What is Decentralized Finance (DeFi)

Decentralized Finance

DeFi stands for decentralized finance and is an emerging market in the world of cryptocurrencies, but what is it really and what can you do with it? On this page you’ll find a description of this new market, the opportunities it offers and some notable DeFi projects that have been released.

How does DeFi work?

DeFi

DeFi is an umbrella term for a range of new decentralised financial applications that, like Bitcoin, are built using blockchain technology. DeFi is shaking up the traditional world of finance by creating an open source and transparent financial ecosystem.

Previously called “open finance”, DeFi makes financial products such as loans, insurance and derivatives transparent and accessible to everyone, including those outside the traditional system. In addition, DeFi eliminates the need for intermediaries and central regulators such as banks, and thus the extra costs these parties normally collect.

Most DeFi products run on Ethereum‘s public and transparent blockchain network and mainly make use of so-called smart contracts, which are digital contracts that are automatically executed when pre-agreed criteria are met. This means that there is a guarantee that a certain transaction will be carried out.

Because this data is stored with blockchain technology, spread across thousands of computers, it is virtually impossible to censor data or shut down services. This technology introduces a wide range of new financial applications, the most popular of which are discussed below.

What can I do with DeFi?

DeFi sector

Under the umbrella of DeFi, we find a wide range of applications today. A few popular applications are discussed below.

Lending platforms

Borrowing and lending crypto-currency through DeFi projects is one of the most popular applications of this new market. One of the advantages of borrowing and lending assets with DeFi over the traditional credit system is that transactions are carried out instantly. There is also no need to trust an intermediary, as they do not exist and you can verify the data yourself via the blockchain. On most DeFi lending platforms, users must first secure their crypto as collateral before they can take out a loan, but compared to traditional loans, further personal data remains anonymous. Compound, Maker and Aave are currently the most popular DeFi lending platforms.

Liquidity Mining

Liquidity mining is the generation of passive income and is a kind of combination of liquidity provision and proof-of-work (PoW) mining. It is somewhat similar to strike; locking crypto into a proof-of-stake (PoS) platform, which allows investors to earn returns by providing liquidity to the platform.

With Liquidity Mining, you also lock in your crypto – usually ERC-20 tokens on Ethereum – and this is done through so-called Automated Market Makers (AMM), such as Uniswap. With this, you basically lend out your fixed tokens to another user, thus providing liquidity to the DeFi platform. In return you receive a return, often in the form of new tokens. How much you receive depends entirely on how much you have deposited, for how long and on which platform.

Yield farming

Yield farming is closely related to liquidity mining. The aim of yield farming is to maximise returns from liquidity mining by automatically moving crypto, or rather liquidity, between different DeFi platforms.

Yield farming was created with the launch of Compound in the summer of 2020 and subsequently the DeFi market exploded. On Compound, users can lock in stablecoins and receive COMP tokens as a reward.

Yearn.Finance took this concept even further. Yearn is a kind of robot that automatically finds the highest return for yield farming and moves tokens between different DeFi platforms.

Governance tokens

The COMP token mentioned earlier is an example of a so-called governance token. This type of token gives investors a form of control over a DeFi platform. People who possess governance tokens of a certain platform can, for example, vote on crucial decisions that are made concerning the project. This makes projects more decentralised and largely in the hands of the users. These kinds of systems are also called decentralised autonomous organisations or DAOs. An example of this is Maker.

Decentralised trading exchanges (DEX)

Most people buy their crypto from a cryptocurrency exchange, or crypto broker. DeFi also introduces the possibility to trade crypto via a decentralised exchange (DEX). The main difference between the two is that with a DEX no intermediary is involved. This makes crypto trading faster and cheaper than on a centralised exchange.

The most popular DEX at the moment is Uniswap. On Uniswap users can directly trade crypto with each other which is called token swap. In addition, Uniswap can also be used for liquidity mining by locking your crypto in so-called liquidity pools.

Stablecoins

Stablecoins are crypto currencies whose value is linked to another asset or currency. In the more traditional cases, the value is linked to the US dollar (USD), such as with tether (USDT) and USD Coin (USDC).

In addition, it is also possible to link stablecoins to the value of other crypto assets. These are so-called tokenised assets and require collateral. This collateral must be more than the required amount due to fluctuations in the price. An example of this is the DAI token from MakerDAO.

Then there are algorithmic stablecoins. Here the value is not based on collateral, but on an algorithm. There are different kinds of algorithms for this. An example is an algorithm that automatically grows or shrinks the supply of a token to keep the value of the underlying asset stable. An example of this is Ampleforth. There are also so-called hybrid stablecoins on the market, which combine the above two mechanisms.

Prediction Markets

One of the first DeFi applications to come to life on Ethereum is the so-called prediction markets. These allow users to bet on the outcome of a particular event. It is possible to make money by betting on the winner and these markets can be more accurate than traditional polls. In the late 2020s, these prediction markets were popular. They were used to bet on who would win the US presidential election.

Bitcoin DeFi

Normally, Bitcoin is not compatible with Ethereum, so it was not possible to secure BTC in DeFi platforms, but Wrapped Bitcoin (WBTC) changed that. The value of a wrapped token is linked to another crypto, in the case of WBTC that is bitcoin. By locking up your bitcoin you will receive WBTC which can then be used in DeFi products.

Meanwhile, DeFi projects are also being developed for the Bitcoin network. This is done using a technology called discrete log contracts (DLC), which are like smart contracts but for Bitcoin.

The future of DeFi

Decentralized Finance technology

Although the DeFi market is still in its infancy, a huge number of new projects have been launched recently. The aforementioned Uniswap, Compound, Aave, Maker, Yearn.Finance and Wrapped Bitcoin are just a few examples. Balancer, Synthetix, Sushiswap and Bancor are also popular, but many more exist.

Total Value Locked

The Total Value Locked, or TVL, is a new way of indicating how much crypto is locked in DeFi products and gives a picture of how big this market is. Since the summer of 2020, this market has exploded and less than 10 months later, a staggering $100 billion of crypto is already locked in DeFi products.

Ethereum competitors

Other blockchain networks are also looking to capitalise on this emerging market. For example, the crypto exchange Binance launched the Binance Smart Chain (BSC) in late 2020, which is rapidly gaining popularity. In addition, Polkadot is seen as one of Ethereum’s biggest competitors with the use of so-called parachains, which should solve the scaling problem and the huge transaction costs on competitor Ethereum. DeFi could get another boost on Ethereum when ETH 2.0 and sharding are introduced. Cardano is planning to introduce smart contracts on the blockchain and will thus also bring DeFi to the network. Some DeFi projects have already been launched on the Tron network as well.

Caution is advised

Although DeFi is seen by many market participants as the future of finance, DeFi in its current form is not yet suitable for everyone. It is still a very new world and therefore also very risky for first-time investors. Several DeFi projects still have errors in their programming, and these have been abused to loot funds from the platforms. So be careful if you are venturing into this!