Nowadays the term of ‘DeFi’ is becoming more and more common. It is an acronym for ‘decentralized finance’. Its main goal is to create a financial system that is 100% based on blockchain technology and digital assets.
DeFi is free of third parties, whether it’s a bank, a service provider or anything else. We will explore this concept in more detail and explain it as deeply as possible to answer the question: “what is DeFi?”. While reading, you will learn about how DeFi works and the key differences between decentralized and centralized finance. We’ll introduce you to how to use DeFi and also talk about Ethereum, among a few other topics.
What is DeFi? – Understanding the Peer-to-Peer Decentralized Financial System
Decentralized finance, or DeFi for short, is a new financial technology that implements financial and value-based services over public blockchain platforms by using smart contracts and decentralized apps. DeFi enables peer to peer transfers or storage without maintenance costs, but also includes traditional services such as borrowing or lending, trading assets or even taking out insurance. In addition, of course, the range of services is much wider.
The term decentralized finance was originally coined in 2016-2017. It’s currently predominantly based on the Ethereum blockchain, but alternative blockchains already exist, however currently with minimal take-up (e.g. Uniswap (UNI), Maker (MKR), yearn.finance (YFI) and so on). The main advantage of the system is that the different decentralized services can be used in combination with each other in an almost completely optional way.
Another key feature is that DeFi allows not necessary to trust either the intermediary (e.g. the bank) or the other party to the transaction when using a service. Moreover, it is not even necessary to know them, as a smart contract is automatically executed when a condition is met (for example, in the case of a car transfer, the document is validated when the exchange asset, the cryptocurrency, arrives on the seller’s wallet).
In addition to the above, DeFi also has other clear advantages, such as freeing users from the costs that banks or other financial service providers impose for using their products/services, and in fact anyone with an internet connection can participate, with transactions taking place in a short time, even minutes.
How Does DeFi Work?
Decentralized finance uses a collection of smart contracts on blockchain networks, primarily Ethereum. Smart contracts are like automated contracts – they executed when agreement conditions met. Here’s a simpler analogy: think of a vending machine, you select a snack, input money, and the item is released – all without human intervention.
When you interact with DeFi, you’re interacting with dApps, decentralized applications. Think of dApps as the apps on your smartphone, but instead of being hosted on centralized servers, they exist and operate on decentralized blockchain networks, making them resistant to censorship and giving users more control and security when they interacting.
To use DeFi services, users connect their cryptocurrency wallet to a dApp to interact with its services. For example, if a user wants to lend assets to earn interest, they would connect their wallet to a DeFi lending platform and deposit their assets into the smart contract governing the lending service. The process is relatively user-friendly, and the user retains control of their assets unless they’re deposited to a contract.
To enhance security and trustlessness in transactions, every action made within a DeFi service is recorded on the blockchain, providing a transparent and immutable history of transactions. This means every transaction is public, can be verified by anyone and cannot be altered, ensuring security and transparency within the ecosystem.
The interoperability of DeFi services is also notable. Various DeFi applications can be combined or used sequentially, allowing for a versatile user experience. For instance, one could use a decentralized exchange (DEX) to swap tokens and then use those tokens in a lending protocol to earn interest, all within the same ecosystem and often within the same interface.
Benefits of DeFi
Lets understand the difference between decentralized finance and centralized financial institutions. Understanding the differences will give you a more comprehensive picture of DeFi.
Centralized Finance vs Decentralized Finance
In the financial sector you will likely to face two different category: Centralized Finance (CeFi) and Decentralized Finance (DeFi).
Picture CeFi as a grand old bank, standing tall with its classical architecture, basically a middleman where patrons queue to deposit or withdraw money, request loans, or engage in various financial transactions. The bank, with its battalion of employees, meticulously oversees each transaction, ensuring the safety and security of its patrons’ assets. Here, the bank acts as a trusted intermediary. However, this guardianship comes with its share of shackles; operational hours, a plethora of paperwork, and a lingering uncertainty over the privacy of one’s financial dealings.
Now, envision DeFi as a modern, 24/7 open financial marketplace. Instead of a physical structure, it’s built on the invisible yet robust foundations of blockchain technology. Here, the sun never sets; transactions buzz through the network at any hour, unburdened by the bureaucracy of intermediaries. Unlike the traditional bank, DeFi doesn’t ask for your identification or a signature on a dotted line. It operates on the principles of open-source, transparent protocols, managed not by individuals but by smart contracts that execute actions based on predetermined rules.
In DeFi, you can lend your assets and earn interest, borrow assets, or even engage in complex financial strategies, all on blockchain platforms that operate round the clock.
The Philosophical Dichotomy and the Future of Finance
In the CeFi world, platforms like Coinbase act as custodians of your crypto assets, much like a bank, providing a secure haven but at the cost of control. On the other hand, DeFi platforms empower you with the custody of your assets, giving you the liberty to interact with a plethora of financial services directly.
The essence of DeFi could be likened to a global, open financial playground where anyone with an internet connection can participate. So basically financial services are not only concentrated in the hands of institutional organisations, but individuals can also transact through a peer-to-peer network.
This contrast between CeFi and DeFi is not just a difference in operational modality but embodies a shift in financial philosophy. It’s about moving from closed, controlled financial systems to open, inclusive, and transparent financial ecosystems. Through DeFi, the unbanked and underbanked across the globe have the potential to access financial services.
Transitioning from the conventional to the decentralized, DeFi challenges the status quo, proposing a new narrative where financial services are democratized, and control is returned to the individual. Through its blockchain-backed, smart contract-driven ecosystem, DeFi is not just reshaping the financial landscape but is inviting everyone to be a part of this financial renaissance.
The Role of Bitcoin and Ethereum in DeFi
Dive into the intricate dance of Bitcoin and Ethereum as they shape the rapidly evolving world of decentralized finance (DeFi).
First, let’s explain the concept of Layer-1. This is the basic ‘layer’ of the blockchain, which includes the blockchain network or protocol itself. This layer is responsible for recording transactions and data. More specifically, it is at this layer that they occur. This includes the Bitcoin, Ethereum or Polkadot blockchain.
Evolution from Bitcoin to Ethereum and DeFi Challenges
Bitcoin was originally created to replace traditional FIATs in digital form. Its main purpose is to store value in a public ledger and to serve as a medium of exchange. With the launch of Ethereum in 2015, the potential of smart contracts for DeFi became clear. Ethereum is specifically designed to support smart contracts and decentralized applications.
When DeFi took off in 2020, smart contracts were not yet running on the Bitcoin blockchain and Ethereum soon ran into problems. One such problem was scalability, as increasing traffic slowed down transaction and smart contract processes. To solve this, various alternatives have emerged, such as Polkadot, Cardano and many others.
Ethereum however developed Ethereum 2.0. It is easy to see that although the problem has put DeFi in an inherently awkward position, it is now a positive, as the DeFi industry solutions on different blockchains have forced competing blockchains into a competitive situation where the goal is to achieve better functionality.
Bitcoin’s Adaption to the DeFi Landscape
It is interesting to note that Bitcoin, due to its fundamental position and nature, is not suited to rapid and sudden changes in terms of blockchain technology. As mentioned above, it was not designed to serve DeFi, but today developers are trying to meet current needs with solutions such as Taproot. This is an update that will enable the creation of dApps on the Bitcoin network, making it possible to build smart contracts and decentralized applications. This update will increase the competitiveness and relevance of the Bitcoin network.
DeFi Use Cases
In this section, we will try to give a short overview of what DeFi protocols can be used for, using some real examples of financial products and services.
DEX and Liquidity Pool
DEX, or Decentralised Exchange, is a brokerage platform for trading cryptocurrencies where liquidity is provided by users, often referred to as ‘liquidity providers’ or ‘investors’. Users add assets to the DEX liquidity pool, thereby increasing its liquidity, and receive tokens representing the value of their added assets. In return, they earn a share of the transaction fees generated by trading activity on the DEX.
While many DEXs operate on the Ethereum blockchain utilizing smart contracts, there are also DEXs on other blockchains like Binance Smart Chain offering lower fees. Accessing DEXs is straightforward, requiring only a wallet compatible with decentralized applications (dApps), a smart device, and internet access. DEXs offer the advantage of user anonymity, with no central body monitoring user activity, but they may have higher fees during network congestion and can be less user-friendly compared to centralized exchanges. The most popular DEXs are UniSwap and SushiSwap.
Lending and Borrowing Platforms
Another popular use of various DeFi projects is decentralized lending and borrowing. The lending DeFI protocol allows borrowers to instantly apply for a loan, even a large one, with their cryptocurrency collateral. Its advantages over the same services offered by CeFi include higher interest rates for lenders, as well as the much-mentioned anonymity and speed.
If you are considering this option, we recommend the Aave or Compound (and there are many other providers) platforms, but it is important to point out the high risks. Including market volatility, liquidity risk and possible smart contract failures.
Yield Farming and Staking
In the DeFi world we find the terms ‘yield farming’ or “liquidity mining” and ‘staking’, but what are they and what is the difference between them? Basically, both terms are used to generate passive income from invested cryptocurrencies.
Yield farming essentially provides liquidity to various token pairs in exchange for a reward to the farmer in crypto. Examples of such yield farming protocols are UniSwap, PancakeSwap, Aave or Curve Finance.
In contrast, staking is when users lock their crypto holdings in a blockchain to help validate transactions or vote on a protocol change. The amount of reward a user receives depends on the amount of crypto locked and the network fees.
It is important to note that both financial products are quite risky investments due to volatile exchange rates.
Cryptocurrencies,Stablecoins and Payments on DeFi
The high volatility of the cryptocurrency market makes it necessary to use stablecoins. These stablecoins, such as USDC or DAI, play a key role in fixing value and building confidence in the ecosystem by maintaining a 1:1 peg to fiat currencies such as the USD or EUR.
Imagine a scenario where you invest $5000 in Ethereum and see its value drop in a year when you decide to cash out. In such cases, the use of stablecoins can act as a hedge, making sure that the value of your investment is accurately recorded at the current exchange rate, protecting you from large swings.
The Future and Risks of DeFi
Although DeFi is still in an evolving stage and on shaky ground, progress is clear. It clearly has potential, which we explore in more detail in this section, alongside the threats.
While the domain of decentralized finance (DeFi) holds immense potential, it’s imperative to recognize that it’s a nascent sector, grappling with inherent challenges and uncertainties. As of now, DeFi hasn’t garnered the broad endorsement that could potentially be facilitated by the evolution of scalable blockchains.
The infrastructure of blockchain, being in its developmental phase, poses difficulties for both developers and participants, making some transactions painfully sluggish on certain platforms. This scenario is likely to persist until enhancements in scalability are actualized, a concept foundational to the evolution of Ethereum 2.0 or Eth2. The process of making fiat contributions to DeFi platforms also exhibits significant latency, potentially hindering the influx of new participants.
A very realistic scenario is that the DeFi will not be able to replace the traditional financial system completely in the near future. Instead it will take over some elements of the decentralized financial system and integrate them, as we can see it right now with big companies like VISA for example.
Decentralised Finance (DeFi) represents a transformative approach to financial systems, offering open, inclusive and borderless financial services. However, with its innovations come certain risks. Smart contracts, the building blocks of DeFi, can contain weak points that, if exploited, could lead to significant losses. The lack of a centralized authority means there’s typically no recourse for users if things go wrong. In addition, DeFi platforms can suffer from liquidity issues, and the highly volatile nature of crypto assets can expose users to significant financial volatility.
