What is DeFi? Beginner’s guide to decentralised finance.
By Andrew Munro
In a nutshell, decentralised finance (DeFi) is like an entire financial system for cryptocurrencies.
While Bitcoin was the first to successfully put money onto the Internet, DeFi aims to create the system for that money to keep moving, working and finding meaningful value.
Just like any currency benefits from being part of a healthy financial system, cryptocurrencies benefit from being part of a DeFi ecosystem.
In coming years, central bank digital currencies, other tokenised assets such as digital gold, real estate or energy and cryptocurrencies like Bitcoin will all become digital assets in the DeFi ecosystem.
This guide explains how DeFi works and why it’s important.
How does DeFi work?
A DeFi ecosystem is built on two characteristics of blockchain technology:
- It can be reliably tamper-proof and largely automated
- It can be programmed to interact with cryptocurrency
With these characteristics it’s possible to create decentralised applications (dApps) that automatically interact with money in many different ways, without needing banks or other intermediaries.
As more dApps are built and as they increasingly integrate with each other, the DeFi ecosystem becomes more effective.
The key to understanding DeFi is to understand the different types of dApps that make up the DeFi ecosystem, what they can do and how they all fit together.
For example, consider how a simple “swap” dApp, which people can use to trade cryptocurrency with each other, improves as it links up with other elements of a DeFi ecosystem.
|Smart contract types||What it does|
A swap program simply allows people to safely trade assets with strangers online.
Two people can swap cryptocurrency with each other.
It’s slow, inconvenient and extremely limited. You can only trade with others using the same platform.
Swap + pricing oracles
Pricing oracles can provide other programs with accurate price feeds and other data.
Two people can swap cryptocurrency with each other.
It’s more convenient, but still slow and inefficient. You still have to wait for a counterparty to make a trade.
Swap + pricing oracles + liquidity pool
Liquidity pools aggregate assets for other dApps to use when needed.
Two people can swap cryptocurrency with each other.
It’s faster, easier and more convenient. By connecting to liquidity pools, the swap program can make more assets available in greater amounts.
By itself a swap dApp is very basic and not suitable for large-scale use. But by connecting it with other programs, it quickly becomes much more capable.
As such, the DeFi ecosystem is likely to experience exponential growth over the coming years as more dApps emerge and connect.
DeFi vs CeFi
CeFi is centralised finance, which is the traditional way of doing things.
In CeFi we solve problems such as liquidity and matchmaking by entrusting them to a central authority, such as a bank or a cryptocurrency exchange.
In DeFi, these responsibilities are split up among different dApps.
The benefits of DeFi
The advantages of spitting the system up this way include:
- Security. By splitting everything up, the system loses many of its weak points and gets many redundancies.
- Competitiveness. Because anyone can build dApps to integrate with other dApps and anyone can access this system, the market for providing financial services becomes very lean, competitive, innovative and consumer-friendly.
- Virtuous cycles. The interdependence between dApps means they can keep driving value to each other and growing rapidly.
- Novel applications. There are many things you can do with blockchain and DeFi that simply can’t be done with CeFi.
- Cost-effectiveness. Because dApps can offer services autonomously, they can also offer them at much lower cost than their centralised equivalents can.
The overwhelming nature of these advantages means much of the global financial system will move from CeFi to DeFi in the coming years.
What holds a DeFi ecosystem together?
So, we have an entirely new, open, permissionless and extraordinarily effective financial system built on the Internet, composed of countless dApps.
But what keeps it growing and what prevents it from falling apart?
There are two main things: a circular economy and blockchain technology itself.
1. A circular economy
The first bit of glue holding DeFi together is the mutual driving of value. In other words, if money keeps circulating it keeps working, just like any other economy.
In the case of the above example, the swap dApp might pay a service fee to both the pricing oracle and liquidity pool for their services, which can then pay it on further. For example, the pricing oracle might re-invest in network security, while the liquidity pool pays people interest on their deposits into the pool.
With all the elements harmoniously working together, paying and receiving fees from each other, the DeFi ecosystem can become financially self-sustaining.
It can also become very profitable for people who have invested in the creation of the best and most widely used dApps as they can often pick up a portion of the revenue earned by those systems.
New value enters the system from two main places:
- Deposits. People deposit funds into the system to earn interest from it being put to work in the DeFinancial system, similar to how people earn interest in bank savings accounts by putting their money to work in the traditional financial system.
- Practical blockchain applications. Applications such as data marketplaces, games, accounting software, distributed computing services and much more are all part of the DeFi landscape and can collect fees for service.
In this way, the endless drive to capture value in the DeFi ecosystem means everyone’s incentives are aligned around creating and supporting the most genuinely useful dApps.
The second thing holding DeFi together is blockchain itself.
The reason dApps work so reliably and can integrate so seamlessly with each other is that they’re based on blockchain technology. This means they’re fully transparent, that anyone can look at their programming to see exactly how they work and that they are guaranteed to follow their programming.
As a result, dApps can instantly trust each other and start doing business together without needing to hire lawyers, sign contracts and so on.
This is made possible through underlying blockchain protocols which support dApps and let them communicate with each other. In the end, the DeFi ecosystem is only as secure as the blockchain fabric supporting it.
Today the most popular blockchain fabric is the Ethereum blockchain, which hosts a wide range of DeFi dApps.
HOW ARE BLOCKCHAINS SECURED?
Blockchains are secure because they require resources to use and operate. These resources can be almost anything a computer can do.
Bitcoin, for example, uses a maths problem as its resource. Computers solve maths problems to build the blockchain and create the resource needed to operate it.
Because the resource itself, Bitcoin, is valuable in its own right, lots of different people are solving those maths problems to create it. And because there are so many people building the blockchain, none of them has enough majority control to take over the construction process. That’s what makes Bitcoin secure and tamper-proof.
What many other blockchains do though and what Ethereum plans to do is simply use ownership of cryptocurrency as the resource, so holding cryptocurrency gives people permission to help build the chain.
That way, as long as the cryptocurrency is distributed widely enough, no single entity can take majority control of the blockchain and we can be reasonably sure it’s safe.
To make the cryptocurrency desirable enough that enough different people want to hold it, these blockchains are usually programmed to pay cryptocurrency dividends to holders, while balancing out that inflationary force by consuming the fees paid by users.
As an added bonus, this helps get the value flowing to create a fertile foundation for dApps to build on.
How cryptocurrency and DeFi work together
Cryptocurrencies are digital tokens for use in DeFi ecosystems. The best known are Bitcoin and Ether (the native resource of the Ethereum blockchain), but beyond them there are countless more, including many created for use in specific dApps.
The main cryptocurrency and token types include:
- Governance tokens. These entitle holders to participate in the governance of a dApp.
- Admission or gas tokens. These are used as access or to pay for services on specific dApps.
- Staking tokens. These are used as blockchain resources in areas that need a separate layer of security over the underlying blockchain fabric.
- Stablecoins. These are designed to be pegged to a fixed price, such as $1 each, for use in everyday payments. They are typically backed by some kind of collateral.
- Security tokens. These are securities, such as stocks or derivatives, which have been tokenised for use in DeFi.
- Asset-backed tokens. These are assets, such as art, cars, real estate, gold, frequent flyer points and coupons which have been tokenised for use in DeFi.
- CBDCs. Central bank digital currencies (CBDCs) are fiat currencies, such as US dollars issued by the central bank, which have been tokenised for use in DeFi.
It’s worth noting that one token can serve multiple purposes at the same time. For example, it’s common for a staking token to double as gas and there’s nothing stopping it from simultaneously being a governance token that’s collateralising a stablecoin loan for everyday payments.
Compound’s cTokens present a nice clear example of this in action. These are cryptocurrencies where interest earned accrues directly to the currency itself in real time.
With bank savings accounts, a small amount of interest is typically paid monthly to funds in the eligible account if they meet certain conditions. With cTokens, the currency itself starts multiplying in your wallet roughly every 15 seconds as it earns interest and it can still be used to make trades or other payments.
Yield farming explained
“Yield farming” is one of the major driving forces behind DeFi’s rapid growth. It’s essentially the sport of trying to maximise the interest earned on cryptocurrency by running it through DeFi dApps in new and often very convoluted ways.
For example, someone might deposit Ether as collateral into a lending platform to receive half that amount in stablecoins, then they’ll use those stablecoins to buy a low-cap cryptocurrency which they’ll lend to a liquidity pool. Or they’ll temporarily provide liquidity to a new platform in return for a cut of the platform’s newly-minted governance tokens.
The returns from yield farming can be immense, but so are the risks. In its early form, the sport of yield farming is characterised by major volatility as farmers constantly jump between whichever farm delivers the highest returns. The majority of the returns are currently being driven by high market demand for these new tokens, which is unlikely to be sustainable.
Although the most lucrative yield farming options require a farmer to jump between projects, a new frontier is emerging in platforms dedicated to making yield farming more automatic and user-friendly. Yearn.Finance, for example, pools user funds into “safe” yield farming opportunities to make it significantly easier while letting users save on gas fees.
Why DeFi is a game changer
As you can probably imagine, the rise of DeFi will likely prove to be a major occasion in financial history.
Some of the outcomes of this are quite straightforward: you can expect almost instant transfers with low and no transaction fees to become the norm and you can look forward to earning higher interest rates on your money.
And if your bank won’t pass these benefits on to you, you can just go around it and get it directly from the dApp yourself.
Other changes are less predictable. As DeFi helps break down the walls between asset classes, letting people unlock the value stored in other possessions such as home equity, it could also push all currencies onto a competitive playing field, raising questions about the future of fiat currency in this space.
DeFi and the current economic crisis could also be a portentous combination. With the “real” economy struggling and an entirely new online economy successfully emerging, it’s possible for cryptocurrencies to very quickly become the currency of choice for people around the world.
Tips and risks when investing in DeFi
With DeFi ecosystems set to grow rapidly, many people are entering in the hopes of striking it rich in the digital economy by buying cryptocurrency.
If you’re one of them, these tips and risks might help give you a sense of what to expect.
- Know the network. It’s valuable to have a mental map of the new digital landscape and an understanding of how different dApps fit together.
- Know what each cryptocurrency actually does. Pay attention to the different types of cryptocurrency and what exactly you’re purchasing with a cryptocurrency. Are you buying governance rights without caring about governance? Is it an admission token that doesn’t actually have to be used?
- Look beyond centralised exchanges. Most of the action happens outside centralised exchanges, where people trade directly from their wallets.
- Practice proper wallet safety. Diving into DeFi means you need a wallet of your own and not just an exchange wallet. Make sure you know how to use it safely. A Ledger Nano X is strongly recommended.
- Don’t underestimate compound interest. Cryptocurrency used to just be only about flipping coins to turn a profit. But these days it’s about making your cryptocurrency work for you and pulling in a long tail of compounding interest. You don’t have to trade to find DeFi profitable.
- Be prepared to lose everything. The DeFi frontier is still an experimental mashup of economics, cryptography and computer science. The results can be unpredictable and you should always consider your funds at risk.
- Mind the scams. There are countless scams in the mostly-lawless DeFi space and there will always be people trying to take advantage of beginners. Never send money to anyone unless you know exactly why you’re doing it.
- Trust no one. As above, mind the scams. Additionally, take everything you read with a grain of salt and do your own research. The idea of DeFi is still new, so there are lots of conflicting opinions on it. It’s important to do your own research and make your own judgments when entering the unknown.
- Expect volatility. The DeFi space is composed largely of over-leveraged gamblers making large bets on small-cap cryptocurrencies in an illiquid market. Exercise caution.
- There are no authorities. Legally speaking, theft and scams are still crimes in the DeFi space. But practically speaking, authorities aren’t able to enforce laws in the DeFi space. Remember that you will likely have no recourse if something goes wrong.
How to get started
Want to explore the DeFi frontier?
You will need:
- An elementary background of what Ethereum is and how it works.
- A personal cryptocurrency wallet and knowledge of how to use it safely. A combination of a Ledger Nano X hardware wallet for security, and MetaMask for usability, could be helpful for safely getting the most out of DeFi.
- Some cryptocurrency, since it’s the native currency of the Internet. The vast majority of the DeFi ecosystem is found on the Ethereum blockchain, so a sizable amount of ETH tokens is helpful for paying gas fees. Fortunately ETH is very easy to buy.