What is DeFi? A Beginner’s Guide to Decentralized Finance

CONTENTS:

1. What is Decentralized Finance (DeFi) Summary
2. Understanding Decentralized Finance (DeFi)
   • A Brief History of Decentralized Finance (DeFi)
   • What is Decentralized Finance (DeFi)?
   • How does Decentralized Finance (DeFi) work?
   • Decentralized Finance (DeFi) Use Cases
   • DeFi Adoption – The DeFi Pulse
3. DeFi Pros and Cons
4. FAQs
   • What is the difference between Centralized Finance (CeFi) and Decentralized Finance (DeFi)?
   • What can I do with DeFi?

1. What is DeFi Summary

Decentralized Finance (DeFi) was first envisioned by Nick Szabo in his 1996 essay: Smart Contracts – Building Blocks for Digital Markets. The objective of Nick Szabo and most cypherpunks was to build an economy in which governments and institutions were unnecessary. An economy that is open, transparent, and trustless, powered by code (smart contracts) rather than third parties. 

Bitcoin sparked the revolution by decentralizing money, while Ethereum pioneered smart contracts and the ability to create decentralized apps (dApps) without a centralized authority. This provided the necessary infrastructure (Base Layer or Layer 0) for the establishment of a new financial system.

However, the DeFi term didn’t appear until a telegram conversation sparked amongst ETH developers and crypto entrepreneurs in 2018. They were looking for a term to describe this new financial system, which uses cryptocurrencies, blockchain technology, “programmable money (smart contracts),” and DApps to create decentralized exchanges, lending services, insurance firms, prediction markets, asset management solutions, and other services.

How does Decentralized Finance (DeFi) work? To build our new decentralized financial system, we’ll need many layers or “money legos” that may be combined to create new products and services. The layers or DeFi components are as follows:

• DeFi Component #1: Base Layer (Layer 0) – Infrastructure (Blockchain, DLT). The first thing we need is an infrastructure or platform. Smart contracts and dApps platforms such as Ethereum (ETH), Binance Smart Chain (BSC), and Algorand (ALGO) serve that purpose. 

• DeFi Component #2: Protocol Layer (Layer 1 & 2) (Backend). The Protocol layer serves as the system’s backend or rules. The first requirement is decentralized stable money (DAI by Maker). The ability to borrow and lend cryptocurrencies is the second requirement (e.g., Compound).

• DeFi Component #3: Application Layer (Layer 3) – Financial Services (DApps). Once we have the backend we need the frontend or user interface (UI) to provide decentralized financial services. Uniswap, Augur, and Syntethix are examples of dApps. 

• DeFi Component #4: Aggregation Layer (Layer 4) – Liquidity. Finally, we need a way to manage, optimize, connect, and aggregate such dApps. Examples include Yearn.finance and Balancer

The DeFi industry is one of the most rapidly growing sectors in cryptocurrency ($76B Total Value Locked according to DeFi Pulse). There are a plethora of use cases such as decentralized stable money, borrow & lending, decentralized exchanges (DEX), crowdfunding, asset management, insurance, real estate, and prediction markets. Anything you can think of that is currently given by a central financial institution might now be delivered by a decentralized financial dApp.

Decentralized Finance (DeFi) offers the opportunity to design a whole new financial system that is more open (permissionless), transparent, secure (robust), and censorship-resistant. DeFi provides higher returns than banks and can be a profitable avenue for wealth generation.

However, DeFi is a nascent financial system with a few challenges and a lot of work ahead of it. Scalability (Low performance), increased accountability (freedom is not free), bad user experience, and an unregulated ecosystem with high volatility and risk are the current challenges of DeFi. 

Keep on reading to learn more about our future financial system!

2. Understanding DeFi

In this section, we will trace the roots of decentralized finance (DeFi), explain what it is, how it works, and discuss its wide range of applications and rapid adoption.

A Brief History of Decentralized Finance (DeFi)

Although Bitcoin can be considered the first DeFi platform, the concept dates back much further. In his 1996 essay: Smart Contracts – Building Blocks for Digital Markets, computer scientist Nick Szabo, envisioned a decentralized economy run by code (smart contracts) instead of third parties. He didn’t use the term DeFi, but he was pointing in that direction. 

Decentralized Finance (DeFi) cannot be comprehended without mentioning Bitcoin, Blockchain, and, most notably, Ethereum.

Bitcoin (2009): In 2009, an anonymous developer called Satoshi Nakamoto published the Bitcoin whitepaper, titled “Bitcoin: A Peer-to-Peer Electronic Cash System.”

Satoshi invented the first cryptocurrency, as well as the first DeFi platform, which enables money to be transferred over the internet using the Blockchain, a new groundbreaking technology (digital ledger), rather than a third party. 

However, Bitcoin’s main application is money and payments. Bitcoin programming language, Script, has limited features. In other words, is Turing incomplete. 

A new solution was needed to increase the capabilities of the Blockchain. Enter…

Ethereum (2013): In 2013, programmer Vitalik Buterin published the Ethereum whitepaper, which was brought to life by the Ethereum Foundation in 2015 after raising over $18 Million in one of the most successful ICOs to date. 

Ethereum brings Nick Szabo’s idea of a decentralized economy to fruition. Ethereum enhanced the Blockchain’s potential by making it programmable or Turing complete. Ethereum is an open platform that enables anyone to run code (smart contracts) and create decentralized apps (dApps) without the need for centralized authority.

DeFi wouldn’t exist without Ethereum. Ethereum is the primary platform for the majority of DeFi protocols and apps.

NXT Asset Exchange (2014): The first cryptocurrency exchanges, such as Bitcoinmarket (2010), were centralized (CEX). Centralized exchanges face the same issues as all centralized solutions, such as massive hacks (e.g., Mt. Gox 2014 $460 million hack), corruption, mismanagement, control (censorship), and fragility. It was evident that the decentralized ideas of Bitcoin (money) and Ethereum (economy) needed to be applied to exchanges. NXT Asset Exchange was one of the first decentralized exchanges (DEX). Others include Counterparty and Block DX. 

NXT Asset Exchange used the NXT ecosystem to create assets that reflected things like bonds or shares. It was, however, relatively limited in that assets could only be traded for the NXT coin. NXT Asset Exchange is currently inactive.

Note: The Open Finance movement includes centralized solutions (e.g., CEX) as well as decentralized solutions (e.g., DEX) to create a stronger financial system.

Maker (2014): Another major breakthrough was Maker (MKR). Some even regarded it to be the true beginning of DeFi. Maker is an Ethereum-based protocol that allowed the creation of the first decentralized stablecoin, DAI. DAI is a cryptocurrency that tracks the price of the U.S. dollar. Maker pioneered decentralized lending by allowing Ether and later other altcoins to be used as collateral to borrow DAI. Maker was launched in 2017.

AAVE (2017): One of the first and most popular borrowing and lending platforms is AAVE. AAVE was launched on the Ethereum blockchain during the 2017 ICO craze. AAVE enables users to lend, borrow, and earn interest on crypto assets without the use of a middleman. Other popular crypto lending platforms (dApps) include dYdX

Synthetix (2017): Another product from the 2017 ICO craze, Synthetix, was one of the first liquidity protocols for derivatives. Synthetix is a platform that allows users to create and exchange crypto assets (synths) that track the value of non-crypto assets, such as commodities, forex, indexes, and other instruments.

Defi Term coinage (2018): DeFi was coined in August 2018 after a telegram conversation amongst ETH developers and entrepreneurs such as Inje Yeo of Set Protocol, Blake Henderson of 0x, and Brendan Forster of Dharma. They were looking for a name that represented the decentralized economy envisioned by Nick Szabo and set in motion by Ethereum. Among other alternatives were Open Horizon, Lattice Network, and Open Financial Protocols. 

Uniswap (2018): Another major breakthrough in the decentralized exchange (DEX) space was Uniswap. Uniswap is one of the largest decentralized exchanges by trading volume built on Ethereum. Uniswap pioneered the automated market maker (AMM) system which relies on a user-to-contract model based on liquidity pools instead of an order book. Uniswap runs entirely on smart contracts, each token is coupled with ETH, ensuring there’s always enough liquidity between any two tokens. Aside from trading, any user can contribute liquidity to a pool and receive exchange fees.

Augur (2018): Augur is the first prediction market built on top of Ethereum. In a prediction market, users wager on the outcome of events and can exchange a portion (share) representing the value of those outcomes. Augur was one of the first altcoins to seek funds through an initial coin offering (ICO) in 2015.

Compound (2020): Despite the fact that it was founded in 2018 as another decentralized lending platform similar to AAVE, the real innovation came in 2020 when it launched its liquidity mining program of governance comp tokens. The additional incentive in the form of comp tokens caused supply and borrow APYs for various tokens to skyrocket. This enabled the development of Yield Farming.

Yearn.Finance (2020): Yearn Finance operates as a lending aggregator or yield optimizer. It is one of the first yield farming solutions, automatically switching between lending and liquidity pools to find the best yield.

Balancer (2020): Balancer is an asset manager as well as a decentralized exchange (DEX). The main difference with other DEXs is that it lets anyone create something like an ETF (an index fund made up of crypto assets) that automatically rebalances to keep the same ratio. 

As you can see, a complete financial system is being built. Other important DeFi solutions worth mentioning are Curve Finance (DEX based on stablecoins), 0x (DEX), YAM Finance (yield farming), Sushiswap (DEX), Pancakeswap (BEP-20 DEX), and PoolTogether (no-loss saving game).

What is Decentralized Finance (DeFi)? 

Decentralized Finance (DeFi) is a new financial paradigm that aims to eliminate financial middlemen (third parties) and create a digital economy that is decentralized, open, and transparent. To put it another way, it aspires to create a decentralized digital economy free of central authority or financial institutions. 

To do so, DeFi uses cryptocurrencies, blockchain technology, “programmable money (smart contracts)” and Dapps to build decentralized exchanges, lending services, insurance firms, prediction markets, asset management solutions, and other services. In other words, DeFi relies on code instead of a middlemen (e.g., Banks). 

Note: Some DeFi experts consider centralized solutions like Centralized Exchanges (CEX) to be part of the movement as well. Others prefer the term Open Finance to avoid contradicting the goal of decentralization. The terms CeFi (Centralized Finance) and DeFi (Decentralized Finance) are also used to differentiate between the two. Regardless, centralized solutions are available and can be used to participate in the crypto economy.

How does Decentralized Finance (DeFi) work?

DeFi is organized by layers, with one stacked on top of the other. These layers are malleable and can be combined and mixed to generate new and intriguing possibilities.  You can arrange them in different ways, just like Lego blocks, to build new and exciting products and services. These layers are referred to as “money legos.”

Let’s build our new decentralized digital economy!

DeFi Component #1: Base Layer (Layer 0) – Infrastructure

The first piece we need is an infrastructure, a platform, or an ecosystem to build our new decentralized financial system. This platform must be programmable and capable of delivering decentralized services (dApps). The go-to platform for DeFi is Ethereum. Ethereum currently (2022) holds a 70% market share in DeFi. 

Ethereum, dubbed “the world’s computer,” is a Do It Yourself platform for developing decentralized applications (dApps). Algorand (ALGO), Avalanche (AVAX), Binance Smart Chain (BSC), Cardano (ADA), Solana (SOL), Polkadot (DOT), EOS, and others are examples of alternative platforms.

DeFi Component #2: Protocol Layer (Layer 1 & 2) – Backend

DeFi is based on smart contracts, which are basically code (ifs and thens) that runs on the blockchain. Smart contracts are adaptable, and they require protocols or guidelines to function as intended by their creators. The Protocol layer accomplishes this goal. You can think of it as the Backend.

We can distinguish between two layers: 

• Layer 1 – Stable Money
  
  
  • The first thing any financial system needs is money. Cryptocurrencies like Bitcoin and Ethereum, however, are far too volatile to be used to develop reliable financial services. To operate inside this framework, we need a more stable currency. We need stablecoins. Stablecoins are cryptocurrencies that are pegged to the value of real-world assets such as fiat currencies (DAI, USDC, Tether, etc), commodities such as gold (Paxos Gold), cryptocurrencies (Wrapped Bitcoin), or other assets. 
  • The most important Layer 1 protocol for Ethereum is Maker (MKR). Centralized stablecoins such as Tether (USDT) use fiat money reserves for maintaining a peg. This requires a central authority. Maker enables the creation of a decentralized stablecoin, DAI, that tracks the price of the US dollar and is backed by crypto collaterals (such as Ether) that are visible to anybody on the Ethereum Blockchain. Maker pioneered decentralized lending by allowing Ether and later other altcoins to be used as collateral to borrow DAI. DAI can also be bought directly from an exchange. DAI is the ideal form of money for DeFi services.

• Layer 2 – Borrow & Lending
  
  
  • Once we have money, we will need specific protocols for lending and borrowing cryptocurrencies without having to entrust our funds to a third party. These money marketplaces allow anyone to deposit cryptocurrency and earn interest on it, as well as borrow other cryptoassets against it. Smart contracts are critical in automating the storage and management of capital introduced to the platform.
  • Examples include Compound (COMP), dYdX, Aave (AAVE), etc

DeFi Component #3: Application Layer (Layer 3) – Frontend (dApps)

If the Protocol layer is the backend, the Application layer (layer 3) is the frontend or User interface (UI) for consumer-facing applications (dApps). Here reside the financial services delivered by dApps.

You can download decentralized applications (dApps) through the Apple or Google Play stores, just like you would with any other app on your phone, or connect your wallet directly on their websites. 

dApp =  Smart contracts (backend or protocol Layer) bundled together + Frontend UI (application layer). 

Examples of dApps include Uniswap, Augur, Chainlink, Synthetix, etc. 

DeFi Component #4: Aggregation Layer (Layer 4) – Liquidity

The final layer is the aggregation layer, which is made up of aggregators that aggregate the various dApps and protocols and give user-friendly interfaces for managing them.

A DeFi aggregator collects the best pricing from across the DeFi ecosystem, including DEXs, loan services, and liquidity pools, and aggregates them in one location so that users may optimize their trades. Users can also compare, analyze, and combine strategies by dragging and dropping blocks to build the optimal approach.

In other words, this is where you’ll find yield farming (yield optimization) and asset management solutions to help you manage your portfolio.

Examples include Yearn.finance, Balancer, InstaDApp, Zerion, Plasma.Finance, etc

Decentralized Finance (DeFi) Use Cases

We’ve already hinted at DeFi use cases, but we’ll elaborate on them here.

• Decentralized stablecoins: Decentralized stablecoins, such as DAI on Ethereum, which is pegged to the value of the USD, or jFIAT on Polygon, which is pegged to fiat currencies, give the stability required to provide decentralized financial services.
• Borrow & Lending: DeFi lending protocols are transparent, decentralized, and run by smart contracts rather than third parties. These have numerous advantages, including fast transaction settlement, collateralization of digital assets, no credit checks, reduced counterparty risk (trustless), etc. DeFi makes borrowing and lending more affordable, faster, and accessible to a wider range of people. Examples include Aave (AAVE) and Compound (COMP). 
• Decentralized Exchanges (DEX): These are exchanges run by smart contracts that allow users to trade digital assets directly without the need of a third party or custodian to hold their funds. Examples include Uniswap and Waves. 
• Crowdfunding: Crowdfunding platforms aim to connect ventures with investors who are eager to invest or donate money. These platforms are decentralized and usually require a cryptoasset or native currency to gain access. Examples include Growdrop and WEIFUND. 
• Asset Management: Asset management solutions give you the tools you need to manage and optimize your portfolio. Yield Farming solutions such as Yearn.finance and portfolio management tools such as Zerion are some examples. 
• Insurance: DeFi insurance refers to insuring yourself, or ‘purchasing coverage,’ against losses caused by DeFi industry events. Examples include Bridge Mutual and Bright Union. 
• Real Estate: DeFi applications are also spreading rapidly into the housing industry. For instance, RealT allows investors to use decentralized exchanges to invest in property. Other examples include D-ReiT. 
• Prediction Markets: Prediction markets allow anyone to bet on the outcome of an event. Examples include Augur. 

Note: We haven't included centralized stablecoins such as Tether (USD) or USD Coin (USDC), or centralized exchanges (CEX) such as Binance, Kucoin, and Coinbase because they aren't strictly DeFi. If you are a complete newbie, we recommend starting with CEX because they are the most beginner-friendly (for now).

DeFi Metheoric Adoption – The DeFi Pulse

The DeFi industry is one of the most rapidly growing sectors in cryptocurrency. There are a plethora of uses. Anything you can think of that is currently given by a central financial institution might now be delivered by a decentralized financial dApp.

In December 2018, the Concourse Open Community, “a community of builders, enthusiasts and researchers working towards a free, bountiful and decentralized future for all humans,” created the DeFi Pulse to keep track of DeFi developments.

What is DeFi Pulse? DeFi pulse is basically a way of tracking how much cryptocurrency has been committed to any smart contract in the DeFi space. In other words, it employs a proprietary statistic known as “Total Value Locked (TVL),“ which has become the industry standard in the DeFi market.
Here is the most current (March 2022) Total Value Locked (TVL)

Note: There is also a DeFi Pulse Index (in which you can invest) that tracks the ten most popular DeFi tokens on Ethereum. 

3. DeFi Pros and Cons

Decentralized Finance (DeFi) offers the opportunity to design a whole new financial system that is more open, transparent, secure (robust), inclusive, faster, and less expensive. However, DeFi is a nascent financial system with a few challenges.

Here are the benefits (Pros) and drawbacks (Cons) of DeFi:

4. FAQs 

What is the difference between Centralized Finance (CeFi) and Decentralized Finance (DeFi)?

Centralized Finance (CeFi) uses third parties or custodians to participate in the crypto-economy. Exchanges such as Binance, Coinbase, and Kucoin are ultimately accountable for the security of their users’ assets. These exchanges provide services such as crypto trading, lending, borrowing, staking, margin trading, and so on. CeFi, in contrast to DeFi, is regulated. CeFi offers seamless fiat currency to cryptocurrency conversions and supports multiple cryptocurrencies. CeFi disadvantages are the same as all centralized solutions: corruption, mismanagement, control (censorship), and fragility. 

We believe CeFi is critical in onboarding newcomers to the new financial system. It often offers user-friendly interfaces and excellent fiat to cryptocurrency conversion services, among other benefits that are ideal for newcomers.

Decentralized Finance (DeFi) relies on smart contracts (code) and decentralized applications (dApps) to provide financial services. In DeFi, the users are responsible for managing their own funds. In contrast to CeFi, DeFi is permissionless, open, and transparent. DeFi is an unregulated space (for now). 

What can I do with DeFi?

The first thing you need in the DeFi space is a crypto wallet to access the decentralized web or Web 3.0. 

You can use DeFi to: 

• Send Money: If you know a cryptocurrency wallet public address, you can use your crypto wallet to send any cryptocurrency anywhere in the world.
• Stake Cryptocurrencies: Proof-of-stake (PoS) consensus mechanism is used by some cryptocurrencies to validate transactions and secure their cryptocurrency ledger. You can take part in the proof-of-stake (PoS) consensus mechanism and earn cryptocurrency for validating blockchain transactions.
• Hold stablecoins: With stablecoins tied to “stable” assets such as the US dollar, you can generate passive income without having to cope with unpredictable crypto prices.
• Earn yield through CeFi: You can use CeFi platforms to lend your tokens and earn better yields than traditional banks. This isn’t really DeFi, but it’s a viable option.
• Trade tokens: You can exchange and trade your tokens via decentralized exchanges (DEXs) that operate 24 hours a day, seven days a week.
• Earn yield through DeFi: You can use DeFi platforms to lend your tokens, provide liquidity, and earn higher yields than traditional banks. 
• Crowdfund projects: You can raise funds by issuing tokens or NFTs, or you can buy them to support projects and initiatives that interest you.
• Manage your portfolio: You can put your money into DeFi index funds, such as DeFi Pulse, which invest in the top DeFi tokens. You can also manage your crypto assets portfolio in one place. 
• Purchase Real Estate: You can purchase real estate tokens and invest in real estate around the world.