Decentralized Finance, most commonly known as DeFi, is a financial ecosystem based on a collective network of participants on a blockchain or a series of blockchains. In contrast, traditional finance models are centrally operated, meaning they have an overarching single point of governance like a company or third party authority. DeFi is an umbrella term used to describe distributed blockchain systems that function in any category of finance such as corporate, personal, or behavioral finance. Most aspects of blockchain and cryptocurrency are decentralized in nature but the true working innovation of DeFi is when two or more of these chains and projects can work together without a primary means of operation.
Almost everything we do with money is an extension of finance including banking, loans, interest rates, derivatives and trading, budgeting, or ownership of assets that have value like real estate. All of these systems today work on our normal finance system that is in custody of a select few or in many occasions a single point of contact for those financial operations.
The concept and function behind DeFi is very important as we look at the changing nature of how money works and operates in our daily lives. A decentralized method to use money has unique benefits and helps most participants within the system equally, while ensuring that the system is highly secure. Most people trying to explain Defi want to give counter-arguments against a centralized system instead of discussing its prolific applications. Although there are plenty of negative aspects to a centralized system, it is not a reasonable approach to pursue to encourage DeFi. Instead, DeFi has not only a substantial amount of positives but also has features that are needed for a new age of technology.
The two main pillars to DeFi are 1) equal participation of the network and 2) allowing a distribution of authority, which in turn makes it more equal and open to all participants. In short, a DeFi network is designed to be open to all and secure by hackers or takeover.
Being an equal participant in a network means you will not be disregarded or discriminated against based on fundamental identities like race, gender, religion, age, or country of origin. It will also be much more difficult for someone to be excluded based on financial tools such as credit scores, income size, and standard of living unless the financial service specifically requires it. Many of the projects in the DeFi space are open source and have their code listed, available to all.
In order to understand the importance of DeFi further it is important to visit a basic understanding of the history of finance, which has changed as social economics have developed. The origin of money itself is not easily defined throughout human history. A common thought but myth of “financial history” is that the monetary system was preceded by a barter system, which some anthropologists claim is not true. Nevertheless, there are historical records that date back to 9000 BC where domesticated cattle and livestock was used as a “money of exchange”.
We do not know if a true barter system was in play as a network, but we do know that certain materials have been used (like the livestock example) as well as natural metals found throughout the world like gold. Using metals in this way is called commodity money. The first solid evidence of this is Mesopotamia in 3000 BC, which coincidently allowed their economy to work at a larger scale.
As centuries passed, many problems and complexities arose with the issuance of metal weighted coins despite this being an innovative way for economic standardization. Issues like metal coins wearing down over consistent use could devalue the coin. Fraud has been committed by changing the metallic composition of coins, even for the benefit of royalty. In addition to the problems of manipulation, it was often a burden to carry so many coins if you wanted to save or purchase something of great value. Being a huge target for theft was also a real threat because sacks of money could not easily be hidden from the public eye.
The beginning of the concept of “account money” was credited to Babylon around 1800 BC regarding interest rates to payback borrowed assets. Paper money however did not appear until the 11th century by the Song Dynasty. Banknotes, promissory notes that can be exchanged for money, were issued in the 1600s but quickly collapsed in less than five years. Afterward, banknote popularity grew exponentially as economies shifted away from material exchange in favor of an exchange based on a pegged measure of value.
Banking in the 15th century became common and was typically done by people groups or families. By the 17th century, modern banking took shape as a result of lending and interest rates merging with paper money. Some of our troublesome financial practices seen today like fractional reserve banking took shape around this time. Paper money was gaining significant ground but still pegged to a coin of value or metal. However, decoupling of precious metals and pegged currencies started to change, beginning with Great Britain and eventually with other countries like the United States in 1971. This marked a full, worldwide scale of money being decoupled from value to a reliance on authoritative trust.
As you may be able to see with these historical patterns, it has always been difficult to see whether financial services and money is defined by a money of exchange (gold, grains, or property) or money of an account (debts or loans). Ironically, blockchain technology seems to combine both of them, with cryptocurrencies like Bitcoin and Ethereum as commodities of sustained value in combination with DeFi for lending and other services through smart contacts. It is quite literally a confluence of the entire record of money used in human history.
There have been many apparent problems associated with the centralized nature of financial institutions, especially within the last 50 years since the dethroning of gold toward a full favor of paper money. Banks and financial companies have had to pay massive amounts of settlements on their unethical practices but sometimes the punishments are worth far less than profits of their breached terms. Banks are also guilty of manipulating precious metals like the case of JPMorgan: a bank that created manipulation of gold and silver during an eight year period, given a relatively petty fine of $550 million, and up for a second case of criminal charges in 2020.
Another issue is blatant security flaws that are extremely problematic when you consider that these institutions can be compromised much easier as a centralized system. Even mobile banking has its limits as the top 14 mobile banking apps all felt short of proper security measures for their users. Something that has a centralization to its operation has less points and often a single point of failure to which money and data could be compromised. The broader part of the world lives largely in a paper money market within a digital era, making them essentially out of reach in a modern approach to finance. However, with paper money showing severe weakness and technological advances, a digital coin has been seriously addressed around the world.
Over the span of decades and different economic issues like the housing market crash in 2008, many people started to lose their trust in the banking system as a result of centralized manipulation and constant bailouts. This led someone by the alias of Satoshi Nakamoto to create Bitcoin in 2009. As an ode to the flaws brought about by the banking system, Satoshi was able to write a message within the genesis block with the phrase “Chancellor on brink of second bailout of banks”, a nod to a feature article about Allistar Darling to “pump” the economy by giving banks cheaper state guarantees.
The popularity of Bitcoin caught wind and started to grow with the idea that it was a functional system of exchange without the need of a “trust party” like a bank. The first “official transaction” was done by someone ordering a pizza for 10,000 BTC, who asked someone on the internet to buy two pizza in exchange for Bitcoin. The day on which this happened is now celebrated as Bitcoin Pizza Day. Although the road of Bitcoin from then til now is slightly complex in how people have used it, overall it has managed to be a successful system with more uptime than some of the most popular and secure companies of today.
The rise of Bitcoin also gave rise to the creation of other cryptocurrencies like Litecoin and XRP in 2013 but in more recent years came the Ethereum blockchain by creator Vitalik Buterin which is the main highway that DeFi is being used.
Today, there are 60 established DeFi tokens and growing, with almost 200 mentionable DeFi projects. These tokens and projects help create solutions in the decentralized finance space in contrast to the issues of banks and other centralized platforms. DeFi projects have real world comparisons with the features they provide like payments, loans, derivatives, and even refinancing options. Many of these projects have extremely intuitive user experiences as well.
Before you can understand the nature of DeFi and decentralized finance projects working together, it’s important to understand the entire ecosystem. As one would expect, decentralization plays a pivotal role in the world of DeFi, most notably in the area of functionality without a party of trust. A person is able to buy, sell, and trade digital assets without talking to anyone or trusting in an online network to keep running into order to obtain a successful exchange. Uniswap is a perfect example of this, where someone can simply go to the website location, connect a wallet, select the coins they wish to exchange, and do so by paying minimal fees.
The world of DeFi has wallets, APIs, plugins, applications, and interfaces all located on a blockchain or connected to a blockchain. This series of features are the on-ramps to what DeFi can accomplish: adding coins like DAI and USDC within a blockchain system to generate annual percentage yields (APY) like a savings account, or using lending capabilities to let other users take advantage of the capital which not only stays in your ownership but can also generate more capital off of the borrowers trading fees. Some projects allow you to own wrapped tokens of popular coins that can be kept in cold storage and generate interest in real time.
These features not only have similarities of traditional finance, but also offer better yield rates and allow someone to utilize a blockchain for peer to peer lending and borrowing. In the world of banks, credit unions, and lending companies this can take a matter of days or weeks and much longer if you need to establish or repair qualifying credit. In some of these cases, credit scores are checked as well as income stabilization and history, which can often be a source or inaccuracy or discrimination. Paperwork for standard loans can be susceptible to human error while sectors like the automotive industry can manipulate consumers into longer terms through coercion to pay higher interest through the deception of lower payments.
In contrast, blockchain technology plays a pivotal role in DeFi by setting the terms, being agnostic toward a user’s identity (only money talks), and by eliminating human error or manipulation.
In short, DeFi offers the following benefits in comparison to traditional finance:
Decentralized Finance uses assets to create financial services by the means of smart contracts, which of course can only be done on blockchains that have these capabilities. Although there are a few different blockchains offering this service under the hood, the biggest blockchain by far in the world of DeFi is Ethereum.
Ethereum has a rich but short history with the vision that was built around smart contacts. This feature allows users to build on the ETH network in numerous ways – from something as basic as messaging or currency exchange or to something more complex, such as creating tokens to be used for other sub-networks, applications for file storage, and decentralized autonomous organizations (DAOs).
Every project built on the Ethereum blockchain must naturally use ETH as a means of exchange. This reliance on blockchain has many strengths as this gives the blockchain more value. Conversely, with most of the DeFi projects on one blockchain, this causes some people to have concern if the network faces issues regarding scaling. Thus far there has not been any major cause for concern but there are always serious considerations to always improve the network.
It would be unfair to focus only on the Ethereum network despite the fact that the umbrella term of DeFi uses Ethereum for 95% of all its operations. The emergence of other blockchain platforms being used for decentralized finance gives a look into what DeFi could offer in the future. Some of these chains also existed before Ethereum but have been slow movers. Nevertheless, the Ethereum network was the first big mover and presents creators with a “self-fulfilling” dilemma. If someone wishes to work on DeFi, Ethereum is the easiest path to take yet this also creates less innovation on other platforms. All things considered, the space is still early and encourages innovation on both the Ethereum chain and others as well. There are some possible contenders in the space in addition to some upcoming blockchains to take advantage.
Here is a list of popular and rising DeFi platform networks. There are hundreds of projects with a decentralized component, but this list focuses on those that have a strong financial application, have a considerable amount of developer activity, and are actively trying to work alongside other projects with similar intentions:
Taking advantage of the DeFi world requires someone to have proper asset management. A required aspect of this management is the ownership of wallets on the network associated with the DeFi coin or service. A wallet is the location where you can interact with your digital assets and cryptocurrencies. Wallets are able to help monitor, send, and receive assets based on the public and private key data that is given.
There are four main types of wallets with some similarities between all of them:
Here is a list of the most integratable wallets used in DeFi for the Ethereum network (add popular companies using each one of these):
DeFi allows you to do one basic but breakthrough financial service since before its name even became popular: sending and receiving digital assets from one person to another without relying on a bank or wait times. It shouldn’t be understated on how valuable sending money this way can be. Sending money this way solves a multitude of issues:
Certain services like Cash App have made great strides to have a more peer to peer experience, however users are still limited to things like daily withdrawal limits and KYC regulations. Crypto.com has also made good progress in designing a “Plan B” that combines crypto wallets with earning interest options and a Visa debit card. Although Crypto.com (formerly Monaco) is almost fully centralized, they do offer a wallet to transfer your private keys into your hands.
A more decentralized option that focused on payments is Flexa, who has a pretty solid partnership with a number of heavy hitters in the cryptocurrency space including Gemini, Shape Shift, Bread, Dharma, and many others.
Another popular payment system is the Lightning Network that although is an independent system that adds smart contract functionality, it is most commonly used on Bitcoin.
In 2018, decentralized exchanges (DEXs) were starting to become a reality and have made lots of headway since then. These exchanges allow you to trade your digital assets from one kind to another without relying on a normal exchange. A number of benefits are present in DEX trading:
We are still in the early days of DEX trading so liquidity can be an issue, but the ability to trade currencies without a third party is a great feature.
Here are some of the most popular DEX platforms:
The lending sector of DeFi is arguably the most popular and competitive area. It is a frontier that is stretching what DeFi is able to accomplish by allowing users to add their assets to a smart contract and use their crypto in different ways. One of the main benefits of lending pools is allowing participation in interest staking of different coins. Users simply deposit the amount they wish onto the blockchain transaction and they are able to obtain interest as long as it remains on contract. Some of these lending contacts let you generate interest in real time and in cold storage.
The second main benefit is the ability to lend assets into a pool to be used by others for trading or investing. This allows you to generate rewards like interest or their fees associated with trading. This is also a great benefit if you have crypto set aside that you don’t wish to trade but still wish to put to good use.
Lending pools are a great utility in DeFi. They share many benefits with centralized systems but without the drawbacks that come with a single point system. Here are some of the selling points of lending pools:
Here is a list of some of the most popular DeFi lending projects:
Stablecoins take a big spotlight in DeFi and are very important to consider why they are used and how they are beneficial to this area of cryptocurrency. If you are unaware of what stablecoins are, they are coins or tokens that are designed to have low volatility in order to maintain a certain value. These stablecoins are typically backed 1:1 by the asset that it’s supposed to represent. The most common type of stablecoins are coins pegged to the United States Dollar like Tether, USDC, TUSD, and Dai. Others are pegged to other currencies like Canadian Dollars of Euros (TCAD, TEUR). In addition, some are pegged to volatile assets like Ethereum and Bitcoin, known as wrapped assets, in this case wETH and wBTC respectively. Although ETH and BTC are coins we consider volatile, they are still not volatile according to their own currency: 1 BTC or ETH (in this case wBTC and wETH) remains 1 BTC or ETH as that is the denomination of those currencies.
Stability in DeFi is important because it decreases the amount of variables in a financial service like lending or investing. It wouldn’t make a lot of sense if you had a stable APY but the asset varies in its own value. This would cause uncertainty in the value of your asset or the benefit of someone lending an asset. Although you can leverage a volatile asset, this dramatically increases your chances of liquidation or massive expectation of asset value. As a result, stablecoins are a mainstay.
The most popular stablecoins in DeFi are as follows:
Some functions of DeFi require you to trade digital assets that aren’t compatible with a platform you wish to use for a service. This requires a process known as “wrapping”. While nothing is technically being wrapped in a physical sense, it is a descriptive term for creating compatibility to a specific network architecture. Bitcoin has many uses on other networks and not just as a standalone currency. Users can wrap Bitcoin to be compatible with the Ethereum network for example which allows that Bitcoin to be ERC-20 compatible that is also backed 1:1 in value. This is also backed by some of the biggest Defi projects and oldest crypto projects in the space. Another big example is Ethereum, which is not actually compatible with its own network, so wrapped ETH tokens also exist and are the most popular wrapped non-stablecoin token. In addition, a lot of stablecoins are also wrapped like sUSD (Synthetix) to be compatible with their own exchange.
Wrapping an asset provides more benefits than just compatibility benefits. Wrapped assets also offer liquidity to a blockchain, allows hard assets to be directly tradable with tokens, and reduces noise by only utilizing one node (if on the Ethereum network for example) instead of multiple. This is aso very handy for decentralized exchanges. In other words, less moving parts so less complications or things to break. When an asset like Bitcoin is about to be wrapped, the Bitcoin is taken under a smart contract and a wrapped BTC token is minted and used while it is held. A user under this smart contract keeps ownership of this wrapped BTC until its use has expired, which can then be burned in exchange for receiving BTC of equivalent amount back to the user.
Coins in this way are recognized as wrapped by using the lowercase “w” prefix, for example: wBTC and wETH for wrapped Bitcoin and wrapped Etherum respectively. It is also assumed that the tickers in all caps, WBTC and WETH, are also considered wrapped.
Most of the features available in DeFi lending today are collateralized, which means that users must have a digital asset or similar collateral in order to move forward with a feature. That changed not long ago in the crypto world with the introduction of Flash Loans made popular by Aave. The company behind the LEND token claims to be the inventor of the first successful uncollateralized loan on chain.
The inner workings of these Flash Loans operate within one single block transaction. In other words, while some DeFi features and lending can be held onto for days, weeks, and even months or years, Aave Flash Loans are returned within one block to ensure liquidity. This loan is generated by the chain and can be used freely while a user is in possession of it.
This immediately raises questions about returning the loan on chain without losing value or by users giving proper repayment. In the CeFi world, it is commonplace for people to miss payments and default on loans. Aave has thought of this and countered it with a built in feature where the transaction becomes reversed if it is not paid in full.
Stepping back a bit, decentralization isn’t just about Ethereum, interest rates, and lending. The sector of trading and derivatives also has a place in the DeFi world, giving another area where crypto and blockchain technology are taking the market share from traditional systems.
Derivatives are simply securities that derive their value from a particular asset. This feature uses contracts as a means of trading instead of the asset itself as well as an agreement between two parties. Some of the most common types of derivatives in the centralized world are Futures, Options, and Swaps. The benefits of derivatives range from locking in a particular price for an asset or by utilizing margin as a means of purchase.
Decentralized derivatives provide all the features of a normal centralized one but offer the ability and freedom to use it without strict regulation and cost. A majority of people are unable to use centralized derivatives because they do not have a big enough portfolio or because their country restricts it without certain regulations (certain countries are not allowed to use crypto derivatives too). However with a DeFi platform, these restrictions are removed, allowing more users to participate, albeit with higher risks.
The most popular DeFi derivatives service to date is Synthetix. They offer over 30 different asset derivatives including commodities like Gold and fiat. They are able to do this by taking advantage of the Ethereum network and allowing users to change their assets into a wrapped ERC20 token called SNX, then trade accordingly. A unique feature of Synthetix is that the trading fees associated with the derivatives are given to SNX holders, allowing users to be rewarded for offering stability to the network.
The world of decentralized finance is expanding daily. Here is a list of projects in their respective categories that are on the frontier of cryptocurrency and blockchain technology.