Bitcoin (a payment system where anyone in the world can send money to anyone else) was just the beginning of the crypto revolution. People who develop decentralized applications (or dapps for short) seek to take accessibility one step further.
Decentralized Finance (or DeFi) was pointed out as a possible solution to lower the entry barrier for those who have difficulty gaining access to bank accounts.
More recently, DeFi are being used by cryptocurrency owners for other purposes: to make more money.
What are DeFi?
As a whole, DeFi applications are financial products that operate on a public blockchain such as Ethereum.
These products are enabled, that is, they do not need third parties. Instead of financial intermediaries such as brokers and banks, everything is automated in the protocol through standalone contracts.
Do you want to take out a loan? You don’t need the bank to lend you the money. You can get a loan directly from your peers.
Ready to bet on bitcoin futures and other derivatives? Give up finding a bettor. You can let the protocol do it all.
Want to convert one asset to another? Decentralized brokers (or DEXs) can facilitate a transaction without taking a large commission.
Who invented DeFi?
There isn’t a single creator of DeFi, but dapps appeared in Ethereum, invented by Vitalik Buterin. They have since expanded to other networks that use autonomous contracts to automate transactions, including Solana, Binance Smart Chain and Avalanche.
Andreessen-Horowitz (a16z), the major venture capital firm, has led multi-million investment rounds in both the Compound and MakerDAO, protocols that are the cornerstones of the current DeFi system.
What is so special about DeFi?
DeFi have several fundamental features.
First, they are “open”, meaning you can use the applications when creating a wallet (usually without showing any identifying information such as name and address). This is theoretically (if not technologically) simpler than having a bank account.
Second, you can move funds almost instantly via a blockchain, so you don’t have to wait for the bank transfer to take place.
Third, the fees (at least for now) are much better than in traditional banks, although transaction costs vary depending on the blockchain network.
Finally, dapps work together as “Legos of money”. This “composability” allows anyone to create, modify, mix and match, link or build on any existing DeFi product without permission.
Unfortunately, this feature can be one of DeFi’s biggest weaknesses, as if a fundamental element, such as the stablecoin DAI, becomes vulnerable or becomes corrupted, the entire ecosystem built around the DAI can collapse.
What can be done with DeFi?
Borrowing and lending
If you have cryptocurrencies, you can lend them to a protocol, such as Aave and Compound, in exchange for interest and/or rewards. It is also possible to borrow cryptoactives from a protocol, which can be very useful if you want to make a trade.
But be careful! Most DeFi protocols use over-guarantees, where more money is allocated than the amount you want to borrow; if the asset’s value drops too low, the protocol can take its warrant to avoid losses.
Many DeFi users use loans as a way to earn assets through “yield farming,” in which they lock funds in an asset pool to gain rewards.
Since rates vary depending on protocol and asset, experienced yield farmers move their assets and capitalize at the best rates.
At centralized brokers such as Coinbase and Binance, you are dependent on the broker to take custody of your assets on every trade. Decentralized brokers remove the middleman so that people can trade directly with each other.
Also, DEXs such as Uniswap and PancakeSwap allow people to list new tokens for trading. Lack of verification increases risk, but it also allows people to “get early” on new assets before they hit the markets.
Sometimes you don’t need to be limited to trading specific currencies or tokens. Derivatives platforms like dYdX and Synthetix allow people to do more than spot trading.
For example, users can engage in leveraged trades, where they bet more than they have or create “synthetic assets” that mimic traditional stocks and commodities.
How are dapps developed?
Anyone capable of writing standalone contract code is capable of creating dapps. There are several tools to test and/or implement standalone contracts, including Truffe and Ganache (on Ethereum).
After downloading the framework for creating autonomous contracts, you can create a token that allows a protocol to use the blockchain network. On Ethereum, the token default is ERC-20; at Solana, SLP; and in Binance Smart Chain, BEP20.
Having a token allows the protocol to interact directly with the currency of the first-tier blockchain. But projects also promote their tokens to drive decentralization.
The Compound Loans protocol, for example, uses COMP as its governance token; those who have it make decisions about the protocol’s code and treasury allocations.
How to use DeFi products?
Anyone can use DeFi products by going to a dapp’s website and connecting with a crypto wallet, like MetaMask on Ethereum or Phantom on Solana. Most dapps do not ask users to provide personal information or register.
However, since dapps are built on a blockchain, you must use that blockchain’s currencies to pay for transactions. Ether (ETH) is required to pay transactions on the Ethereum network, just as SOL is required on the Solana blockchain.
The future of DeFi
As of November 2020, less than $20 billion worth of locked-in value on various DeFi products, primarily on Ethereum. As early as November 2021, that number had risen to nearly $98 billion.
If the trend continues and the DeFi maximalists are right, this is just the beginning of a huge DeFi wave. True advocates argue that the advantages of an open and decentralized financial system are irresistible for not capturing trillions of dollars of value.