What is Decentralized Finance (DeFi)? A Complete Guide

19 Nov 2020

DeFi, short for Decentralized Finance, is a term used to describe financial products that are built on permissionless and decentralized blockchains like Ethereum.

This includes all sorts of exciting financial applications that offer lending, borrowing, trading, insurance and much more. The possibilities are almost limitless.

More broadly, DeFi refers to a movement, where the goal is to build a better financial system by leveraging the power of permissionless blockchain technology to create one that is transparent, permissionless, cheaper, open-source and decentralized.

DeFi has been at the center of the 2020 crypto bull run and the DeFi sector grew massively in this period. The total value of Ethereum (ETH) locked in DeFi applications rose from $1 billion in June to over $13 billion in November according to DeFi Pulse.

What is DeFi used for?

There are 1000’s of DeFi applications and protocols and the majority of them fall into four main categories of use cases:

  1. Lending & Borrowing
  2. Decentralized Exchanges
  3. Stablecoins
  4. Advanced Trading

It’s important to note that there are many more applications outside of these four use cases. Below is a map of Ethereum’s DeFi ecosystem from TheBlock to give you an idea of the diversity of the ecosystem.

Most platforms in the DeFi ecosystem are decentralized applications (dApps). These are digital applications that run on a blockchain - in the figure above on the Ethereum blockchain - and run outside the system of a single authority controlling it.

While standard web applications like Twitter and Uber run on the computer systems of their organizations, which have full control over the apps, dApps run on an immutable blockchain and are inherently censorship-resistant.

Lending & Borrowing

Compound (COMP) is the largest of the DeFi lending and borrowing dApp and lets anyone earn interest by lending out their cryptocurrency. It also lets users borrow, so you could deposit some crypto and in return receive extra cryptocurrency for a fee.

One of the attractive features of Compound and all the other DeFi protocols is that you keep custody of your assets. Meaning you are in control of your crypto, whereas on centralized exchanges like Binance you hand over custody of your crypto to the exchange.

However, it's important to note that interest rates vary a lot. So depending on what crypto you want to borrow or lend the rates typically range from 0.2% - 15% APY (Annualized). You can monitor the rates on IntoTheBlock’s DeFi Insights page.

Decentralized Exchanges (DEXs)

Buying and selling is at the heart of the crypto markets. Until recently this happened almost entirely on centralized exchanges like Coinbase.

The trading volume on DEXs has grown rapidly in 2020. In August the trading volume on leading decentralized exchange Uniswap was greater than Coinbase! Uniswap reached a staggering $426 million in monthly trading volumes and Coinbase facilitated $348 million in monthly trading.

This chart from Dune Analytics shows the monthly DEX volumes over the past two years. As you can see there has been huge growth in the Summer of 2020:

Uniswap, a decentralized protocol for P2P crypto exchanges that lets users trade Ether and ERC-20 tokens from their MetaMask accounts, also allows users to earn interest by supplying assets to shared liquidity pools.

Check out our guide on how to connect to MetaMask so you can get started on Uniswap right away.

Uniswap was created by Hayden Adams and launched at Devcon 4 in late 2018. Uniswap v2 was released in May 2020 which made it cheaper and easier to trade. Since then the volume really took off and attention was drawn to Uniswap and DEXs in general.

In August 2020 Uniswap raised $11 million in a Series A fundraise that included Andressen Horowitz, Union Street Ventures and other top venture capital firms. Check out this guide on Uniswap and the UNI token to learn more!

The DeFi ecosystem includes numerous other decentralized exchanges, including SushiSwap, Bancor, Balancer, and DeversiFi. There are several reasons for users to opt for these trading platforms: a lack of know-your-customer (KYC) checks,  permissionless trading, and being non-custodian - meaning users do not have to entrust a central authority with their funds - are among the top reasons.

Stablecoins

Stablecoins are one of the most important parts of the crypto markets and are especially important in DeFi, they have a variety of important use cases.

There are two main types of stablecoins:

  1. Fiat-collateralized
  2. Crypto-collateralized

Fiat collateralized stablecoins are pegged to the price of fiat currencies such as the US Dollar (USD) or the Euro (EUR). This peg is achieved when a custodian holds a 1:1 ratio of fiat currency to the stablecoin they issue. So that the stablecoin is always redeemable for the equal quantity of fiat currency.

The largest stablecoin is Tether (USDT) and at the time of writing it has a market cap of over $17 billion making it one of the top five cryptocurrencies ranked by market capitalization.

Crypto-collateralized stablecoins are backed by cryptocurrencies and use their own algorithm to maintain a stable price. The most popular crypto-backed stablecoin is DAI that maintains its peg to 1 USD using the MakerDAO protocol. DAI is created when crypto collateral such as ETH is deposited in MakerDAO and DAI is issued.

For example, if a trader is concerned that the value of their crypto portfolio might drop they can buy stablecoins to lower their risk. The best part is that they don’t have to sell their crypto and buy fiat currency that would need to be stored in a bank.

Another example is consumer loans. They can’t be denominated in volatile cryptocurrencies that can move 10-20% in value in a single day. It is much more efficient to denominate DeFi loans in stablecoins.

Advanced Trading

There are various different types of advanced trading features available in DeFi. Lets look at synthetic assets and margin trading.

Synthetix (SNX) is an application that offers users a way to create and trade synthetic assets. Crypto synthetic assets can be created to emulate the value of any asset in the financial world, including stocks like Tesla and Amazon, as well as gold, bonds, commodities, currencies, and indices.

This platform brings non-crypto assets to native DeFi protocols so traders can diversify their portfolios and gain access to markets they otherwise wouldn’t have been able to. All whilst staying in the DeFi ecosystem.

Margin trading applications like Fulcrum let users trade with leverage whilst maintaining custody of their crypto. Fulcrum offers leverage of up to 5x. It's important to remember that when using leverage your potential profits are greater but so are your losses.

Why is DeFi Growing So Fast?

There are two key drivers behind DeFi’s growth.

  1. Composability
  2. Yield Farming

Composability

You can think of DeFi as lego money.

Each protocol can be combined with other protocols to build new applications that are greater than the sum of their parts. This is because DeFi apps are built using publicly available code that lives on the blockchain. So any developer with a great idea can build a new application and benefit from all of the research and development that has come before them.

Another element to why there is such a fast pace of innovation is forking. If a developer thinks they can improve on an existing application they can simply fork the protocol to create a copy and add any improvements they want.

Sushiswap is a popular fork of Uniswap that aims to offer the same great trading experience but also ensure the DEX is community governed and the protocol tokens are fairly distributed. SushiSwap incentivized users to first add liquidity to Uniswap to then move to its own platform. This type of fork is called a ‘Vampire Attack

Yield Farming

Yield farming, otherwise known as liquidity mining, involves protocols incentivizing users by rewarding them with the protocol's native token in return for using the application.

In DeFi as in traditional finance more liquidity means a better user experience (UX). You can think of liquidity as the fuel to build efficient markets. With more liquidity; lending protocols can offer more attractive rates and larger loans, DEXs can offer tighter spreads and lower slippage and so on.

However, there is a chicken and the egg problem with liquidity. How does an application offer great liquidity without a large user base and how can an application attract users without deep liquidity?

This problem was a major barrier to DeFi growth. Liquidity mining has been used to overcome the challenge of incentivizing users to provide liquidity. Protocols such as Compound reward users who take out loans and borrow money on their platform with COMP tokens.

This does two very important things:

  1. Attracts more users by incentivizing them to use the application
  2. Distributes the native protocol token to users

One of the secondary benefits of yield farming is that the protocol token gets automatically distributed to the addresses actually using the application. This is great if a project wants to hand over the governance to token holders as a strategy to decentralize governance. The COMP token is used to vote on protocol changes so owning COMP gives you a say in how Compound develops.

Liquidity mining helped fuel the growth of the decentralized finance ecosystem through the added rewards offered to users. In some cases, APYs went up to 1,000% thanks to the distribution of governance tokens. These rates attracted investors and added liquidity to the space.

What are the risks?

As with all crypto investing the risks are high and the classic advice for all crypto traders is to do your own research and never invest more than you can afford to lose.

Beyond the basics there are a few things to watch out for when researching and potentially investing in DeFi coins.

  1. Are the rates too good to be true?
  2. Is the team credible?
  3. Does the project have an authentic and active community?
  4. Is the protocol audited?

Are the rates too good to be true? One of the golden rules of investing is that risk equals rewards. So if you see unbelievably high rates offered by lending protocols then proceed with caution as that typically means the risks are very high.

Is the team credible? Given the decentralized nature of DeFi it is not uncommon for anonymous teams to create protocols that start to gain adoption. However, if you don’t know who the team is how can you trust the application they have built?

This is a tricky question to answer. Bitcoin is trusted even though we don’t know who Satoshi Nakamoto is. In the ‘wild west’ of DeFi there have been many instances where anonymous teams have ‘exit scammed’ and stolen user funds. In these instances these anonymous creators had administrative access to the protocol. Nearly all the best projects in the space have professional and well regarded teams working on them.

Does the project have an authentic and active community? In DeFi the community counts for a lot. They help drive the roadmap, strategy and growth of a project. A project without a healthy community is cause for concern. Why is no one engaging with the team? It may be because the DeFi community has no faith in the project or team. Vibrant and large communities suggest the project has got real adoption and this lowers the risk the project will fail.

Is the protocol audited? One of the beautiful things about blockchains is immutability, but this is a blessing and a curse. If there is a bug in a dApp smart contract this can get exploited and money can be lost forever. As we saw in the DAO hack of 2016, where a hacker stole 3.6 million ETH from a smart contract.

Some projects pay security researchers to conduct audits of the code to see if there are any vulnerabilities. Unaudited projects are riskier than audited, but just because a project has been audited it does not mean that it is safe. Check out DeFi Score to learn more about how to measure risk in DeFi.

What Does the Future Hold?

In the years to come we expect DeFi to continue gaining market share by improving the user experience. So that it is safer, easier and faster to use a decentralized alternative to centralized financial service providers like your bank or even Binance.

As the ecosystem matures projects will become more decentralized and distribute governance of the protocol amongst its users who own the native protocol token. Increasing the level of decentralization will make these applications more resilient to attack and regulation.

While the future is far from certain, DeFi looks set to grow and take market share from centralized financial institutions and replace them with open, permissionless and decentralized financial applications.

 

 

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