Decentralized finance (DeFi) is a sector within the cryptocurrency industry focused on providing decentralized financial services. It consists of numerous financial services created by developers that anyone can access. These services differ from centralized alternatives, as they are run by groups of individuals through decentralized organizations and give users greater control over their funds.
The DeFi sector is a hotbed of innovation with new decentralized and non-custodial financial services being added every week. Anyone can take advantage of these services from anywhere in the world.
According to World Bank data from 2017, about 1.7 billion adults around the globe were estimated to be unbanked — without an account at a financial institution. Financial services on DeFi protocols have no entry requirements, so anyone can have access to financial services through it. The only entry barrier, in essence, is the know-how.
The DeFi ecosystem is built on top of public distributed networks and uses self-executing agreements written into lines of code called smart contracts, ensuring that access to financial services is democratized.
What’s so special about Defi?
DeFi has several key features.
First, it's "open," meaning you can use the applications by creating a wallet—often without displaying any identifying information, such as name and address. That's theoretically (if not technologically) simpler than having a bank account.
Second, you can move funds around near-instantaneously via a blockchain, so no waiting for the bank transfer to clear.
Third, the rates (for now, at least) are much better than at traditional banks, though transaction costs vary depending on the blockchain network.
Last, DeFi applications work together like “money Legos." This "composability" allows anyone to create, modify, mix and match, link, or build on top of any existing DeFi product without permission. Unfortunately, this feature may also be DeFi’s biggest weakness, because if a key component, such as the DAI stablecoin, becomes vulnerable or corrupted, the whole ecosystem built around DAI may come crashing down.
What can we do with DeFi?
There are three basic types of DeFi applications.
If you own cryptocurrency, you can lend it to a protocol such as Aave or Compound in exchange for interest and/or rewards. Likewise, you can borrow digital assets from such a protocol, which is particularly useful if you want to make a trade. Be careful, though! Most DeFi protocols use over-collateralization, meaning you must put up more than the amount you want to borrow; if the asset's value falls too much, the protocol may take your collateral to avoid losses.
Many DeFi users utilize this as a way to earn assets through "yield farming," in which they lock up funds in a pool of assets to get rewards. Since rates vary depending on protocol and asset, skilled yield farmers move their assets to capitalize on the best rates.
With centralized exchanges such as Coinbase and Binance, you rely on the exchange to take custody of your assets with each trade. Decentralized exchanges remove the intermediary so people can trade directly with one another. Moreover, DEXes such as Uniswap and PancakeSwap allow people to list new tokens for trading. The lack of vetting increases the risks, but it also allows people to "get in early" on new assets before they hit wider markets.
Sometimes you don't want to be limited to trading particular coins or tokens. Derivatives platforms such as dYdX and Synthetix allow people to do more than spot trading. For example, users can make leveraged trades in which they bet more than they have, or even create "synthetic assets" that mimic traditional stocks and commodities.
How are DeFi applications produced?
Anyone capable of writing smart contracts is able to create DeFi applications. There are several tools for testing and/or deploying smart contracts, among them Truffle and Ganache for Ethereum. After downloading a framework to build smart contracts, you can create a token that allows a protocol to utilize the blockchain network. On Ethereum, this is an ERC20 token; on Solana it's called SPL; and Binance Smart Chain has BEP20s.
Having a token allows the protocol to interact directly with the layer-1 blockchain's coin. But projects have also promoted their tokens to push decentralization. Lending protocol Compound, for instance, uses COMP as a governance token; those who hold it get to make decisions about the protocol's code and treasury allocations.
How do we use DeFi products?
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. Most DeFi dapps do not require users to give up any personal information or register.
However, because the applications are built atop a blockchain, you must use that blockchain's coins to pay for transactions. ETH is required in order to pay for transactions on the Ethereum network, SOL is necessary on the Solana blockchain, and so forth.
The Future: Staying Safe
The DeFi sector is exploding with innovation and, as was the case with initial coin offerings (ICOs), malicious actors try to take advantage of users maximizing their earnings through all sorts of schemes.
It’s important to determine whether a DeFi application has been audited before using it, but there are several questions users need to ask themselves before interacting with a protocol or buying its governance token.
Triple-digit annual percentage yields (APYs) aren’t unheard of in the DeFi space, partly because of the possibilities associated with yield farming. However, a golden rule of investing is that risks equal rewards: Above-average APYs are normal, but if they are too good to be true, a deeper look is necessary.
That deeper look would involve researching the team that originally created the DeFi protocol. Before protocols move to become DAOs, a centralized team works on its smart contracts. It’s not uncommon for anonymous teams to develop projects, so the best way to gauge whether the team can be trusted or not is to analyze their transparency as to what’s being done in the protocol.
Finally, it’s important to understand if the project’s community is authentic. Deploying bots on social media to hype up a project has been done before, but an active community that openly discusses governance proposals, future implementations, user experience and more cannot be faked.
Open-source projects like DeFi Score have been created to quantify risks in permissionless lending protocols on DeFi. These can help users understand how they should access the risk in these protocols.