DeFi is an abbreviation for “decentralized economy”, an umbrella term for a variety of financial applications in cryptocurrency or blockchain that are aimed at disrupting financial intermediaries.
DeFi draws inspiration from blockchain, the technology behind the digital currency bitcoin, which enables multiple devices to keep a copy of a transaction history, which means that it is not controlled by a single central source. This is important because centralized systems and human gatekeepers can limit the speed and sophistication of transactions while offering users less direct control over their money. DeFi is distinctive as it expands the use of blockchain from simple value transfer to more complex economic use cases.
Bitcoin and many other digital assets stand out from older digital payment methods, such as those operated by Visa and PayPal, by removing all intermediaries from transactions. When you pay with a credit card for coffee at a coffee shop, a financial institution sits between you and the business in control of the transaction and retains the authority to stop or pause it and register it in its private ledger. With bitcoin, these institutions are cut out of the picture.
Direct purchases are not the only type of transaction or contract that is monitored by large companies; Financial applications such as loans, insurance, crowdfunding, derivatives, betting and more are also in their control. Closing intermediaries from all types of transactions is one of the main benefits of DeFi.
Before it was usually called decentralized financing, the idea of DeFi was often called “open economy”
Most applications called “DeFi” are built on top of Ethereum, the world’s second largest cryptocurrency platform, which differs from Bitcoin in that it is easier to use to build other types of decentralized applications in addition to simple transactions. These more complex economic use cases were even highlighted by Ethereum creator Vitalik Buterin as early as 2013 in the original Ethereum White Paper.
This is because Ethereum’s smart contract platform – which automatically executes transactions if certain conditions are met – offers much more flexibility. Ethereum’s programming languages, such as Solidity, are specifically designed to create and distribute such smart contracts.
For example, suppose a user wants their money sent to their friend next Tuesday, but only if the temperature rises above 90 degrees according to weather.com. Such rules can be written in a smart agreement.
With smart contracts at its core, dozens of DeFi applications work on Ethereum, some of which are explored below. Ethereum 2.0, an upcoming upgrade to Ethereum’s underlying network, can boost these apps by cutting out Ethereum’s scalability issues.
The most popular types of DeFi applications include:
- Decentralized Exchanges (DEX): Online exchanges help users exchange currencies for other currencies, whether US dollar for bitcoin or ether for DAI. DEX is a hot type of exchange that connects users directly so that they can trade cryptocurrencies with each other without relying on an intermediary with their money.
- Stablecoins: A cryptocurrency linked to an asset outside the cryptocurrency (for example, the dollar or the euro) to stabilize the price.
- Lending platforms: These platforms use smart contracts to replace intermediaries such as banks that handle lending in the middle.
- “Wrapped” bitcoins (WBTC): A way to send bitcoin to the Ethereum network so that bitcoin can be used directly in Ethereum’s DeFi system. WBTC allows users to earn interest on the bitcoin they lend through the decentralized lending platforms described above.
- Prediction markets: Markets to bet on the outcome of future events, such as elections. The goal of DeFi versions of prediction markets is to offer the same functionality but without intermediaries.
In addition to these apps, new DeFi concepts have emerged around them:
- Return: For savvy traders who are willing to take risks, there is yield cultivation, where users scan through various DeFi tokens in search of opportunities for greater returns.
- Liquidity break: When DeFi applications attract users to their platform by giving them free tokens. This has been the liveliest form of yield farming to date.
- Compatibility: DeFi apps are open source, which means that the code behind them is public for all to see. As such, these apps can be used to “compose” new apps with the code as building blocks.
- Money legos: To put the concept of “compatibility” in a different way, DeFi apps are like Legos, toy blocks click children to build buildings, vehicles and so on. DeFi apps can in the same way be buttoned together as “money legos” to build new financial products.
Lending markets are a popular form of DeFi, which connects borrowers to lenders of cryptocurrencies. A popular platform, Compound, allows users to borrow cryptocurrencies or offer their own loans. Users can make money from interest to lend their money. Compound sets the interest rates algorithmically, so if there is higher demand for borrowing a cryptocurrency, the interest rates will be pushed higher.
DeFi lending is security-based, which means that in order to take out a loan, a user must provide security – often ether, the symbol that drives Ethereum. This means that users do not give out their identity or associated credit points to take out a loan, which is how normal, non-DeFi loans work.
Another form of DeFi is stablecoin. Cryptocurrencies often experience sharper price fluctuations than fiat, which is not a good quality for people who want to know how much their money will be worth a week from now on. Stablecoins link cryptocurrencies to non-cryptocurrencies, such as the US dollar, to keep the price under control. As the name suggests, stable coins aim to provide price stability.
One of the oldest DeFi applications living on Ethereum is a so-called “prediction market”, where users bet on the outcome of any event, such as “Will Donald Trump win the 2020 presidential election?”
The participants’ goal is obviously to make money, although predictive markets can sometimes predict results better than conventional methods, such as elections. Centralized markets for forecasting with good results in this regard include Intrade and PredictIt. DeFi has the potential to increase interest in predictive markets, as they are traditionally broken by governments and often shut down when operated in a centralized manner.
Frequently asked questions about DeFi
How do I make money with DeFi?
The value locked into Ethereum DeFi projects has exploded, with many users reportedly making a lot of money.
Using Ethereum-based lending apps, as mentioned above, users can generate “passive income” by lending their money and generating interest on the loans. Yield cultivation, described above, has the potential for even greater yields but with greater risk. It enables users to leverage the lending aspect of DeFi to put their cryptocurrencies to work and generate the best possible returns. However, these systems tend to be complex and often lack transparency.
Is it safe to invest in DeFi?
No, it’s risky. Many believe that DeFi is the future of financing and that investing in disruptive technology early on can lead to massive profits.
But it is difficult for newcomers to distinguish the good projects from the bad ones. And it has been very bad.
As DeFi has increased in activity and popularity until 2020, many DeFi applications, such as YAM coins, have crashed and burned, sending the market value from $ 60 million to $ 0 in 35 minutes. Other DeFi projects, including Hotdog and Pizza, faced the same fate, and many investors lost a lot of money.
In addition, DeFi bugs are unfortunately still very common. Smart contracts are powerful, but they cannot be changed when the rules are embedded in the protocol, which often makes bugs permanent and thus increases the risk.
When will DeFi become mainstream?
As more and more people are drawn to these DeFi applications, it is difficult to say where to go. Much of it depends on who thinks they are useful and why. Many believe that various DeFi projects have the potential to become the next Robinhood, which attracts new users by making financial applications more inclusive and open to those who do not traditionally have access to such platforms.
This financial technology is new, experimental and is not without problems, especially in terms of security or scalability.
Developers hope to eventually fix these problems. Ethereum 2.0 can handle scalability issues through a concept called sharding, a way to split the underlying database into smaller chunks that are more manageable for individual users to run.
How will Ethereum 2.0 affect DeFi?
Ethereum 2.0 is not a panacea for all of Defi’s problems, but it’s a start. Other protocols such as Raiden and TrueBit are also in the process of further addressing Ethereum’s scalability issues.
If and when these solutions fall into place, Ethereum’s DeFi experiments will have an even better chance of becoming real products, possibly even becoming mainstream.
Bitcoin as DeFi
While Ethereum is the best dog in the DeFi world, many proponents of Bitcoin share the goal of cutting the middle ground from more complex financial transactions, and they have developed ways to do so with the Bitcoin protocol.
Companies such as DG Labs and Suredbits work, for example, with a Bitcoin DeFi technology called discrete logging (DLC). DLC offers a way to execute more complex financial contracts, such as derivatives, using Bitcoin. One use case of DLC is to only pay bitcoin to someone if certain future conditions are met, say, if the White Sox wins their next baseball game, the money will be distributed to the winner.