DeFi (Decentralized Finance) is a term for a broad range of financial services that rely on blockchain technology but go beyond mere coin trade and transfer. The idea behind DeFi is to defy all boundaries and limits that exist in modern finance and to create a comprehensive ecosystem of fair and transparent services for all use cases (exchange, gaming, insurance, fundraising, private investment, etc.).
The term itself allegedly appeared on Telegram from an exchange between Ethereum enthusiasts. They were suggesting various names for a new movement of financial DApps on Ethereum. Among other suggestions were Open Horizon, Lattice Network and Open Financial Protocols. Finally, a certain Blake Henderson said DeFi sounded good, as it “comes out as DEFY.”
Why has DeFi emerged at all? Why CeFi (traditional, centrlized finance) was not enough? To understand this and grasp the potential of DeFi, one has to be familiar with the problems of the global financial system as we know it today. These problems have been outlined on many occasions, but here is a checklist to remind:
DeFi comes to the rescue, as in it:
DeFi offers more and more use-cases in various areas to respond to needs of everyday people, business men and even artists.
Ethereum was the game-changer as it introduced smart contracts enabling the user-to-contract model suitable for decentralized applications. Various business cases emerged, in particular, ICOs. In fact, Ethereum itself started with an ICO back in 2014. Since then many projects have started via decentralized financing. It is a good idea, though bumps did occur on the road, as some fraudsters raised considerable sums of money offering little more than an executive summary of their project with buzzwords. Some promising projects got blocked by regulators, like Telegram’s TON. Some were killed by questionable code vulnerabilities, like the DAO. Yet, reputable initiatives such as Aave, Bancor, Kyber, Ren were started this way. Even the bad rap didn’t kill the idea of an ICO.
Of course there was a period when the market felt salty about DeFi but with the advent of liquidity mining platforms like Compound the situation U-turned.
Some go far enough to say that DeFi started with BTC, as it was the first ever true digital money and gave rise to blockchain-based apps (DApps).
And it is not exactly untrue. BTC does resolve many of the CeFi issues we mentioned above (true ownership and control of values). The recipe, the solution is decentralization, trustless transactions that require no intermediaries. Also, all the rules are hardcoded and no government can change them or abolish the whole thing.
According to Daniel Larimer, the founder of Bitshares, Bitcoin is a sort of a proto-DAO, a new kind of decentralized equivalent to a traditional company:
But Bitcoin has a lot of limitations that are resolved in Ethereum-based platforms and eventually in Decentralized Finance and DAOs.
DeFi skyrocketed in 2020. Why then? Hard to tell, maybe it was just the time for it to take off. The fact is that the marketcap of DeFi protocols increased 12-fold and hit a whopping $19.6 billion during what is now referred to as DeFi Summer 2020.
It was Compounds COMP that blazed the trail around May 2020 as people rushed in liquidity mining. At a certain point it looked like a bubble about to burst, but it has never happened adding credibility to the whole idea of DeFi.
Value Locked demonstrates the adoption scale of a DeFi project as the total USD value of ETH and other ERC-20 tokens locked in service smart contracts.
The demand for stable coins also surged adding to the overall hype.
In 2021 the trend persisted with DeFi being all the rage.
Stablecoins or stableassets are designed to limit volatility of cryptocurrencies. The idea is an instrument that is pegged at a 1:1 ration to some popular asset: a fiat currency, a commodity, or another crypto.
Crypto-based stablecoins like DAI are called decentralized stablecoins. Those pegged to fiat like USDC, USDT are centralized, as they still rely on the CeFi universe.
Centralized or commodity stablecoins are very popular as they allow taking the best of the two worlds: stability of a traditional asset and flexibility of a digital one.
Crypto-based stablecoins are often used by borrowing services to implement their collateral models.
Overall, stablecoins are both an asset in itself and an important element of DeFi ecosystems.
As opposed to centralized exchanges bridging the fiat world and the crypto world, DEX (decentralized exchanges) operate without any intermediaries between parties of the conversion transaction. And, they require no KYC (know your customer) identity validation procedures. Of course, the blockchain community loves DEX. Top DEX are Uniswap, SushiSwap, PancakeSwap, Balancer. Each has multiple versions by now.
Yet, DEX was not the last step and DEX aggregators emerged to allow users to find best deals even faster. 1inch, Matcha, Paraswap top the list.
By all means you have heard of Compound, Maker, Aave and Cream by now. Those top lending protocols made debt instruments available to everyone. Usually borrowing implies using your cryptocurrency as a collateral to get liquidity at an attractive rate. And people seem to love these given that by April 2021 the total borrowing volume achieved $9.7bn showing a 102-fold year-on-year increase.
As DeFi expands beyond its cradle, the Ethereum network, services allowing users to move funds between different networks become increasingly popular. Of course DEX and DEX Aggregators were first, but they have restrictions. To avoid those bridging solutions appeared. They allow moving larger volumes in a more efficient and cost-saving manner. Top services are Ren, THORChain, and Anyswap; centralized exchanges like Binance also explore the bridging options.
You could have guessed by now that high profits can be made just by putting money into various DeFi protocols that require initial liquidity. It may sound like a bubble or a Ponzi scheme, but time has proven it to be a fair and legitimate business. And there are many new opportunities arising daily with more people seeking them. It’s almost impossible to track all of them. So, aggregators or farms come to the rescue. Yearn Finance and Harvest Finance are your top search options.
Of course you know what insurance is in the fiat off-line world. Get insurance to cover the risk of breaking your leg or car, having your house robbed or flooded. As the crypto market develops the need for more security has become obvious. And this need goes beyond digital security, it is now about having your risks covered. DeFi allows creating products like that. Here are some examples: Nexus Mutual, Armor Protocol, and Cover Protocol.
Just to give you an idea of how DeFi works: John can join a DeFi platform that offers several leveraging instruments, loans, hedging options etc. John is quite familiar with cryptocurrencies and actually holds some ETH. He wants to buy a car, there is a very good offer right now, and his savings in ETH are just enough to take this one. But he expects ETH to rise soon and is very unwilling to part with it. And here are DeFi coins to the rescue. John is very likely to find a DeFi cryptocurrency service that allows getting a loan in the platform fixed-rate tokens (stablecoins, see further) against a collateral in ETH at an interest that is below an expected rise in ETH or with no interest at all, as DeFi platforms have diverse monetization models. Once getting tokens, John converts them to fiat and buys a car. Then John can repay the loan in the platform tokens to get his ETH back. So, thanks to DeFi, John kills two if not three birds with a stone: he gets a car, retains his ETH and avoids rate fluctuations as long as these do not profit him.
Of course there is a caveat. If ETH falls dramatically, John will have to refinance his loan to make sure the collateral remains within the accepted range. Otherwise he becomes exposed to the risk of losing everything depending on platform rules.
Now you are eager to start, aren’t you? Here are some suggestions on how to do it:
DeFi is still mostly about Ethereum. So gurus suggest getting a self-custody wallet that supports Ethereum-based coins. Metamask will actually do. Make sure to protect your sensitive data and you are good to go.
Stablecoins can be a safer way into the world of crypto as they are less volatile by definition. Also some are tied to understandable assets like fiat or commodities.
Like with any skill, trading takes time to learn, choose a pair of assets on a major DEX, get some and make minor moves. Try to catch the wave, surf trends, learn from the mistakes of other people and your own. Be prepared to lose and to win. Maybe get DeFi insurance?
Try decentralized prediction, indices, derivatives and other options that will surely appear.
That’s the question you are likely to be asking yourself after reading this article. Well, only you can answer it. This article covers the basics of DeFi for educational purposes alone, it does not contain any financial advice or recommendations. Cryptocurrencies and blockchain products are high-risk assets and you have to do your own research before taking any serious decision.