Decentralised finance, more commonly referred to as ‘DeFi’, has become increasingly popular due to the growth of the cryptocurrency industry. But what is DeFi? And how does it work? This relatively new sector encompasses a variety of peer-to-peer financial products built on blockchain technology that aim to provide greater financial freedom to its users.
What is DeFi?
DeFi is a financial paradigm shift that seeks to eliminate the need for financial intermediaries, creating transparent products that are accessible to anyone. This is achieved through the power of decentralised, programmable blockchains that can enable peer-to-peer financial products on a global scale.
To truly understand decentralised finance, it is important to first understand the current function of centralised finance in the worlds of traditional and digital finance.
Centralised finance (CeFi)
Centralised finance, also known as ‘CeFi’, involves intermediaries such as banks, brokerages and centralised exchanges. These institutions hold people’s assets and facilitate financial transactions, providing products such as bank accounts, loans, credit cards, stocks, bonds, financial derivatives and more.
In traditional finance, a centralised institution would be your local bank. In crypto, a centralised institution is an exchange like Coinbase or Binance. The source of their revenue are the fees paid by anyone who uses their products, including fees on credit card purchases, interest payments and brokerage fees. These are just a few examples which keep this trillion-dollar industry turning a profit.
CeFi has a number of advantages, namely the ease of use and lack of responsibility required for the consumer in holding your own funds. In traditional finance, users can usually call to reset a password and typically don’t need to worry about thieves stealing their funds. Most CeFi platforms and services in crypto have support teams, too.
Disadvantages of CeFi
However, CeFi also has disadvantages. Those using CeFi to conduct financial transactions are placing trust in the institution to take custody over their assets. Around the world, there have been numerous cases of banks taking depositors’ savings to cover instances of bad debt. As a prime example, the Global Financial Crisis (GFC) in 2008 saw a large number of financial institutions go bankrupt due to their poor management of debt and misuse of client funds.
Unlike decentralised blockchains, the transaction database of a centralised institution is not publicly available. The result of this is that the activities of these institutions are largely unknown to the world, leading to the possibility of fraudulent or immoral transactions going undetected. For those in less developed economies, access to CeFi can be severely restricted, leaving them with no way to obtain financial services. This is usually because they lack verifiable documentation or access to financial education.
How DeFi works
Decentralised finance is defined as a new realm of financial products based on peer-to-peer payments through blockchain technology that doesn’t require a centralised intermediary. This means anyone with access to the internet can borrow, lend, earn interest, trade assets or derivatives and make transactions. Yields are often higher because trust is enabled by the smart contract, rather than an intermediary.
New DeFi applications and tools are constantly emerging and usually require individuals to connect to the platform or protocol with a web3 wallet, such as Metamask.
Once their wallet is connected, they gain access to the platform’s products and can interact directly with other users of the platform via smart contracts. Smart contracts are programs that run on the blockchain and are used by DeFi platforms to execute tasks when certain conditions are met. There are many different DeFi platforms out there, each of which requires the use of its own smart contracts to power it.
It is worth noting that some centralised platforms like Coinbase provide an avenue for you to tap into DeFi platforms and tools — but hold your assets on the exchange. Most truly decentralised protocols require you to protect and keep custody of your own assets.
The infrastructure of DeFi
DeFi utilises specific infrastructure, including blockchains and smart contracts, to create open-source, peer-to-peer financial products that are interoperable and accessible for all.
A blockchain is a distributed ledger of information that is stored across many different computers, known as validators, on the same network. Every time a certain amount of information or transactional data needs to be stored, it is added in a ‘block’. This forms a chronological chain of blocks, which is why they’re called ‘blockchains’.
Unlike centralised databases, decentralised blockchains store copies of the data on all computers in the network. All computers must reach consensus before adding a new block, meaning that they all agree their copy is the same as everyone else’s. If a bad actor decided to alter the information, they would need to alter the information on the majority of computers in the network. If a blockchain is sufficiently decentralised through a large network of validators, this is practically impossible.
At the most fundamental level, blockchains remove some of the restrictions associated with centralised financial systems.
Smart contracts are programs that run on the blockchain and execute tasks when conditions are met. As decentralised blockchains are open-source, DeFi platforms and their associated smart contracts are generally open source, too. This opens up further benefits over traditional systems:
- Composability: a DeFi application can be copied, improved or altered and relaunched as a new and sometimes better product.
- Transparency: DeFi allows users to check the security of the platform, unlike centralised institutions where everything is hidden behind closed doors. DeFi allows for audits by anyone so that by using the blockchain, users can ensure that their funds are being used as they should be.
What are DeFi coins?
DeFi coins, also known as DeFi tokens, are used by DeFi platforms as a form of utility. The utility can range from governance voting, claiming a share of platform fee revenue, allowing for certain utilities and more. Particular DeFi projects utilise their native token in many different ways to give value to existing investors while incentivising new investors to buy and hold the token, which puts upward pressure on the price.
Bitcoin as DeFi
As the first ever cryptocurrency, Bitcoin gave birth to the concept of DeFi by offering a method of peer-to-peer value transfer that was secure, fast and easy for anyone to use. Unlike traditional, centralised financial services, Bitcoin allowed for cheap, anonymous, international payments that didn’t discriminate. As a result, people in developing countries with minimal financial infrastructure could transact on a level playing field with anyone else.
While Bitcoin may have opened the door to this innovation, the lack of programmability of its blockchain limited any further developments. Soon after Bitcoin’s inception, another blockchain emerged to solve this problem. That blockchain was called Ethereum.
How will Ethereum 2.0 impact DeFi?
Ethereum 2.0, now formally known as ‘The Merge’, is one of the largest upgrades in Ethereum’s history. Ethereum is a globally decentralised platform built on blockchain technology that allows anyone to build applications and transact digital assets without the need for a central authority. Ethereum was a major catalyst for DeFi innovation. The programmability of Ethereum has allowed for some of the smartest minds in the world to create products that could never have existed previously.
Why is Ethereum switching to proof-of-stake and how will it work?
Ethereum 2.0, or ‘The Merge’, is an upgrade that is moving the Ethereum chain from Proof-of-Work (PoW) to Proof-of-Stake (PoS). PoW requires energy-intensive software systems to be run by all computers validating transactions in the network. PoS reduces the energy required by 99.95% and decreases the barrier of entry for individuals who wish to participate in the validation of the Ethereum ecosystem.
This leads to further decentralisation of the chain, making it more secure than before while paving the way for further upgrades that will improve the scalability and capacity of Ethereum. This will make DeFi applications built on Ethereum even more accessible via cheaper, faster transactions.
How to make money on DeFi
DeFi opens the door to endless opportunities for investors to make money, so let’s look at some use cases.
How to invest in DeFi
Investing in DeFi usually means going beyond the familiar comforts of centralised exchanges and custodial wallets. To delve into the world of DeFi, investors must understand how to take control of their own assets in a Web3 wallet. This allows them to interact with smart contracts that run DeFi applications and take advantage of the opportunities in this innovative space.
- To get started, one must own some cryptocurrency that can be used in DeFi applications (e.g. stablecoins or larger, well-known cryptocurrencies like ETH).
- The next step is to move the asset into a Web3 wallet, such as Metamask. Make sure you are moving your crypto to the correct blockchain. For ETH, it should be sent to an Ethereum Virtual Machine (EVM) address, or for others like SOL, it should be sent to the native chain (Solana). Before sending, double check both the address and supported chain is correct.
- Once you have your asset in your Web3 wallet, you can now begin to use DeFi applications. A good place to start is a decentralised exchange (DEX), such as Uniswap, to make a trade. DEXs allow you to swap one cryptocurrency for another.
- Once on the DeFi platform (and after ensuring it is legitimate), click the ‘connect wallet’ button. Your Web3 wallet should prompt you to connect to the site.
- You can then use the application, and if a transaction is required, your wallet will prompt you to approve the transaction each time. Congratulations, you are using DeFi!
DeFi borrowing and lending
How do DeFi loans work? DeFi loans are a way to ‘put money to work’, which means that instead of sitting idle in a wallet, they can be lent out by depositing funds into a smart contract. To access a loan, collateral must be deposited to secure the loan for the lender. The individual who deposits collateral can then borrow against the collateral and use the borrowed funds. In return, the lender receives interest payments from the borrower. Here is an example:
Investor 1 has some assets sitting idle and wants to use them to make a passive income. They deposit the assets into a smart contract on a DeFi platform. Investor 2 has some assets that they do not want to sell, but needs short-term capital to make another investment or purchase. Investor 2 deposits the assets they own into the same DeFi platform to use as collateral. They then borrow some of Investor 1’s assets for a fee. They can only borrow an amount that is less than the collateral deposited so that, in the event that Investor 2 does not pay back the loan or the collateral value goes down, Investor 1 will receive the collateral to cover the loan amount.
This is just a basic example, but there are many use cases for DeFi loans. For lenders, the greatest attraction is the possibility for passive income on deposited crypto-assets. For borrowers, DeFi loans give access to cheap and instant capital that can be used without restriction.
What is DeFi staking?
DeFi staking involves locking up some assets in order to earn rewards. The mechanism and reason for the locking can take two forms. The first is to secure and validate a blockchain. This involves setting up your own validator software or delegating your tokens to someone who already has a validator.
The other form of ‘staking’ is through individual DeFi platforms, where you can lock tokens on the platform to earn rewards. This form of staking is also referred to as farming. Staking with DeFi can be a great way to earn passive income using your assets. One important note to make is that DeFi staking can have taxable implications, so it’s important to note the guidelines of your tax jurisdiction in regards to any rewards earned.
Is investing in DeFi safe?
Investing in DeFi does have its risks:
- Many DeFi protocols have only existed for a year or less, meaning they aren’t battle tested in all market conditions.
- If a DeFi smart contract contains a flaw, it is likely to be exploited. If this occurs, there is a high chance that all funds contained in the contract will be stolen.
- DeFi tokens are often volatile and there have been many cases where specific tokens have dropped over 90% inside 24 hours due to poor market conditions.
Although DeFi can be risky, the danger of losing funds can be greatly decreased by investing in solid projects that have a reputable, working product. Make sure you’re investing safely by using a hardware wallet to store funds, only ever connect to well-known DeFi platforms and never share any private information, such as login details, passwords or recovery keys, with anyone else.
When will DeFi go mainstream?
DeFi adoption is growing every day, but it currently lacks the ease of use and security required for mainstream adoption. Over time, it is likely that DeFi will grow to become more secure and the infrastructure that allows investors to access DeFi, such as wallets and smart contracts, will become much easier to use for the everyday investor. Once this happens, DeFi will gain more mainstream attraction and become a staple in portfolios.
After all of that, you should now know what DeFi is. This space opens the door to innovative developments and incredible new opportunities that are now accessible to anyone around the world with an internet connection.