To understand decentralized finance, you’ll first need to take a glimpse under the hood of the traditional finance system. The conventional approach is one of centralized finance, where loans, interest, and other financial products originate from banks, brokers, and institutions. There’s always a middleman somewhere, and your funds/assets reside outside your custody.
Decentralized finance, or Defi, attempts to remove as many intermediaries as possible by connecting participants through peer-to-peer financial services. Transactions are initiated by smart contracts and secured on a public blockchain, the same technology behind cryptocurrencies like Bitcoin and Ethereum. However, some perks come with the centralization of the traditional financial system, and investors should be wary of the risks involved with Defi technologies.
The Basics of Defi
Is Defi crypto? Not exactly, but cryptocurrency does provide the liquidity necessary for the system to function. Think of it as a plumbing system; Defi is the piping and values and cryptocurrency the water flowing through them. Decentralized finance is a series of programs and applications that allow lenders, borrowers, traders, and investors to interact without a centralized institution looming over the transaction. To better understand Defi, let’s define a few terms first:
- Smart Contracts - Instead of a bank or brokerage initiating the transactions, smart contracts lay out the terms in the world of Defi. A smart contract is a self-executing protocol that activates when agreeable parties are found. Smart contracts allow Defi technologies to do away with third-party intermediaries since the programming enforces the agreement. Smart contracts are the basis of dApps; think of them as like the handshake that confirms the agreements.
- dApps - A portmanteau of decentralized applications, dApps are programs coded onto the blockchain that enable buyers and sellers (or borrowers and lenders) to find each other and engage in anonymous financial activity. dApps can be used to engineer all kinds of financial lending or trading programs on decentralized blockchain networks.
- Custodian - A custodian is where your assets are actually kept when using a financial services company. For example, your stocks and bonds aren’t sitting in a safe in your basement, are they? No, they’re kept in custody at a financial institution, usually on a private centralized ledger. Traditional financial custodians often have restrictive rules and high fees for their services, something Defi seeks to eliminate.
- Digital Wallet - Instead of a custodian, participants in Defi services have self-custody of their assets in digital wallets. Digital wallets can be hot (online) or cold (offline) and are used to connect to different dApps and blockchain networks such as Uniswap or OpenSea. Each wallet has a personal digital key for sending and receiving assets. Digital wallets can store cryptocurrency and NFTs, but make sure you don’t lose the key - without it, your assets will be lost.
Defi Crypto Examples
Cryptocurrency can be used to take part in all features of the Defi ecosystem. Here are a few individual examples:
- Decentralized Exchanges (DEXs) - Unlike crypto exchanges like Coinbase which use a central order book to match buyers and sellers, DEXs are peer-to-peer networks without a centralized order book. Instead of a third-party intermediary matching orders, the protocol on the public blockchain underlying the network matches the buyers and sellers.
- Borrowing and Lending - Defi allows users to borrow and lend money. For example, AAVE is a popular Defi lending protocol consisting of a series of liquidity pools of different cryptocurrencies. If you own Ethereum, you can stake your ETH into a liquidity pool to be lent out.. The pool then lends that Ethereum out to borrowers under the governance of a large group of AAVE token holders, known as a Decentralized Autonomous Organization (DAO). You reap the rewards of the DAO’s profits in the form of additional tokens.
- Yield Farming - One of Defi’s riskier ventures is yield farming. Unlike lending programs where clients stake their various tokens to earn additional tokens, yield farming is more like a mutual fund for cryptocurrency. Yield farmers pool their digital assets together to lending, borrowing, and other more speculative activities. Yield farmers often cross from liquidity pool to liquidity pool searching for the most lucrative agreements, hence the name yield farming.
- Stablecoins - Cryptocurrency is notoriously volatile, which is a major reason why stablecoins have increased in popularity. Stablecoins are pegged to another asset, such as the US dollar or the price of gold, to create stability in the price of the coin. Buying and holding stablecoins allows users to earn interest while minimizing the volatility inherent in most cryptocurrencies.
Defi is one of the many growing ecosystems in the cryptocurrency industry, but decentralization comes with a cost. There are no government safeguards or FDIC insurance on assets in Defi programs and hacking can be prolific. Plus, if you lose your personal key to your digital wallet, you might suffer from a complete asset loss.
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