Decentralized finance (DeFi) is a way to conduct business using distributed ledger technology for cryptocurrency and alternatives to traditional methods.
after reading this, you'll understand:
The basics of decentralized finance (DeFi)
How DeFi got its start
Projects and use cases within DeFi
What the future holds for DeFi
Decentralized finance (DeFi) is a way of conducting business using distributed ledger technology — commonly referred to as blockchain. DeFi platforms offer cryptocurrency and financial services as alternatives to traditional methods.
DeFi has exploded into a trillion-dollar industry, sparking worldwide waves of both financial disruption and financial inclusion.
Many events have shaped the DeFi space. The most prominent of these is the appearance of the first cryptocurrency, Bitcoin, in 2009. Despite Bitcoin’s spectacular growth, financial services have appeared very slowly for Bitcoin — mostly due to its inherent lack of stability and adoption. Mainstream institutions won’t accept a Bitcoin loan because of its price volatility. It makes Bitcoin a poor asset for planning any investment accurately.
Things change quickly in crypto, however, and decentralized finance (DeFi) has been developing rapidly. Built on open-source principles that prioritize transparency and community participation, as well as decentralization, DeFi is being used in many new and exciting ways.
DeFi is an umbrella term for applications and projects in the public blockchain space geared toward disrupting the traditional finance world. DeFi refers to financial applications built on blockchain technologies, typically using smart contracts. Smart contracts are automated enforceable agreements that do not need intermediaries to execute. Anyone with an internet connection can access them to perform financial transactions and many other activities.
DeFi consists of applications and peer-to-peer protocols developed on decentralized blockchain networks that require no access rights. The decentralized apps (dApps) are used to facilitate lending, borrowing, trading and other financial activity. Most DeFi applications today are built using the Ethereum network, but many alternative public networks have emerged to deliver superior speed, scalability, security, and lower costs.
Historically, central authorities have issued the currencies that underpin our economies. As people developed trust in those currencies, the power of monetary systems grew. However, trust has been broken repeatedly, making people question the centralized authorities' ability to manage said money. DeFi was developed to create a financial system that is open to everyone and minimizes the need to trust and rely on a central authority.
It’s argued that DeFi started in 2009 with the launch of Bitcoin, the first digital asset built on a blockchain network. Bitcoin made it possible to envision a transformation in the traditional financial world. The launch in 2015 of Ethereum and, more specifically, smart contracts made it all possible. The Ethereum network is a second-generation blockchain that leverages the potential of this technology for the financial industry. It encouraged businesses and enterprises to build and deploy projects that formed the ecosystem of DeFi.
DeFi created many opportunities to create a transparent and robust financial system that no single entity controls. In 2017 projects reached a turning point and began to go beyond cryptocurrency transfers.
Financial markets can enable great ideas and drive the prosperity of society. Still, power in these markets is centralized. When people invest in the current financial system, they relinquish their assets to intermediaries, such as banks and financial institutions. The control, and much of the risk management, rests at the center of these systems.
Historically, we’ve seen bankers and institutions failing to manage risks in the market. The 2008 financial crisis was a catastrophic illustration of this. Undoubtedly, when central authorities control money, risk accumulates at the center and endangers the system as a whole.
Bitcoin and early cryptocurrencies, which were initially developed to give individuals complete control over their assets, were only decentralized when it came to issuance and storage. Providing access to a broader set of financial instruments remained challenging — until the emergence of smart contracts that made DeFi possible.
Smart contracts are digital contracts that define the terms of a transaction via computer code. They also verify, execute, and enforce transactions without the need for a third-party intermediary.
Without middlemen, there is no need to pay middlemen or wait for third parties to do their work. This can dramatically reduce costs and speed up processes. As a result, smart contracts can be cheaper, faster, and more secure than traditional contracts.
Also, smart contracts inherit the transparency and security of the distributed ledger they run on. On a public ledger, transactions can be viewed. This transparency allows you to verify your transaction and rest assured that the exchange happened correctly. Moreover, the records of transactions are immutable. They cannot be easily altered or deleted on a distributed ledger — and if they are, this change can be detected. These security and transparency benefits are unique to public ledgers and smart contracts.
Finally, smart contracts make complex transactions easy. They can define and complete intricate, multiparty exchanges with precise timelines. Programming tools make it possible to code even the most complex transactions, and once a smart contract has been written, it can be used over and over again. Additionally, multiple smart contracts can be used in tandem to execute even more elaborate exchanges.
DeFi has grown into a complete ecosystem of working applications and protocols that deliver value to millions of users. Assets worth over $239 billion were locked in DeFi ecosystems as of April 2022, making it one of the fastest-growing segments in the public blockchain space.
Here's an overview of the most popular DeFi use cases and protocols available today.
Certain decentralized applications require that real-world data be connected to the blockchain. For example, prediction markets treat real-world events, such as elections, as financial products and require the real-world data to be stored on-chain for funds to be released to those who predicted the results.
An oracle connects the blockchain to the outside world — or to other chains. They are often used to send real-world data to the blockchain but can also send data from the blockchain to the real world. In most cases, software oracles that connect to public APIs are used. In some cases, hardware oracles with physical sensors are used to determine things like wind speed to allow smart contracts to be executed.
To weed out “bad data,” protocols often use consensus oracles. These oracles aggregate data from various sources and use a consensus mechanism to reach a single data point.
Decentralized lending lets users lend cryptocurrency to others to gain annual yields. Decentralized borrowing allows individuals to borrow money at a specific interest rate. Unlike traditional finance, these DeFi protocols enable peer-to-peer lending, removing the need for intermediaries.
Because DeFi lending protocols use an automated smart contract code to enable loans, users don’t have to wait to get their funds. These protocols also remove the need for credit checks and enable users to borrow cryptocurrency regardless of location. Some decentralized lending platforms offer rate-switching features that let borrowers switch between variable and stable interest rates to protect themselves from volatility.
Although DeFi lending is an ideal solution for many users, it isn’t without risk. Many lending protocols require users to lock their funds in a liquidity pool, making them susceptible to impermanent loss. Flash loans, a type of loan in which funds are borrowed and returned within the same transaction, also can be problematic. They allow DeFi users to borrow large sums of cryptocurrency that might be used to manipulate token prices.
Launched in 2018, Compound Finance is the brainchild of Robert Leshner. The project is a lending protocol developed on the Ethereum blockchain that allows users to gain interest by lending out assets or borrowing against collateral. The Compound protocol makes this possible by creating liquidity for cryptocurrencies through interest rates set using computer algorithms.
Numerous blockchain-based insurance policies cover real-world scenarios like farming, disasters, and more. Many blockchain-based insurance policies use a parametric insurance model in which claims are paid to the party involved as specific parameters are met. These parametric insurance policies often use hardware and software oracles to determine when disbursements should occur. With smart contract technology, disbursements happen automatically rather than relying on a centralized entity to trigger the payment.
Decentralized insurance policies offer numerous advantages over centralized policies. For example, if you have a centralized hurricane insurance policy and a hurricane causes property damage, you might need to go through a lengthy claims process before receiving the funds needed to repair your home. On the other hand, a decentralized policy could use smart contracts to pay the total value owed as soon as the damage occurred.
DeFi insurance also refers to insurance that covers blockchain-related activity. This type of coverage is ideal for those with significant amounts of crypto assets on an exchange. A DeFi insurance policy can cover losses incurred from an exchange hack. Additionally, DeFi insurance can offer security for stablecoin investors in the event of a price crash.
Decentralized exchanges (DEXs) are one of the essential functions of DeFi. DEXs allow users to exchange or swap tokens with other assets without a centralized intermediary or custodian. Traditional exchanges (centralized exchanges) offer similar options, but the investments offered are subject to that exchange's will and costs.
Founded in 2018 by Hayden Adams, UniSwap is the largest automated token exchange. The project was launched after receiving support from venture capitalists and the Ethereum Foundation. UniSwap automated transactions between cryptocurrencies through smart contracts.
UniSwap services include swapping tokens, adding liquidity, and removing liquidity.
Derivatives allow users to interact with assets without buying them, although, in some cases, the user has the option to buy the underlying asset. Lock derivatives are contracts where traders are bound to agreed-upon terms throughout the contract’s life, whereas option derivatives let holders buy or sell the underlying asset before expiration.
Many DeFi derivatives are tied to cryptocurrency tokens and other DeFi products, although they can also track the value of traditional assets. Defi derivatives marketplaces that deal with real-world assets usually allow users to create synthetic assets pegged to underlying real-world assets. Most DeFi derivatives marketplaces allow traders to use leverage to increase their potential returns, although this also increases their risk.
DeFi derivatives may lead to regulatory issues down the line for exchanges that haven’t properly registered with the SEC. The SEC has sent numerous subpoenas to cryptocurrency projects selling tokens that resemble investment contracts.
Yield farming is a popular way for cryptocurrency traders to earn passive income on their tokens. Yield farm protocols use smart contracts to lock users’ tokens and pay interest rates on their locked assets. Users who lock tokens on yield farm protocols earn interest based on transaction costs if their funds are used for liquidity and loan interest if their funds are used for DeFi loans.
The rewards paid to traders exist to offset potential risks associated with locking their tokens. Risk exists primarily in the form of impermanent loss, although token volatility and rug pulls are of concern as well.
Sometimes, the pool’s creator manually decides the annual percentage rate. In other cases, the yield farming protocol determines and alters the APR with smart contracts.
Stablecoins are helping DeFi gain prominence by providing a viable solution to volatility issues surrounding cryptocurrencies. The name says it all. Stablecoin value is tied to a relatively stable asset, like gold or the US dollar, to keep its price consistent. Stablecoins became useful during risky moments in the crypto space, providing a haven for investors and traders. Stability makes them a reliable collateral asset. Stablecoins also play an important role in liquidity pools — an integral part of the DeFi ecosystem.
Founded in 2015 by Rune Christensen, MakerDao is an organization-building technology for savings, borrowing, lending, and a stable cryptocurrency on the Ethereum blockchain. The project was one of the earliest DeFi protocols. Instead of conducting an initial coin offering (ICO), the project privately sold MKR tokens to fund the development over time. Maker's stablecoin, DAI, was launched in 2018 and has experienced significant traction.
The protocol for this decentralized autonomous organization works like this:
A user can send or deposit Ethereum tokens (ETH) to a smart contract on Maker's protocol and create a Collateralized Debt Position (CDP). This enables users to take DAI at a specific collateralization rate.
If the price of ETH drops, the CDP of a user is automatically closed to ensure the network has enough capital locked against the borrowed tokens. This can be prevented by putting in more ETH or taking out less DAI in the first place.
ETH can be claimed by paying back the amount, with the addition of a small fee.
Prediction markets are platforms where individuals can make predictions on future events by betting. The markets cover things like sports, politics, stock prices and the weather. DeFi opens these markets for participation. The concept of decentralized prediction markets has long been touted as a possibility through smart contracts.
Augur is a decentralized prediction market platform that utilizes the collective prediction of the masses. It uses Ethereum to harness the "Wisdom of the Crowd" to create real-time predictive data. The first version of Augur was released in 2015, and its mainnet was released in 2018.
Augur offers two primary actions and uses an ERC-20 token:
Market creation. Users can create an Augur market by spending some ETH. When creating a market, users need to set the taker fees and maker fees, which should be low enough to incentivize people to bid and high enough to cover the cost.
Trading events shares. Users can buy or trade shares that represent the odds of the occurrence of a market event. Traders can make money by buying positions at a low cost and selling them when the price increases. People who predict an event correctly will also receive rewards when the market closes. Those who guess wrong lose their stake.
The Augur token is REP (reputation token). REP is an ERC-20 token used on the Augur platform to create a prediction market, buy participation tokens, or dispute an outcome.
Another class of service offered by DeFi is asset management. It intends to make investing faster, less expensive, and more democratized. Aspects of the DeFi ecosystem play very favorably for asset management, including transparency, composability, and trustlessness.
Transparency promises to make information accessible and secure. Composable means users can enjoy hyper-customization of portfolios. Finally, a trustless system provides access to historically illiquid assets.
Launched in 2020 by Evan Kuo, Ampleforth aims to provide a non-collateralized digital asset that helps traders and investors diversify their crypto portfolios. Ampleforth is an asset-management protocol of DeFi designed to be a smart commodity, synthetic money. "Synthetic" because they're created by humans but aren't raw materials like gold.
Ampleforth adjusts its tokens' supply daily to match the market demand using a smart contract. These smart contracts use price oracles to get real-time data. These decentralized price feeds help determine if the token's price is within the equilibrium range (0.96-1.06 USD). If an AMPL token price is lower than $0.96 — the supply decreases. If it is greater than $1.06, Ampleforth increases the supply.
A key innovation in DeFi has been the introduction of governance tokens, which give holders voting rights over protocol decisions and updates. This democratic approach to protocol management gives individuals a say in the future development of the platforms they use.
Security tokens have also emerged as a crucial component of the DeFi ecosystem, representing ownership in real-world assets like real estate, stocks, or commodities through tokenization. This process of converting traditional assets into digital tokens on the blockchain has opened up new possibilities for fractional ownership and increased liquidity in previously illiquid markets.
As the DeFi ecosystem matures, risk management has become a central focus. Protocols use sophisticated risk assessment tools, insurance mechanisms and collateralization requirements to protect users and boost system stability. These measures help mitigate risks like smart contract vulnerabilities, market volatility and potential security breaches.
Privacy in DeFi transactions remains a crucial consideration. While blockchain transactions are inherently transparent, protocols are developing privacy-preserving solutions that balance the need for transaction privacy with regulatory compliance and system security.
One of the most significant developments in the DeFi space is the push for interoperability between different blockchain networks and protocols. Cross-chain bridges and protocols are enabling users to transfer assets and information across different blockchain networks seamlessly, creating a more connected and efficient DeFi ecosystem.
The future of DeFi extends beyond just financial applications. We're observing a quantum leap in the possibilities for monetary systems through the innovation of distributed ledger technologies. For the first time in history, a global financial system for a worldwide population is being shaped by that same population. Anyone can participate in DeFi protocols' governance and get a seat at the table where the world of decentralized finance is actively created.
The DeFi space is gradually catching up with the traditional financial system, while simultaneously expanding financial inclusion to reach previously underserved populations. Despite some of the obstacles that come with operating on the bleeding edge of innovation, the world of decentralized finance is on the path to prosperity. When DeFi and fintech map and merge, we'll have an inflection point where nascent financial technology is just part of a new financial system — one that realizes the dream of being fast, secure, available, and egalitarian.
Hedera’s low and fixed fees, scalable transactions, and immediate settlement make it the best network for building the DeFi infrastructure. Find out more about what third-party organizations in the Hedera ecosystem have built already and what Hedera can do for your and your dreams.