There has been quite some hype around DeFi in the crypto space.
And it’s no surprise.
While the total value locked in decentralized finance applications was standing at $671.3 million on January 1, 2020, the industry has grown to a $14.3 billion market by December 31. This represents a yearly surge of over 2,000%, which is over six times greater than Bitcoin’s 306% growth last year.
Since then, the decentralized finance market has continued its ambitious expansion, with users pouring $39.79 billion into DeFi apps by February 10, 2021.
But what is DeFi, how does it work, what benefits does it offer to users, and how did it manage to grow so big so fast?
Let’s explore the answers to the above questions together in this comprehensive guide about decentralized finance!
What Is DeFi?
Decentralized finance or DeFi refers to a movement in the cryptocurrency space in which alternative financial solutions are created using blockchain technology and digital assets.
With DeFi, anyone on the globe with an internet connection, a desktop or mobile device, and a compatible cryptocurrency wallet can access decentralized financial solutions.
DeFi apps allow users to manage their finances, get insurance, borrow, trade, and exchange digital assets or generate a passive income via various savings products while maintaining control over their funds.
DeFi solutions offer a great level of privacy to users, and most processes are automated and transparent.
Also, since DeFi apps lack intermediaries, they feature efficient networks with rapid transactions, reduced fees, and higher potential for profits.
What Is a DeFi Protocol?
A DeFi protocol or a DApp (decentralized application) refers to the actual solution that provides decentralized finance services to users.
Built on top of blockchain networks, DeFi protocols are operated using digital currencies and smart contracts. The latter refers to a self-executing and enforcing digital agreement between two or more parties.
While they are often used interchangeably, decentralized finance protocols shouldn’t be confused with DeFi platforms, which we will introduce in the next section.
What Is a DeFi Platform?
Unlike protocols, a DeFi platform refers to the blockchain network where the actual decentralized finance solution is deployed.
As decentralized finance applications are automated, smart contract support is mandatory for a blockchain network to become a platform for DeFi.
For that reason – and due to the massive activity on the blockchain –, Ethereum leads as the top DeFi platform with the vast majority (200) of decentralized finance solutions built on top of the project’s chain.
Interestingly, Bitcoin is the second most-used DeFi platform with 26 projects despite that its network doesn’t natively support smart contracts. However, with the Lightning Network’s introduction, it’s possible to run smart contracts and DeFi apps on BTC.
Coming next, the highly scalable smart contract platform EOS secures third place with 21 DeFi projects.
DeFi vs. Traditional Finance: How Does Decentralized Finance Work?
To understand our topic, it’s crucial to know how decentralized finance solutions work compared to traditional finance approaches.
Traditional finance products – such as loans, savings accounts, wealth management, banking, and insurance – operate on a centralized basis.
The service provider has full control over the ecosystem and the authority to set its own rules and terms. For that reason, the company has the right to provide or restrict the access of customers to its products and services.
For example, let’s see how a loan application process works in traditional finance.
- You make an appointment with your bank, visit the branch to answer several questions, and fill out the necessary forms.
- After that, you have to submit documents to the bank.
- The financial institution reviews the submitted papers along with your credit history and other data related to your financial background to determine your eligibility for the loan.
- If the bank finds everything okay, it issues you the loan and transfers the requested funds into your account, which you will have to pay back along with interest.
However, if the bank finds it too risky to lend you money, it will deny your application.
Denial can be due to many reasons, including bad credit history, insufficient collateral, low income, too many pending loans, or an unstable job. In other cases, the financial institution may reject your application for a cause they won’t inform you of.
As you can see, the whole process – which can take from a few days to several weeks – is definitely not transparent or democratic. The bank is in charge of everything, focusing on maximizing its profits while taking the least amount of risks.
While we can’t judge banks for doing so – as most companies follow the same practice to run a profitable business – banks deny access to traditional finance products for many people. And, sometimes, those who get rejected are the ones who need those services the most.
Also, some traditional finance products like lending are only accessible domestically due to regulations and the inability to determine an applicant’s credit score on an international basis.
In the last section, we described an example of how a loan application is processed in traditional finance. Now let’s see how borrowing with DeFi works:
- A user connects a compatible cryptocurrency wallet to a DeFi lending platform to access the app.
- Upon successfully connecting the wallet, the user selects the digital asset and the amount of coins to use as collateral and deposits it into a smart contract on the lending platform.
- When the coins have arrived, the user selects the amount of stablecoins (e.g., DAI, USDT, USDC) to borrow as well as sets and agrees to the loan’s terms.
- After finalizing the process by tapping or clicking a button, the platform automatically locks the customer’s collateral and distributes the borrowed amount to the user from a lending pool.
- The user pays back the borrowed amount and the corresponding interest according to the terms agreed in the contract.
- Upon successful repayment, the lending platform automatically releases the borrower’s collateral.
- Contrary to traditional finance, the whole process in which the user applies for and gets the loan issued takes only a few seconds or minutes.
Furthermore, the process doesn’t involve any intermediaries, and everyone with the necessary digital asset collateral can receive a loan with flexible terms vis-a-vis DeFi solutions.
What Are the Benefits of DeFi?
DeFi solutions provide multiple benefits to users, including:
- Decentralization: DeFi solutions function as decentralized applications (DApps) that are deployed on blockchain networks. Unlike traditional systems, where data is stored on a central server or database, blockchains are maintained by a decentralized network of computers (the miners or validators).
- Transparency: Since DeFi solutions are blockchain-based, everyone maintains the same copy of the blockchain, storing all the data and recording changes to the distributed ledger in real-time. All this information is available for anyone on the public chain to verify, audit, and analyze transparently.
- Immutability: In blockchain networks, validators have to reach a consensus to verify transactions or add new blocks to the chain. As a result, once a record is added to the distributed ledger, it is immutable and can’t be modified.
- Open access: DeFi DApps are deployed on permissionless blockchains such as Ethereum. As a result, anyone with a compatible device, cryptocurrency wallet, and an internet connection can access DeFi solutions globally without geographical, financial, or other restrictions.
- Democratic governance: Instead of a company or a financial institution, most DeFi products are governed by the community. Here, holders can use their tokens to vote on future protocol upgrades, fixes, and other governance-related decisions. However, it’s important to mention that not all DeFi projects start as community-powered solutions. Instead, they initially use a centralized governance model (e.g., a developer or an organization is in charge). But later, the creator hands control over the project to the community by issuing and distributing native tokens to users.
- Interoperability: One of the most important features of DeFi is interoperability, which allows developers to build upon, integrate, or combine DApps with other decentralized finance solutions. This is the reason why DeFi protocols are often called “money legos” in the crypto space.
- Programmability: Developers can deploy smart contracts for DeFi solutions to automate processes and create new products.
- Non-custodial finance management: Traditional finance solutions – and even centralized exchanges – keep their customers’ funds in their custody while using their products (take savings or bank account as an example). On the other hand, most DeFi applications don’t hold user funds. Instead, they operate on a self-custodial basis where customers have to connect their wallets without depositing money to accounts managed by the service provider. For that reason, users have full control over their digital assets and personal data when they use DeFi apps.
- Privacy: Since DeFi solutions have no custody over customer funds, they don’t require users to register accounts, provide personal details, or submit Know Your Customer (KYC) and Anti-Money Laundering (AML) documents. For that reason, it’s possible to use decentralized finance services privately or (pseudo)-anonymously. However, that can change soon based on the outcome of future regulations.
What Are the Use-Cases for DeFi?
Empowering DeFi with numerous use cases, projects have been taking the lead to create decentralized alternatives to traditional finance solutions.
In this section, we have compiled the most important DeFi use cases along with example apps for each.
Let’s see them!
1. Lending and Borrowing
One of the most popular DeFi activities is lending and borrowing.
And for a very good reason.
Earlier in this article, we have shown how borrowing works on DeFi platforms, and we can safely conclude that it’s a rapid, efficient, and automated process that lacks any middlemen and allows borrowers to access extra capital in stablecoins within a few minutes.
However, it’s important to mention that DeFi loans are overcollateralized, meaning that borrowers have to deposit more collateral than the amount of funds they can borrow.
While this may seem counterproductive at first, over-collateralization protects lenders against non-paying borrowers (as the collateral is automatically transferred to the lenders upon non-payment).
On the other hand, crypto-backed loans in DeFi allow investors, traders, and businesses to access extra capital – which they are free to exchange for fiat currency any time (e.g., to pay rent, utility bills, business expenses) – without selling their digital assets.
DeFi platforms issue loans from lending pools in which users deposit their cryptocurrency holdings (usually stablecoins). In exchange for contributing coins to a pool, lenders can earn interest on their tokens.
Interestingly, one of the reasons why DeFi lending has become so popular is due to the fact that users have access to much higher interest rates (usually ranging between 5-15% annually) than with traditional finance products (e.g., government bonds, savings accounts).
2. Decentralized Exchanges (DEXs)
A decentralized exchange or DEX is a peer-to-peer (P2P) cryptocurrency service that allows buyers and sellers to connect without intermediaries and the requirement to hold user funds in custody.
Instead of relying on centralized elements, decentralized exchanges execute trades automatically using smart contracts.
While DEXs are not new, they only played a minor part in the crypto space until the recent DeFi boom, which helped them gain ground against centralized exchanges.
A reason why decentralized exchanges initially lagged in adoption in the crypto community is because of issues with liquidity.
However, since DeFi solutions introduced liquidity pools, incentivizing users to contribute their coins in exchange for an interest, DEXs now have access to significantly more liquidity than before.
Furthermore, many decentralized exchanges have started supporting atomic swaps, in which crypto users can conveniently and instantly switch a token to another coin.
3. Derivatives and Margin Trading
Cryptocurrency derivatives and margin trading have become increasingly popular in the industry.
In short, a “derivative” is a financial instrument that derives its value from the performance of an underlying asset, which can be anything from stocks and bonds to Bitcoin and DeFi tokens.
“Margin trading” refers to the practice in which someone uses borrowed funds to trade an asset, allowing him to secure higher potential gains (that also comes with greater risks).
While such products were only available for the public with centralized providers in the past, DeFi creators have recently introduced decentralized derivatives and margin trading platforms where users can trade assets without KYC and custody requirements.
Examples: USDT, DAI, USDC
Stablecoins are cryptocurrencies that have their values pegged to a single or a basket of other instruments.
Although the underlying instrument can be virtually anything (e.g., other digital assets or commodities like gold and silver), most stablecoins are based on major fiat currencies, such as USD and EUR.
As their name suggests, stablecoins provide a solution to cryptocurrencies’ volatility issues by pegging them to assets that aren’t subject to extreme price swings to stabilize their value.
While their value remains steady, stablecoins can be held, used, exchanged, and transferred via blockchain networks just like any other digital asset.
Stablecoins play a key role in DeFi as they are widely used across lending, payment, and yield farming solutions.
Staking refers to locking up a part of a user’s cryptocurrency holdings to validate blocks and get rewarded for supporting the blockchain network.
Staking has the same purpose as mining in Proof-of-Work (PoW) networks like Bitcoin, in which miners leverage their computational power via specialized hardware to verify transactions and add new blocks to the chain.
However, validators in Proof-of-Stake (PoS) networks and their variants use their tokens instead of their computational power to validate blocks.
Unlike cryptocurrency mining, where miners have to purchase expensive equipment to get started, staking has no upfront costs for validators. For that reason, it is more accessible to users, and it has gained increased popularity in the digital asset space.
As only selected validators are rewarded, individuals and companies have created staking solutions to maximize their profit chances. As a result, users can make a similar passive income as in DeFi lending.
Although, it’s important to mention that while lending involves mostly stablecoins, staking requires locking up a project’s (non-stablecoin) token. This increases the risks of volatility but also the chance for increased returns (in case a staked coin’s value moves in a favorable way while being locked up).
6. Yield Farming
Yield farming is a DeFi-exclusive activity that is widely popular in the industry, especially among those with a higher risk appetite.
Yield farming, also called liquidity mining, refers to using complex strategies to lend and stake digital assets throughout multiple DeFi protocols to maximize gains.
In its basic form, farmers deposit (lend) their funds into liquidity pools to earn rewards. However, in many cases, the platform issues a token to the user representing the coins he has lent to the pool (e.g., for lending DAI on Compound, users are issued cDAI).
Since users are free to utilize these tokens in other DApps, many yield farmers move them to other DeFi solutions to make an additional profit. And they may continue to do so with the coins they get on the second protocol.
However, as the most profitable strategies involve multiple (non-stablecoin) cryptocurrencies, they pose much higher risks to users than, for example, DeFi lending or staking.
7. Wealth Management
Cryptocurrency wallets have been around since Bitcoin’s launch in 2009, allowing users to store, receive, and send digital assets.
However, the original crypto wallets are very different from the ones we have now.
With the rise of the DeFi space, many cryptocurrency wallets have added a functionality that allows users to interact with decentralized finance applications.
Many DeFi-compatible crypto wallets now function as one-stop wealth management solutions by integrating multiple apps under one platform.
In addition to the basic features, users can now utilize their wallets to trade, swap, stake, yield farm, or lend cryptocurrencies.
Furthermore, some decentralized finance projects have created specialized wealth management apps that can be connected with DeFi-compatible wallets.
In addition to a store of value, one of the first use cases of cryptocurrencies was for payments.
Since blockchain networks operate continuously without intermediaries, they offer global access to faster and cost-efficient payments to crypto users.
However, due to blockchain networks’ decentralized architecture, digital assets often struggle with decreased scalability and congestion.
Multiple DeFi projects are working on Layer 2 scalability solutions to fix this issue, allowing transactions to be processed on side-chains or off the main blockchain. As a result, users can have access to cheaper and more rapid transfers.
In addition to scaling solutions, other DeFi projects have created payment applications to facilitate efficient digital transactions for individuals and businesses.
9. Asset Tokenization
Asset tokenization refers to the practice in which the rights for real-world or traditional finance assets are converted into cryptocurrencies.
Theoretically, there are no limits for tokenizing instruments. From artwork, in-game items, to real estate and commodities, anything can be “moved” to the blockchain to be represented by a token.
However, asset tokenization creates the most value when hardly accessible or illiquid instruments are converted into cryptocurrency.
As a result, such assets can be exposed to a larger market, making it much easier for users to buy or sell them.
For example, tokenizing private companies’ shares can be used to create a secondary market in which participants can easily exchange them. Real estate is another good example of an illiquid asset that can be improved by tokenization.
Insurance is among the most interesting applications of DeFi solutions.
It was not common to hear about insurance products other than traditional finance before the DeFi boom.
As some decentralized finance products involve increased risks, projects have created insurance products to protect investors against potential losses.
However, DeFi insurance solutions are very different from the ones in traditional finance.
Instead of a single firm providing the service – with the involvement of several sales agents and other intermediaries – decentralized insurance products are managed and offered by the community.
Interestingly, in addition to crypto-related activities and services, DeFi insurance products have been created around other, more general areas like flight delays and hurricane protection.
Is DeFi Safe for Investors?
At this point, you know what DeFi is, how it works, as well as its benefits and use cases.
Now let’s talk a little about the safety of the industry.
Whether DeFi is safe for investors is based on the strategies and the actual decentralized finance solutions used to generate potential profits.
For example, lending a stablecoin on a major, reputable DeFi protocol poses relatively low risks to investors as the loans’ over-collateralization protects them against non-paying borrowers.
Also, as stablecoins are subject to minimal volatility – especially when we compare them to DeFi tokens with small market caps – investors don’t have to worry about potential price swings that could eat up their profits.
On the other hand, using a complex yield farming strategy that involves lending, staking, or trading 3-4 different non-stablecoin tokens can come with very high risks.
For that reason, DeFi is definitely risky for investors who don’t do their own due diligence before using an app.
However, DeFi can be a safe investment for those who know how different smart contracts and DApps manage their money, refrain from utilizing overly complex strategies, understand the risks beforehand, and engage with only reputable service providers.
With that said, we have collected for review some of the potential challenges and risks of DeFi:
- Smart contract bugs: As mentioned earlier, DeFi applications are powered by smart contracts, allowing both users and service providers to automate processes. However, everyone makes mistakes, including developers, especially in the case of complex smart contracts. Smart contract bugs are often hard to fix and can lead to potential exploits and investor losses.
- Hacks: Unfortunately, errors in smart contracts are still common among DeFi projects. For that reason, hackers are increasingly targeting the space, aiming to exploit the vulnerabilities of projects.
- Fraud: The DeFi space is yet to be regulated, and some projects are taking advantage of the current situation to scam investors with fraudulent schemes.
- Future compliance issues: Currently, there is no regulation around DeFi. However, since the industry is growing rapidly, it is realistic to expect multiple governments to regulate decentralized finance in the near future. While effective regulation is definitely good for the space, DeFi users may lose some of their abilities, such as using solutions without submitting KYC and AML documents.
- Impermanent loss: Impermanent loss is a unique term used in DeFi and applies to mostly yield farming activities. In short, an investor can face this risk while supplying liquidity to a pool. Impermanent loss occurs when a token in the pool grows in value and arbitrageurs step in and use the opportunity to make profits, reducing the liquidity provider’s gains. In such a case, an investor could have made a better profit by holding the tokens in the pool instead of supplying liquidity. If you want to learn more about impermanent loss, we recommend reading the following article.
How to Stay Safe in the Decentralized Finance Industry
Based on our findings in the previous section, we can conclude that the decentralized finance industry poses some risks to investors.
However, it’s definitely possible to stay safe while using DeFi services, and we have collected some handy tips to help you:
- Do your own research before using an app: While this may be obvious, many people forget to do their own due diligence before utilizing a solution or investing in something. This advice is especially crucial for DeFi apps, as they often use complex mechanisms and business models to operate. For that reason, make sure you understand the strategies and the decentralized solutions used for investing to know your opportunities and risks beforehand.
- Be cautious with solutions promising extraordinarily high rates: If something seems too good to be true, it probably is. For that reason, you should take DeFi projects promising excessively high returns (e.g.,1,000% gains in one week) with a grain of salt. When you find a new app, analyze how it works, do a background check on the developers, and see what others say to stay safe.
- Check smart contract audits: Since smart contract bugs pose a high risk to the industry, DeFi projects often hire third-party firms to audit their code to find and fix potential issues and vulnerabilities. As a rule of thumb, you should refrain from using DeFi services without audited smart contracts. To get increased insight into a project’s safety, we recommend going through all audit-related documents.
- Consider DeFi insurance products: Buying insurance for a DeFi product is a good way to protect your investment against possible cyber-attacks and smart contract failures.
Stay away from projects with anonymous owners: While Bitcoin has proven itself a trustworthy project since its launch by the mysterious Satoshi Nakamoto, it doesn’t mean that you should blindly trust DeFi projects where core developers refuse to reveal their identities. On the contrary, you should be very careful as the risks of exit scams and other fraud is higher for solutions with anonymous dev teams.
- Look for activity on GitHub: Since DeFi projects are open-source, their code and related developer activities are shared publicly on GitHub. For that reason, it’s possible to see the newest changes to the apps there. If a project hasn’t made any updates to the code in the past few months, it means that it has likely been abandoned by the team.
How to Get Started With DeFi
Now we have explored the industry’s essentials, let’s see how to get started with DeFi.
Step 1: Create a DeFi-Compatible Wallet
The first step to use a DeFi app is to create a compatible cryptocurrency wallet.
However, if you want to maximize your security, consider getting a hardware wallet from a reputable provider like Ledger or Trezor. Since hardware wallets are popular among crypto users, most DeFi applications support them.
After creating your wallet, you will be given a seed phrase. Since this crucial piece of information allows you to restore your account, it’s important never to share it with anyone.
Instead, you should write it down on a piece of paper and store it in a place you have exclusive access to. It’s also a good idea to keep it digitally on your computer’s hard drive in a secure location as well (never upload it to the cloud as it could compromise your security).
As a side note, some crypto wallets use their own security features for restoring accounts and may not offer seed phrase backups for customers. These solutions often use guardians (e.g., a hardware wallet, a trusted person, or a third-party service) to restore user wallets.
Step 2: Get Cryptocurrency
When your wallet is ready, it’s time to get some crypto to use for DeFi.
The easiest way is to purchase coins with fiat currency.
The easiest and the fastest way to exchange fiat to crypto is via a credit or debit card, but this option is often more expensive than the others.
On the other hand, if you are comfortable waiting a few days until you can purchase crypto, bank transfers are a great option, especially when you can access domestic wire transactions.
It’s possible to get digital assets via other methods (even without spending a dime), such as by stacking sats.
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Step 3: Connect to a DeFi App
When you have your coins ready in your wallet, it’s time to select a DeFi app to use.
On mobile, the connection between your wallet and the decentralized finance app is mostly established with WalletConnect, a service combining multiple wallet and DeFi solutions. Here, you have to scan a QR code with your smartphone’s camera to access the service or log into your account and authorize the DeFi app for desktop and web wallets.
The process is a bit more complex for hardware wallets as you have to plug your device into your computer and type in a security key for connecting to the DApp.
Don’t forget to confirm the connection in your wallet app to finalize the process.
Step 4: Deposit Funds
Once you have established the connection between your wallet and the DeFi service, you have to deposit funds to utilize it.
However, unlike with centralized exchanges, this deposit will go into a smart contract instead of the service provider’s accounts, which allows you to remain in custody and maintain control over your digital assets.
After initiating the deposit from the DeFi app, you will have to authorize it via your wallet.
Upon a successful deposit, you are ready to lend, exchange, borrow, stake, farm yield, or participate in other decentralized finance activities.
After ending your DeFi journey, don’t forget to withdraw your funds to your wallet.
DeFi Is Here to Stay
DeFi has empowered crypto with numerous new use-cases by providing a decentralized alternative to traditional finance products.
While there is significant demand for them, traditional finance services often operate inefficiently, lack transparency, need middlemen, and fail to provide access to many.
DeFi solves this issue by leveraging blockchain technology to provide a wide range of services, allowing users to manage their finances, access savings products with good rates, and borrow funds on their digital assets.
With such astonishing growth in recent months and new use cases and solutions appearing on the market every day, DeFi is definitely here to stay.
Notwithstanding their increasing popularity, DeFi solutions can come with high risks to investors. For that reason, we recommend everyone to do their own due diligence and follow the best practices to stay safe while taking advantage of decentralized finance’s benefits.
DeFi Frequently Asked Questions (FAQ)
1. How much money is in DeFi?
As of March 24, there is $40.82 billion of digital assets locked in DeFi apps.
2. What is decentralized technology?
Solutions using decentralized technology lack a central party (e.g., a company, institution, government body) from their networks that can exercise its authority over other users.
Instead, applications using decentralized tech are maintained by the community and governed democratically.
Blockchains and DeFi protocols are good examples of decentralized technology.
3. What is an example of a decentralized exchange?
Examples of decentralized exchanges include:
For more examples and to learn more about decentralized exchanges, we recommend reading the following article on the Permission.io blog.
4. Are banks centralized or decentralized?
Banks and the banking network operate on a centralized basis.
Financial institutions have full control over their governance, products, networks, services, as well as who can get access to their solutions.
While the DeFi industry is growing rapidly, decentralized banks are yet to appear on the market or gather widespread attention among users.