What is Decentralised Finance?
DeFi is short for decentralised finance. It offers the same financial services as the traditional banking system which is centralised finance (CeFi).
That is to say it offers; savings, exchanges, loans, trading, etc. but on a decentralised platform. Decentralised means there is no intermediary like a bank so transactions are peer-to-peer. This is because it is based on blockchain technology.
Why Use DeFi
It might be best to start with the reasons why DeFi started in the first place.
People were inspired by how Bitcoin decentralised money. However people wanted to take things a step further. Instead of just having decentralised money, they wanted to have financial services decentralised as well. Therefore that would mean getting away from our current CeFi system.
On the other hand DeFi is an improved financial system that is perfect for the internet age. DeFi opens up new possibilities for people to take part in global markets.
For DeFi to offer decentralised financial services, developers needed to build a stand-alone financial system. In fact cryptocurrency is a parallel financial system. Building this stand-alone and completely new financial system is a huge undertaking.
DeFi consists of many different projects. Some projects are at a more advanced stage than others. The projects are getting released once they are ready as expected.
However even though developers have a lot to do, the DeFi space is getting built at a rapid pace. This is partly because of the large numbers of developers that are working on DeFi projects.
As a result you have a selection of different services all competing for your business. So you can pick the one that you think is best for you. You will not be stuck with only your local options (if you have any local options at all).
Benefits of DeFi
Similarly to cryptocurrency, because DeFi is on a blockchain it does not require a trusted intermediary like a bank. Additionally because DeFi applications are peer-to-peer, you do not need to trust the other party you are transacting with.
All you have to do is place your trust in the code. The code will execute the service for you, likewise with any blockchain transaction.
The applications built for DeFi provide a much needed technology upgrade to banking. A lot of DeFi projects will be online 24/7 and will execute requests much faster than traditional banks.
Low Barrier to Entry
Signing up to a service on DeFi is easy and hassle free.
You will not need:
- Any government issued ID’s or any other government documents,
- Proof of address,
- Proof of income,
- Credit checks or
- Social security
All you require is an internet connection and some crypto funds to participate. The system will verify if you have funds to execute any transactions you request when required.
Disadvantages of DeFi
In true cryptocurrency fashion, DeFi is meant to be censorship-resistant and cheaper.
However some dapps on DeFi are more centralised than others. It would depend on the service and how it was set up. As a result the more centralised services are much less censorship-resistant. The solution here is for people to use the more decentralised dapps where possible.
Another issue is that at times some platforms have very high fees, aka gas fees for smart contracts. In fact at times users have complained that Ethereum’s fees are too high.
The gas fees should come down once Ethereum upgrades to its 2.0 version. Additionally by time other platform will make sure that their fees remain low as well. Most importantly because they must compete in price with other dapps.
How Is The DeFi System Built
The DeFi system has different layers each built upon one another. They are:
- The blockchain – that serves as a foundation layer to build they ecosystem.
- The assets or currency – to provide a way to transact on the network.
- The protocols or coded rules – the code that will make the network function.
- Oracles – Oracles are code that lets a smart contract know when an event has happened. This is so as the smart contract can go ahead and complete a function.
- The applications or dapps – They will facilitate the financial services. These would include for example; savings, exchanges, lending and borrowing, trading, insurance, transfers etc.
1. Blockchain – Choosing a Platform
At the very beginning when DeFi was still a concept, entrepreneurs needed to select a platform to build the system. Since DeFi is by definition decentralised, blockchain is the perfect technology to pair with a DeFi ecosystem.
However the developers had to figure out which blockchain to use. At the time Bitcoin was out of the question because it could only support its own cryptocurrency. I don’t want to get too technical, but Bitcoin used ECDSA as a signature.
Satoshi Nakamoto could not use a better signature at the time. However, unfortunately ECDSA was not flexible and it was limited on what it could do.
In fact eventually Bitcoin developers made the Taproot upgrade. This upgrade supported Schnorr signatures that allows Bitcoin to have more functionalities. As a result Bitcoin can support its own DeFi ecosystem. At the moment Bitcoin DeFi is small, but it is growing.
Back then developers created Ethereum to support extra functionality. Ethereum was perfect for the job because it is has a really flexible programming language. So it can support applications that are built on top of its platform.
Today there are some other cryptocurrencies that have their own DeFi ecosystem. Like for example Solana, Polkadot and Cosmos.
These platforms are still new and not as established as Ethereum at this point. However they do have amazing teams and road maps to make improvements on the limitations of Ethereum.
Crypto Blockchain Fact
People call Ethereum a cryptocurrency, but it is actually a crypto commodity. It is very different to cryptocurrencies like Monero and XRP.
This is because crypto commodities are similar to real world commodities like for example oil or sugar. That is to say they are raw materials and are used to make other things. For example sugar is used to bake cakes.
So in the case of crypto commodities, they act as a platform for developers to build applications on them. This means that all platforms making up the DeFi system are crypto commodities.
For an explanation of these differences you can read the book Cryptoassets. It is featured in our top list of cryptocurrency books.
The DeFi ecosystem needs to allow people to transact on the network. So the ecosystem needs a currency.
At the beginning the crypto teams did not want to use cryptocurrencies because they are volatile. The price fluctuates up and down a lot and the system needed something more stable and reliable. Otherwise the DeFi system would not work out well in the long run.
In fact otherwise the teams would have chosen Ether which is Ethereum’s native crypto. As a result the first DeFi application called MakerDAO, created a stablecoin called Dai. Dai is the native token of the platform that is pegged at a one to one ratio to the US dollar. So 1 Dai is equal to $1.
Although Dai is pegged to the dollar it is backed by cryptocurrency as collateral to fund the system. The amount of Dai in the system does not exceed the value of the collateral.
Consequently this provides trust and confidence to those that use the system. Additionally users of the platform can easily verify the amount of Dai available by checking on the blockchain.
Since those times the stablecoin market and DeFi have evolved. So there are many other stablecoins that are used in DeFi today.
Value of Stablecoins on Ethereum
Moreover today there are not only stablecoins on Ethereum, but also on other platforms as well.
As the space evolved some cryptocurrencies are getting adopted and used in DeFi. That is to say even though cryptocurrencies are still volatile. However people do not seem to mind this at all. Firstly because they got used to the volatility and secondly they like holding and transacting with regular crypto.
In fact Ether, Sol and other tokens are used for buying NFTs.
Bitcoin’s DeFi ecosystem has apps that use their own tokens. However there are others that use Bitcoin. So in a sense they are more “pure” which is perfect for Bitcoin maximalists. Or for people that prefer Bitcoin. Especially because it is the king of cryptos and not some other lesser known coin.
3. DeFi Protocols – Smart Contracts
For the services on DeFi to work they need smart contracts. Smart Contracts are the building blocks for creating the functionality for the apps or dapps (decentralised applications).
They are like regular, real-world paper contracts, but fully digital. All they are is code created to complete a function or service for you. As a result, developers have a lot of flexibility to code whatever is required.
In fact a smart contract can either execute a service there and then or at a future date. It could also have a condition in the code. Therefore the contract will complete the transaction when the conditions come true.
There are a wide range of use cases for smart contracts paired with blockchain technology. Including finance, NFTs, legal purposes, healthcare, physical real estate and other industries.
All could transition to a blockchain and use smart contracts for their services. However DeFi would only cater for financial services and not other industries.
Smart Contract Example
To help you understand how smart contracts work we can use Kickstarter as an example.
Kickstarter is where people crowd fund ideas. Teams lay out their idea and stipulate a goal amount on the platform. People outside the team that believe in the idea can fund the project. If the project meets the funding goal, Kickstarter will forward the funds to the team. However if it doesn’t the funds will go back to supporters.
Smart Contract Benefits
Smart contracts like crypto also get verified by the blockchain. So people using the blockchain always know that the transactions are properly checked and honest.
It is important that smart contracts are coded well and checked before release for two reasons:
- Firstly, developers cannot edit code after release. This is good for peace of mind of the users of the contract. They know it is set in stone and no one can alter the deal.
- Secondly, developers need to code contracts well to avoid any hackers taking advantage of a vulnerability.
Oracles are code that notify a smart contract of an event that happened. As a result it triggers the smart contract into action to complete an outcome.
Oracles open up many more possibilities for what a blockchain can process. This is because oracles do not just carry on-chain data. However they can also carry information from the real world to the blockchain and vice versa.
In fact oracles can expand the services available on DeFi like with insurance. For example a farmer takes out crop insurance just in case there is a draught. Around the fields there are tools that constantly monitor the weather.
If the sources notice drought for over 10 days then the oracles will carry that information to the smart contract. Consequently the smart contract will automatically pay out the farmer.
The Final step needs developers to build dapps on the platform to provide services. It is good to note that some dapps are more decentralised than others. How decentralised they are would depend partly on the service provided and how the developers code the dapp.
The services that entrepreneurs in the DeFi space need to cater for are:
- Collective investments
- Asset management
- Lending and borrowing
You can have a look here at the full list of DeFi dapps that have been built on Ethereum.
Since blockchain will benefit society, a lot of money is getting invested in the DeFi space.
It may come as a surprise to most, but a lot of DeFi projects are well underway. The space has a large amount of dedicated developers who have put in a lot of work. In fact DeFi already has a flourishing ecosystem.
Since 2020 the amount of investment into DeFi grew at an astonishing pace. At the beginning DeFi had $4 total value locked on 3rd August 2017. As of today the 11th May 2022 it has increased to an astounding $67 billion of total value locked.
How DeFi is Evolving
As mentioned earlier, initially Ethereum was the only platform that was built to support DeFi. However as time passed developers started working on other projects.
These projects want to contribute to DeFi and provide all the services that it would need. As a result it would create a one stop shop for all financial services on a decentralised platform.
Different dapps could end up competing against each other because they offer similar services. This is a good thing because competition is good for a healthy market. Some dapps are on different platforms and not just on Ethereum. So these new dapps may also want to improve on Ethereum’s limitations.
To clarify Ethereum’s code is flexible so the developers could always upgrade the network. However there might not be any need for certain things. Other platforms could fulfil that need.
One factor that Ethereum is not addressing is interoperability. Instead of having separate blockchains doing their own thing, blockchains would communicate with each other. This is necessary because otherwise the space would fragment. Additionally it provides convenience to users who can transact more easily across different blockchains.
So Bitcoin, Ethereum and other blockchains that work in their own system can get ‘bridged’. Like this they can communicate with each other.
Additional Benefits of a DeFi System
The reasons for creating a DeFi system is because centralised systems are not transparent. They are prone to mismanagement, corruption and fraud.
I sincerely believe that banking establishments are more dangerous than standing armies, and that the principle of spending money to be paid by posterity under the name of funding is but swindling futurity on a large scale.Thomas Jefferson to John Taylor, 1816.
In this quote Thomas Jefferson was talking about the ability for central banks to print money. They do this at the request of government.
Money printing has two main consequences:
- Firstly it impoverishes future generations that need to pay the debt.
- Secondly it leads to inflation. If there is extreme levels of money printing it can lead to a crack up boom.
Bankers and politicians are prone to making the same mistakes and make the populations go into debt. However crypto and DeFi is a way to take power away from institutions. This is because it removes their ability to control money.
Additionally since the last financial crisis it became clear that there are systemically important banks. These banks are classified as ‘too big to fail’. They are such major pillars in the financial system that their failure will be truly catastrophic. In other words decentralisation makes perfect sense because it reduces the risk of systemic failure.
Frequently Asked Questions
What is the difference between DeFi and crypto?
Why is DeFi so popular?
What is DeFi used for?
· Lending and borrowing