Decentralised Finance (DeFi), explained

In little over a decade, the development of cryptocurrencies have spawned a parallel universe of alternative finance. Bitcoin, a payment system in which anyone can send money to a recipient anywhere in the world, was just the beginning.

Now, the digital money revolution is moving into the world of banking – and has regulators sounding alarm bells.

Imagine there were no banks – instead, there are pieces of code running a program which act like a bank and are open to everyone. They don’t require you to trust them, are censorship resistant and, most importantly, much cheaper than traditional banks.

That is the future those building decentralised finance (DeFi) applications are aiming to bring about, one which would revolutionise the entire financial system.

In the last 18 months, the idea of DeFi has mushroomed within the crypto market, growing by 1,200 percent since the end of 2020.

While estimates vary, the total value locked in DeFi reached over $189 billion as of January 2022.

What is DeFi?

DeFi harnesses three main things: cryptography, the blockchain, and smart contracts.

As with cryptocurrencies, DeFi is built on the blockchain – the decentralised, immutable, public ledger that enables all computers on a network to hold a copy of a history of transactions. The idea is that no single entity has control over or can alter the ledger.

What makes DeFi distinct from cryptocurrencies like Bitcoin is that it expands the use of blockchain from direct value transfers to more complex financial use cases.

While Bitcoin can only be used as a store of value, DeFi – powered by decentralised applications (dApps) – allow parties to exchange, lend, borrow, and trade directly using the blockchain without any intermediaries and costs.

At the core of DeFi are smart contracts, which is computer code that acts as a digital agreement between two parties.

Running on the blockchain, smart contracts automatically execute transactions if certain conditions are met, and can be used for a variety of financial protocols like issuing crypto-backed loans and paying out interest on holdings.

Smart contracts are the fuel that powers DeFi and its popular protocols like Aave, Compound, and hundreds of others. Because they’re processed on the blockchain, smart contracts can be sent automatically without a third party involved.

Most DeFi projects are built on top of Ethereum, the second-largest cryptocurrency platform, because its programming languages are specifically designed for creating and deploying flexible smart contracts. They have since expanded to other networks that use smart contracts as well, like Solana and Avalanche.

Anyone can use DeFi products by going to an application’s website and connecting with a DeFi-enabled crypto wallet (such as MetaMask on Ethereum or Phantom on Solana).

Because the apps are built on a blockchain, users then must use that blockchain’s tokens to transact. For example, Ether is required to pay for transactions on the Ethereum network and SOL is necessary on the Solana network.

What’s so unique about it?

There are several key features that make DeFi radically different from the current financial system.

For one, it’s completely open – meaning you can use the applications by creating a digital wallet, rather than requiring having a bank account.

Second, you can move funds around in almost an instant via the blockchain, reducing waiting times for bank transfers to clear.

Third, the rates – at least for now – are much more competitive than traditional banks, although transaction costs vary depending on the blockchain network (Ethereum, for example, tends to have higher fees than other blockchains).

What can you do with DeFi?

There are three basic types of DeFi applications.

Lending and borrowing

DeFi allows people on the internet to earn money similar fashion to how bankers do – by earning fees on financial services.

In most cases it’s done by providing liquidity, where investors “stake” digital currencies, only they are lending digital currencies to apps rather than to people or companies.

You can lend cryptocurrencies to a protocol in exchange for interest and/or rewards. Similarly, you can borrow digital assets from protocols to make a trade.

Most DeFi protocols use over-collateralisation, meaning you must put up more than the amount you want to borrow. So if the asset’s value plummets, the protocol may take your collateral to avoid losses.

Many advanced DeFi users utilise an investment strategy called “yield farming”, a risky practice which involves lending or staking cryptocurrency tokens to gain rewards in the form of interest. It is like earning interest from a bank account, only you’re technically lending money to the bank.

Trading

While centralised exchanges like Coinbase and Binance take custody of your assets when trading, a decentralised exchange (DEX) removes that intermediary so direct peer-to-peer trading can take place.

Popular DEXs like Uniswap and PancakeSwap allow users to list new tokens for trading as well as swap one token for another. For example, on Uniswap, a user can swap Ether for USD Coin.

DEXs work better the more liquidity they have on hand, so they compete as much on providing attractive deals for liquidity providers as they do on being affordable for traders.

Derivatives

Like with regular finance, derivatives are an essential element of any capital market, and DeFi is no exception.

Compared to lending and trading, the DeFi derivatives space remains in its infancy. While derivatives are highly regulated in the real world, DeFi derivatives can be created by almost anyone in an open and permissionless way.

Synthetix is the most popular derivative protocol in DeFi at the moment, allowing for the creation of synthetic assets that track the value of a range of tradeable things. The protocol currently supports synthetic fiat currencies, cryptocurrencies, and commodities.

The role of Stablecoins

Because crypto is volatile, it is not very practical for direct transactions like payments and loans.

For example, if an investor used Ether in a DeFi protocol to earn interest, there’s a possibility that a price drop in Ethereum offsets any yield earned.

The solution? Stablecoins, which are cryptocurrencies pegged to assets like the US dollar, to provide steady value in digital form for blockchain transactions.

Stablecoin tokens like Tether and USD Coin act as a bridge between the DeFi and centralised finance worlds, enabling investors to generate yields on their crypto assets in the DeFi market while alleviating the adverse effects of market volatility.

What are the risks?

Participating in the “wild west” of finance inevitably comes with a corresponding amount of peril.

In many cases, the people facilitating DeFi transactions are anonymous, which has led fraud to become rampant. “Rug pulls,” when developers abandon projects after investors contribute significant assets, are a notorious form of fraud in the crypto sphere, with DeFi particularly susceptible.

A poorly created smart contract could have loopholes that allow scammers to steal, or other design flaws that affect the value of assets.

Since most DeFi services aren’t insured, if a platform fails or is hacked, millions can be on the line. In 2021, DeFi investors lost at least $1.5 billion due to security issues.

Regulatory pushback

At the moment, regulation is virtually nonexistent – though that could change soon.

In August 2021, US Securities and Exchange Commission (SEC) chairman Gary Gensler called for tougher regulation, suggesting that some platforms could fall foul of securities laws.

A few months later, Gensler argued that “without protections, I fear that it’s going to end poorly.”

Thailand’s SEC has also come out in favour of regulation, suggesting that some DeFi projects could require a licence to operate in the country.

The Bank of International Settlements (BIS) has also weighed in, warning that DeFi vulnerabilities “exceed those in traditional finance” and could even threaten global financial stability.