading is worth the risk.
The Promise of DeFi
Despite the risks of DeFi, more and more people see the vast opportunities of this growing sector. In a world where traditional finance excludes most of the world’s population, DeFi offers a new vision for an inclusive and open financial system that transcends borders.
Hope you enjoyed reading our “What is DeFi?” guide and getting to know more about this sector of the blockchain industry.