Decentralised finance, or Defi, is a system for providing open access to financial services. This is achieved by recreating the tools of traditional finance in a cryptocurrency context, using blockchain as the means of distributing, recording and storing value.
Think of all the services you associate with a bank: savings, lending, credit, insurance. Defi provides all of this in a permissionless setting.
Why is it permissionless? Well, in order to obtain credit from your bank – or to even obtain a bank account in the first place – you need to produce certain documents and pass a background check to determine your creditworthiness.
With Defi, no one cares who you are, where you are, or how rich you are. If you have an internet-connected device and a basic knowledge of how crypto works, you can interact with Defi and use it to manage your money and grow your wealth,
Defi is a subset of the cryptocurrency industry. Most of the underlying technology that powers the crypto-economy can be called decentralised, since that’s a basic characteristic that all blockchains share.
The difference with Defi is that it’s focused specifically on utilising this ability to actively manage your wealth, without requiring the permission of anyone, be it a bank, credit agency, or financial regulator, to participate.
A blockchain on its own can’t recreate traditional financial services; it’s merely the engine that powers Defi. To make it drive, there needs to be wheels and a chassis attached, which is where DEFI comes in, using decentralised applications (dApps) that make it easy to interact with the underlying blockchain, and enable you to manage and grow your cryptocurrency .
You’ll often hear the term Defi used in the context of Ethereum, the largest smart contract network in the world and the second most valuable cryptocurrency (ETH) after BTC, based on market capitalization.
To date, most of the Defi industry runs on the Ethereum blockchain, but many other networks such as Polkadot, TomoChain, and Tron also offer Defi services.
Regardless of the blockchain being used to support it, Defi operates in the same way. Primitives are core services that are used to anchor decentralised finance. Developers then build applications upon these primitives to create products and services for interacting with Defi.
Composability describes the chaining together of Defi primitives to create new services, building upon their codebase and combining it with a user-friendly interface. Defi primitives are sometimes described as Legos, because they can be stacked together like Lego blocks to create new services.
Examples of Defi primitives include MakerDAO, whose protocol allows anyone to use their crypto assets as collateral to mint stablecoins, Curve, which is a protocol for swapping stablecoins, and Compound, which is a platform for lending and borrowing.
Second layer platforms such as Yearn Finance and Pickle build upon these capabilities, making it easier for users to take advantage of the underlying service.
We can think of Defi as a layered sandwich with the following ingredients:
Combine the three and you end up with a powerful set of tools that recombine the world of traditional finance in a crypto context.
Defi is a means of managing and growing your money. Virtually anything you can do with a digital bank or credit card can be done in Defi. Instead of fiat currency (i.e. the money that’s stored in your bank), Defi uses stablecoins, usually pegged to the US dollar or to a national currency such as EUR or GBP. Instead of using assets such as property, gold, or savings as collateral, Defi uses crypto assets such as ETH or BTC.
If you’d like to take out a loan in Defi, for example, you don’t need to declare your income, submit your tax documents, or prove your creditworthiness: you simply need to lock your crypto assets into a smart contract to be used as collateral.
Defi allows you to take advantage of the following services:
Defi wallets combine tools for money management into a mobile or desktop app, allowing you to earn interest on your crypto usually by staking crypto assets into a smart contract and to receive an agreed return paid in that same cryptocurrency.
Using the same platforms, you can borrow Stablecoins and crypto assets, in return for paying interest. Given DEFI is permissionless you can only borrow against existing crypto as collateral, that way credit checks and application forms aren't necessary.
Similar to staking, yield farming enables you to earn interest and secondary tokens by locking tokens such as ETH into a smart contracts. Whereas staking is passive - funds are locked up on a one time basis - yield farming is the active pursuit of the best yield so might involve multiple a complex set of steps e.g staking ETH to mint a synthetic ETH, yETH which is then staked elsewhere for a Stablecoin, which in turn is farmed elsewhere.
Defi users can ‘pool’ tokens into automated market makers (AMMs) such as Uniswap. Every time someone swaps between the two tokens that are in the pool (e.g. ETH and USDT), you’ll earn a portion of the fee.
All of these services – plus many more, pertaining to things like credit, insurance, and derivatives – are provided by smart contracts. These are pieces of code that have been programmed to perform a particular task.
In traditional finance, these are processes that are performed by people, such as bank managers and accountants. Smart contracts automate this, creating a system that is more efficient and inclusive.
A smart contract can’t discriminate against you based on your income, gender, or nationality: it simply checks whether a transaction is valid (e.g. do you have enough collateral to receive the stablecoin loan you are seeking?) and then processes it.
For example, when you lend money using a Defi lending platform, you don’t have to worry about the borrower running off with it and never returning it. The smart contract ensures that you retain a claim to your original stake (i.e. the capital you loaned), and are able to withdraw it at any time.
Similarly, if you’re borrowing money using Defi, the collateral you must lock into the smart contract will prevent you from defaulting on the debt along with an agreed process for increasing collateral if its value falls below a certain level.
This results in a more transparent financial system in which anyone can participate.
Hopefully you can now understand why DEFI is such a big deal. New technology is reinventing and disrupting banking. What was previously only possible on Wallstreet can now be achieved on a smart phone. New technology doesn't on its own enable high returns on assets, so how exactly does DEFI generate such dramatically higher returns?
Defi is a wonderful invention that many people believe to be the future of finance. Like any new technology, though, decentralised finance comes with risks, both systemic and external.
Systemic risk includes the potential for a vulnerability in the smart contract. If the Defi protocol hasn’t been thoroughly tested for bugs, it could be exploited by a hacker who could steal funds. If this happens, there is little recourse for compensation: Defi removes human organisations from the equation, remember, so if you lose funds, there is no helpline to call or claims form to file.
Unfortunately, the increasing popularity of DEFI and a huge influx of new DEFI applications has inevitably seen a big increase in the exploiting of smart contracts to drain funds.
Generally speaking, Defi primitives like those we mentioned earlier are among the safest protocols to use, since they have been extensively audited – though they still carry a degree of risk. The newer and more experimental the Defi service, the likelier the possibility that it will contain a vulnerability.
Much of the interest in DEFI stems from the exceptional rates of return that you can earn on your crypto assets in comparison to traditional finance. With interest rates at record lows, the ability to earn double, and in some cases triple digit returns, is extremely appealing.
Much of this is possible because - as of 2021 - we are in a bull market, where the overall sentiment in the market is high. This means that there is :
All of the above are susceptible to a prolonged market correction, as has been seen several times through crypto's history. A bear market would crash demand for leverage, reducing interest rates, see the trading on DEXs plummet, and thus rewards for providing liquidity and the perceived value of tokens earned would fall through the floor.
As the saying goes, 'when the tide goes, we'll see who's been swimming naked'
There is also the risk of user error. While Defi design is improving all the time, it’s still not as user-friendly as traditional financial apps for banking and saving. It thus helps to have a degree of technical knowledge, to understand what is happening when you interact with these protocols, and the steps you should take to prevent loss of funds.
Don’t interact with Defi until you know what you’re doing, and as with all things in crypto, don’t invest with more money than you can afford to lose.
At the moment, decentralised finance is still tiny compared to the rest of the financial world, but is growing quickly, and its users are predominantly tech-savvy cryptocurrency holders. The core concepts of decentralised finance – open access, transparency, and equality – make it appealing to a huge market, including the unbanked and the hard to bank.
It will take time for Defi applications to become sufficiently user-friendly for beginners to be able to access them with confidence. Given the low interest rates currently available in traditional finance and the attractive yields available in Defi (APYs can run into double or even triple-digit percentages), it’s easy to see why Defi is so enticing.
Though small investors can understandably need time to adjust to the new world of DEFI, professional investors and financial institutions have a huge motivation to look closely the opportunities within DEFI given the superior return on capital they can generate. We look at more advanced methods for capturing yield, but mitigating risk in later article looking at a concept called contango.
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