What is DeFi? Ultimate Guide to Decentralized Finance

DeFi (decentralized finance) is booming, with the amount of funds within the DeFi ecosystem growing 20-fold in 2020 alone. At the same time, risks remain high, with a number of hacks and bugs resulting in large sums of money lost. So what’s the hype all about, and how can newcomers get their bearings in this high-risk, high-reward market?

What is DeFi?

DeFi refers to a set of services, companies, and protocols that aim to eliminate the need for trusted 3rd parties in finance. The visionaries building DeFi applications imagine a world where the ownership and transfer of assets is secure, borderless, transparent, and censorship resistant.

Using blockchain-based, distributed ledger networks, DeFi will theoretically allow all kinds of financial transactions, from buying car insurance to derivative swaps, to take place in an automated, P2P (person-to-person) fashion.

Origin of Decentralized Finance

The story of DeFi really began with Bitcoin. Bitcoin was an attempt to disrupt one specific type of financial institution— the central banks responsible for issuing national currencies. 

In some ways, Bitcoin also competes with other kinds of financial institutions. For example, it enabled cash transfers without any help from intermediaries like Western Union or Moneygram. Bitcoin wallets can also be considered as a kind of savings account like those offered by normal banks. 

With the rise of Ethereum, smart contracts, and the idea of “programmable money,” software developers and entrepreneurs started to explore the possibility of disrupting other kinds of financial services. DeFi entrepreneurs are now working to program money in order to automate and decentralize almost every imaginable kind of financial service.

Related: Start Investing in DeFi Projects Like Chainlink and Uniswap on Coinbase.com

The Case for DeFi

DeFi offers an alternative to the legacy financial system, and a number of significant advantages.

Improved Systemic Stability. There’s an old saying that goes, “If it isn’t broken, don’t fix it.” After the 2008 global financial crisis, the world realized this couldn’t really be said about the global financial system. During the crisis, it became clear that with highly centralized financial architecture, bad decisions by a few bad actors could threaten the entire world economy. DeFi offers the promise of breaking up concentrations of financial power like New York, London, and Hong Kong, and distributing this wealth and power in a more robust and resilient system.

Increased Productivity. DeFi also holds the potential to realize major efficiency gains by automating many tedious and time consuming activities. This can reduce fees and increase productivity. Instead of paying fees to exchanges, lenders, brokerages, or investment funds, people, businesses and institutions worldwide can transact directly with each other. 

Less Red Tape. Centralized financial markets are mostly siloed in single nations. Under this model, international transactions face many barriers, since each jurisdiction has different laws and regulations. DeFi transcends these barriers, since decentralized networks are borderless by nature.

More Financial Inclusion. A built-out DeFi ecosystem could bring a complete suite of financial services anywhere in the world with an internet connection. DeFi proponents argue this can help to empower those with no financial access and reduce poverty.

Global Markets, Open 24/7. The largest stock exchange in the world, the NYSE, is open for trading from 9:30 AM to 4:00 PM on weekdays. In decentralized markets, trading never stops and participants from the whole world can join in the trading. This means higher volume and higher liquidity, which makes for a more attractive market.

Distributed Security. With centralized platforms, hacks can result in leaks of login details of millions of users. Centralized cryptocurrency exchanges are one of the most popular and profitable targets for hackers. Decentralized exchanges do not have this same vulnerability. It’s much harder to hack a million individual users than it is to hack a single server used by a million people. Hacks can be expensive to pull off, so it’s often not worthwhile for hackers to go after individuals. Decentralized protocols allow each user to maintain full control over their assets, eliminating the danger of exit scams and reducing the risk of hacks.

How does DeFi work?

The majority of DeFi applications today use public blockchain networks like Ethereum. These networks enable both secure P2P transfers of digital value and storage of immutable smart contracts on the blockchain. 

Smart contracts are programs capable of holding and transferring funds based on certain conditions. Almost every financial transaction or activity imaginable can be coded into smart contracts.

Examples of DeFi Smart Contracts

• Collateralized Loans. If someone wants to take a loan from a DeFi service, they can apply to open a credit line. This credit line would take the form of a smart contract holding the amount of the loan. When the borrower transfers collateral to the contract, the contract releases the funds to the borrower.
• Crowdfunding. Crowdfunding platforms like IndieGogo and Kickstarter have gained popularity in the last decade. Someone can request funding for a project, and if they are able to reach a funding threshold, the funds are released to them. If they are not able to fund the project, the funds are returned to the donors. Kickstarter takes a 5% fee for this service, but a smart contract can automate these functions and potentially offer lower fees.
• Trading. A trading contract might look something like this: Alice agrees to buy $125 Canadian dollars for $100 US dollars. Bob sends $125 CAD to the contract. When Alice sends $100 USD to the contract, the contract transfers the CAD to Alice and the USD to Bob. As more assets are digitized, the trade in other assets like commodities, equity, and derivatives can also become part of decentralized, global markets.
• Insurance. An insurance fund collects premiums from a large number of participants, distributing risks. This is really a relationship between all of the participants in an insurance fund, and these relationships can also be coded via smart contracts.
• Futures. Futures are a contract where a buyer agrees to purchase something from a seller in the future for a fixed price. Normally these contracts are regulated in financial markets like the Chicago Mercantile Exchange (CME), but they can also be coded into smart contracts for global deployment.
• Yield Farming. Yield farming is a common DeFi activity. In it, ordinary users form liquidity pools which then act either as lenders of market makers, ensuring that a DeFi application has enough capital. In return, they earn profits derived from interest or fees. 

As the DeFi ecosystem becomes more developed, more kinds of assets may be tokenized, expanding what contracts are capable of. Hopefully these examples are enough to give you a rough idea of how DeFi smart contacts work and what they can do. 

Related: What is DogeCoin? An Introduction to DOGE

Token Economics

DeFi projects mostly rely on tokens for their profitability rather than revenues. Fees charged by DeFi platforms or applications are usually used to incentivize users who provide services to the platform, much as Bitcoin miners provide security to the Bitcoin network.

When developers create a project, they usually assign a percentage of the tokens to themselves. These tokens are usually integral to the functioning of the project. If the project is successful, demand for the token increases, which causes its price to increase. This in turn results in profits for both the developers and investors.

Major DeFi Applications

Following are some of the most popular and well-known DeFi applications that aim to make it easy for anyone to use smart contracts. This is just a small sample of the many DeFi projects out there which can help to understand some of the contours of the DeFi landscape.

Uniswap

Uniswap is a decentralized cryptocurrency exchange. It uses an incentive scheme to reward users for providing liquidity, thus ensuring the smooth flow of trades. There are two types of contracts on the platform; trade and factory contracts. Trade contracts allow exchanging different types of tokens, and factory tokens allow issuing new tokens. The platform supports all ERC-20 standard tokens.

As of April 2021, there was an estimated $6 billion in value locked in Uniswap contracts.

Chainlink

Chainlink is a project that seeks to provide blockchains the ability to communicate with the outside world. For example, some loans contain variable interest rate provisions. If a smart contract has such a provision, it needs ways to find out what the current interest rate is. 

Chainlink makes this possible by using an incentive system where data providers earn money by “staking” LINK tokens and providing information. If they give wrong information, they lose their stake. With time, data providers build up a reputation by consistently providing accurate data. Once enough data providers agree on something, it is considered to be accurate, and this data is then delivered to smart contracts which are programmed to accept data from the Chainlink network.

In this way, different types of information are delivered to smart contracts without any central point of failure. 

Related: Start Investing in DeFi Projects Like Chainlink, Maker, Aave, and Uniswap

Maker

One of the biggest complaints about cryptocurrency is volatility. Fixed supply means that prices swing wildly as demand fluctuates. Stablecoins, where value is pegged to an asset like the US dollar, were designed to solve this problem. However, many shady practices by stablecoin providers (like not disclosing actual reserves of dollars backing the tokens) led to calls for decentralized stablecoins.

Maker was the first decentralized stablecoin. In exchange for cryptocurrency deposits, the Maker smart contract issues Dai tokens, each worth one dollar. Systems of incentives are used to ensure that volatility in the cryptocurrencies doesn’t leave contracts under-collateralized. In effect, the issuance of Dai acts like a collateralized loan which can be used for things like margin trading. 

The internal mechanics are kind of complex, but it has been functioning for a number of years now, proving that decentralized stablecoins are possible.

Aave

Aave is a lending pool system. A bank works much in the same way— depositors put money in, and borrowers take money out, but it’s the bank that manages all of the accounts. With Aave, this is managed by smart contracts, and security is provided by collateral in the form of cryptocurrency.

Aave pioneered “flash loans,” which are a form of uncollateralized loan that can only exist on a blockchain. They avoid collateral requirements by requiring repayment within the space of a single block. If payment is not made, the entire contract is voided and is not recorded on the blockchain. 

This can be used for purposes of arbitrage between two exchanges on the Ethereum blockchain, for example. The borrower has a few seconds to make a profitable trade and pay back the principle plus interest. In most cases, this would likely be used as part of automated trading strategies.

Criticism

Hacks. One of the foremost criticisms of DeFi is the frequency of hacks and bugs. In 2020, there were at least 17 major DeFi hacks causing more than $174 million in losses. Just as lawyers can sometimes find loopholes in a contract, DeFi hacks often take the form of loopholes in smart contracts that cause the contract to release funds to a hacker. 

Regulation. It’s great that DeFi is open and free, but the lack of regulation means that all kinds of behaviors are allowed which are regulated in traditional financial markets, including insider trading, ponzi schemes, and fraud. These problems could eventually be mitigated by private verification services, but for the time being, scams are still common.

Scams. Although not nearly as bad as the 2017 ICO craze in terms of the amount of outright fraud, DeFi has certainly seen its fair share of exit scams, pump-and-dumps, and vaporware schemes. Some dismissed the entire industry as vaporware with no intrinsic value, but to be fair, there are many working products. It’s unclear, however, if real value is being added, or if profits are resulting from money pouring into the space as part of a speculative frenzy. 

User Experience. Even with fast block times, blockchains are simply not as fast as centralized servers. This is the price of decentralization. When the Ethereum network experiences surges in traffic, it can lead to delays in block confirmation times and network congestion. Ethereum is struggling to upgrade the network to handle more volume, but there have been multiple delays in the development roadmap.

The complexity of the protocols and smart contracts underlying many DeFi applications also makes them very difficult for many users  to use. This could also be said of the early versions of email, of course.

High Collateral Requirements. DeFi allows anyone to enter the market without regulation, but the relative absence of credit means that collateral requirements are very high relative to centralized finance. Some projects are seeking to address this problem, but as yet have not achieved serious traction.

Corrupt Bankers, Decentralized. Some critics view DeFi as a decentralization of the unethical practices of centralized banks. Predatory lending, creating money out of nothing, distorting market values, and engaging in manipulation are all possible with DeFi, casting doubt on the utopian dreams of some DeFi proponents. Of course, the presence of unethical practices does not affect short term profitability, but it does suggest that the DeFi ecosystem could experience systemic collapse similar to the crises of the legacy financial system.

Related: What is Monero? A Crash Course in the Leading Privacy Coin

The Future of DeFi

The DeFi boom is reminiscent in many ways to the ICO craze of 2017. Filled with scams and hacks, it’s still a very high risk market, and many or most DeFi projects are likely to fold in the long run. 

On the other hand, this was also true of the dotcom bubble and the early internet, and the stakes are arguably much higher with DeFi. Google disrupted publishing and Amazon took a big bite out of retail, but now decentralized protocols are aiming to take on the entire world financial system. 

Centralized banks are not likely to give up dominance without a fight, however. In the wake of the frenzy of retail investment in ICOs, there was a backlash from regulators in many countries, and it’s likely that DeFi will face similar hurdles. 

DeFi is not only competing for existing markets— it’s also aimed at the estimated 2 billion people worldwide with no access to formal financial services. Of course, they will have to compete for this market with other centralized fintech ventures, who, for the time being, have much smoother user experience.

There’s no shortage of potential here, but at the moment, the bulk of the gains are fuelled by hype and speculation. In the long term, it will be important to watch the development of fundamentals. If DeFi projects are solving real world problems in a way that generates significant value, they are likely to survive. 

From this perspective, a good gauge of the quality of a long term DeFi investment is to look at how people are using it to make money. Where is the money coming from? Is it coming from doing things more cheaply and efficiently than centralized financial institutions are able? Or is it coming from wheeling, dealing, and day trading in the middle of deep flows of speculative capital?

It could be argued, of course, that Amazon was unprofitable for many years, but much of its present profitability comes from operating at a loss in order to build the world’s biggest online marketplace. So when considering a DeFi investment, some useful questions to ask might be: Can this project achieve market dominance? What problems does it solve? Will it become more valuable as it grows? Will it become more efficient or less efficient as it gets bigger? Are the solutions required for it to scale up proven or unproven?

For now, all of the volatility in DeFi makes it a day traders paradise, but good long term investments in the space will require understanding the technology and its value propositions and keeping a close eye on trends in the market.