What Is Decentralized Finance (DeFi)?
Decentralized finance (DeFi) refers to a parallel financial system built upon the blockchain. As one of the most innovative applications of blockchain technology, DeFi exploded onto the scene in a big way in 2020.
In this article, we dig deep into DeFi: how it works and how it threatens to disrupt the conventional banking and financial system (TradFi).
The Evolution of Crypto
If Bitcoin revolutionized the way that money can be exchanged, Ethereum paved the way for a rethinking of the entire financial sector.
Ethereum builds upon many of the same principles that underpin Bitcoin, such as trustlessness, permissionlessness, and decentralization. However, Ethereum went a step further by becoming the first blockchain to introduce smart contract functionality.
The code run via smart contracts is transparent and auditable on the blockchain. Once published, the programming within them runs 24/7 to automate crypto transactions on a peer-to-peer basis.
By cutting out the banks, governments, and other intermediaries who have traditionally assumed responsibility for executing transactions and for establishing ‘trust’ between parties, smart contracts appear to have obliterated many of the barriers that have historically kept millions of people around the world locked out of the financial system.
Why Is DeFi Important?
According to the latest figures from the World Bank, 1.7 billion people around the world remain “unbanked.” The overwhelming majority of those affected are women, non-binary people, and populations based in the Global South.
In TradFi’s centralized banking model, access to financial services can be denied to those unable to prove that they live within a certain jurisdiction or that they earn over a certain threshold. In fact, the sector has a long, ongoing history of excluding people based on their gender or ethnicity.
DeFi typically offers lower fees than the traditional banking sector. It also cuts out artificially long transfer times. In DeFi, users can send money around the world and have transactions confirmed on the blockchain within minutes, or even seconds. And most importantly, there are no barriers to entry - anyone with an internet connection can take part in DeFi.
How Is DeFi Used?
With nothing more than an internet connection and a crypto wallet, anyone, anywhere can now take sovereign control of their finances. You can access financial services without having to pay extortionate bank fees or compromise your personal data.
Furthermore, in this brave new financial system, there is no intermediary to expropriate funds or freeze personal bank accounts, as took place during Argentina’s financial collapse of 2001. However, please note that this is only true in DeFi protocols. In crypto, there are plenty of centralized exchanges that can and will freeze your wallet. DeFi, on the other hand, is underpinned by the “not your keys, not your crypto” motto.
Many of DeFi’s current use cases replicate those offered within TradFi. Such applications include:
Lending and borrowing. The majority of transactions within DeFi continue to fall within this category. Compound and Aave are examples of protocols that offer these services.
Trading via decentralized exchanges (or DEXs) such as Uniswap or Saber.
Staking crypto assets for interest via a protocol like Lido.fi or Ankr.
Taking out insurance policies with Nexus Mutual or Etherisc.
The innovation doesn’t stop here. Receipt or deposit tokens represent a use case that is unique to DeFi. Through this mechanism, users can continue to lend and trade upon assets while they are staked. This allows users to maintain liquidity whilst earning from their assets.
How Does DeFi Work?
There are a number of layers to the DeFi stack. This layering allows users to interact with the underlying blockchain, compatible assets, and protocols.
In the next section, we’ll go through some of the main elements of this stack and what they mean for users.
The blockchain infrastructure
Each ecosystem is defined by the blockchain technology that sits at the settlement layer, or layer one. Known as the “consensus mechanism”, there are two main approaches for ensuring that the public ledger that forms the basis of this settlement layer is secure, fair, and efficient. It is this mechanism that determines the way in which tokens are created - or mined - and validated across the system.
Proof of Work (PoW) is the mechanism used by Bitcoin. Miners use computational power to solve increasingly complex puzzles in order to receive tokens. Those who solve the problem then validate the upcoming blocks on the blockchain.
Proof of Stake (PoS) is based upon validators locking up a certain amount of the native token. To become a validator and have access to a node on the Ethereum 2.0 network, a user has to stake 32 ETH.
DeFi native assets
Each blockchain has its own native protocol asset: in Ethereum, that’s ether (ETH) and in Bitcoin, that’s BTC.
Different token standards determine how a token can interact with the underlying blockchain. Ethereum’s ERC-20 standard is used to generate new tokens in the Ethereum network. These fungible tokens can be used for anything from governance to DeFi. The ERC-721 standard, by contrast, is used for non-fungible tokens (NFTs). However, all tokens produced in the Ethereum network require the usage of ETH as a payment method for network fees.
Stablecoins are also key to the DeFi asset basket. Such tokens, like USDC or DAI, are pegged to the US dollar or other fiat currencies. They achieve two principal objectives within DeFi by:
1. Anchoring stability into an otherwise highly volatile sector.
2. Facilitating easy exchange between different DeFi tokens and protocols.
It is important to remember that not all stablecoins are made equally. Broadly speaking, there are four categories of stablecoins. These include those that are backed by either fiat or crypto collateral, those that are commodity-backed, as well as algorithmic stablecoins. Each category implies differentiated levels of risk.
Decentralized apps (dApps)
The application layer is where the rubber hits the road in terms of usability. It’s this front-end of the stack, that we interact with when we stake, exchange, or mint assets.
Driving the explosive innovation in dApps is another of DeFi’s defining features: composability.
Whereas TradFi’s approach to fintech is proprietary and exclusive, the code that sustains DeFi is open-source and publicly verifiable. Developers can freely mix and match existing code to create new applications. This capability is sometimes referred to as “money legos”.
Zerion is an example of an aggregator that uses composability to connect, and build upon, pre-existing apps. It combines protocols, such as Metamask, Compound, MakerDAO, and, Uniswap, into one offering, to create an innovative cross-portfolio tool.
Non-custodial wallets also function according to these principles of interoperability. Users can, for example, set up a wallet with MetaMask and later, using their seed phrase, import their assets into a different wallet, such as Rainbow. Always check links when using your seed phrase and remember that customer support will never ask you for your phrase.
DeFi Risks
DeFi offers you the possibility to take back control – and custody – of your finances in ways that, until recently, were unthinkable. But with great power comes great responsibility. Although governments are approaching the issue of regulation, there is no customer protection from scams, theft, or loss that are rife within this nascent industry.
Cryptocurrencies are also highly volatile. Although blockchain technology is likely to revolutionize the way that agreements and finances are managed in the future, in the short term investors and users may incur losses in the face of market downturns and unstable protocols.
More broadly, the high energy consumption of the PoW mechanisms that underpin blockchains such as Bitcoin and Ethereum 1.0 is often cited as a concern.
As ever, research, security best practices, and caution are key to engaging in this space.
Conclusion
DeFi has the potential to revolutionize the financial system, making financial tools accessible to women, non-binary people, and other marginalized communities across the world.
The best way to learn about the sector is by getting involved. If you haven’t already, try setting up a wallet and researching suitable protocols to invest in. Read up on security best practices before jumping in. And remember that if it sounds too good to be true, it probably is!
While DeFi offers users an unparalleled opportunity to build wealth, the technology is still in its infancy.
At Surge, we aim to provide a safe space for learning how to navigate crypto and Web3’s unchartered terrains. What are your thoughts on DeFi? Drop into our Discord or join the discussion on Twitter to let us know.