Decentralized Finance (DeFi) has revolutionized the crypto space. Have you ever had DeFi explained to you in a way that was unclear or didn’t make sense? “What is DeFi?” is a question that many newcomers to the industry want to answer. However, definitions vary depending on who you ask. Fear not! In this “What is DeFi? – DeFi Explained” article, we’re going to break down the fundamental concepts of decentralized finance and explore some of the common terms used in the industry.
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DeFi Explained – A Simple Explanation of DeFi
So, what is DeFi? Decentralized Finance (DeFi), or “open finance”, is a term used to describe an ecosystem of open-source technologies and financial products. DeFi operates outside of the traditional financial system without the need for intermediaries. Accordingly, anyone with an internet connection can participate.
On a fundamental level, Bitcoin could be considered as DeFi. After all, the big orange coin operates well outside of the legacy financial system. However, the term refers more specifically to a series of protocols and technologies that replicate various aspects of the traditional financial system in a trustless way. Using smart contracts, these protocols automate terms and agreements between borrowers, lenders, buyers, and sellers.
Furthermore, DeFi can be thought of as financial “lego”. This is because various DeFi apps and protocols can be interconnected and used in tandem to create advanced financial tools. For example, you could lock up some ETH in a liquidity pool with Compound Finance to take out an over-collateralized loan of DAI. Then, you could stake the DAI you borrowed in another protocol such as Synthetix or Aave to earn further interest. Moreover, this enables users to benefit from multiple revenue streams while earning multiple token rewards.
Also, DeFi users can participate in a process known as “yield farming”. Yield farming lets users jump between multiple protocols to earn the best annual percentage yield (APY) on locked assets. That said, it is worth noting that yield farming can be incredibly risky if you don’t know what you’re doing. If you want to learn more about yield farming, flash loans, and liquidity pools, check out the DeFi 201 course at Moralis Academy!
According to Coinbase, Decentralized finance (DeFi) is an umbrella term that refers to an ecosystem of “peer-to-peer financial services on public blockchains”. It enables anyone to lend, borrow, trade, and earn interest with minimal costs, regardless of wealth, status or geography. Plus, this can be achieved without intermediaries or centralized systems.
Decentralized finance means many things to many people. For example, it can be challenging to gain access to financial instruments in countries with struggling economies, hyperinflation, and prohibitive financial institutions. In some areas of the world that lack financial inclusion, DeFi acts as a tool for survival and wealth preservation.
However, DeFi has also gained notoriety for an extremely high-risk, over-leveraged type of trading and investing, known as “yield farming”. Decentralized borrowing and lending protocols such as Compound and MakerDAO enable token holders to put their assets to work. Users can lock up crypto funds to take out an over-collateralized loan or lend them out to other users to earn interest. Furthermore, many of these protocols offer a native token which can add further gains.
DeFi tokens play an essential part in incentivizing users of DeFi protocols. Many borrowing and lending platforms offer a native token as a reward for interacting with the platform. Furthermore, some of these tokens grant holders governance rights. Accordingly, these token holders can vote on proposals to make changes to the platform.
There are many different DeFi tokens. Despite the high yield that many of these platforms offer, DeFi tokens can be incredibly volatile. Popular tokens include Uniswap (UNI), Compound (COMP), PancakeSwap (CAKE), SushiSwap (SUSHI), and Avalanche (AVAX). These tokens are native DeFi tokens. However, several other tokens fall into the category of DeFi tokens. For example, Chainlink (LINK) is not a DeFi specific token. However, as a substantial number of DeFi projects rely on Chainlink oracles, the LINK token is widely considered to be a DeFi token.
Now that we’ve answered the question “What is DeFi?” it’s time to take a closer look at the DeFi ecosystem and some of the groundbreaking technologies that are gaining immense popularity. Many of these technologies have become an essential part of the landscape and have been replicated across multiple blockchains. Below, we take a look at some of the most popular elements of decentralized finance.
Decentralized Exchanges (DEXs)
A centralized exchange (CEX) like Coinbase or Binance offers custodial services, meaning that they hold your crypto assets for you. A decentralized exchange (DEX) is a non-custodial exchange whereby users can make peer-to-peer transactions by interacting with smart contracts. Generally speaking, most DEXs do not require a photo ID for signing up.
There are many different types of DEX. However, the most popular uses the automated market maker (AMM) model. AMMs such as Uniswap or PancakSwap operate without centralized order books. Instead, buyers and sellers are matched algorithmically using smart contracts.
Automated Market Makers rely on liquidity provision for decentralized token swaps. Liquidity providers can deposit tokens into a smart contract to provide assets for token swaps. Doing this enables users to make a passive income in the form of trading fees. Most liquidity pools require deposits of an equal amount of two assets. For example, a user could deposit one ETH with a value of $4,000, with 4,000 DAI, or USDC. Accordingly, DEX users can execute token swaps using this liquidity.
Although providing liquidity to liquidity pools can be a profitable endeavor, it is not without risk. It is worth noting that when providing liquidity to such DeFi protocols, you could end up with a different ratio of ETH to DAI or USDC. This is called impermanent loss. Impermanent loss occurs when the price of deposited assets changes.
Additionally, liquidity providers stand to benefit further by using liquidity pool (LP) tokens. LP tokens represent a share of a specific liquidity pool. For example, if you deposit an equal value of ETH and USDC into a liquidity pool, you might receive ETH-USDC LP tokens. These LP tokens can then generate additional value in secondary pools.
Flash loans are an advanced uncollateralized lending method. In traditional finance, lenders usually require the borrower to provide some form of collateral. Also, loans can often take a long time to be approved and require a great deal of paperwork. Furthermore, most loans are paid back over the course of weeks, months, or years.
However, flash loans work differently. WIth flash loans, borrowers do not need collateral. Also, the borrowing and repaying of flash loans happen in a single transaction in just a few seconds. Moreover, flash loans use smart contracts to execute complex transactions that define the terms of a trade. Despite flash loans being an innovative method for generating wealth from very little, they have also been used in multiple attacks to exploit ill-protected DeFi protocols.
Yield farming, or liquidity mining, is a type of crypto investment strategy whereby token users can lend out crypto and receive interest in return. By hopping between multiple protocols, users can seek the highest returns for their assets. Also, some yield farming protocols offer a specific token on top of the interest for borrowing. Many of these tokens have seen tremendous price action following the adoption of the platform. Accordingly, users of the platform have an additional incentive to borrow and lend.
Because of the volatile nature of yield farming, it can be a high-risk endeavor. Impermanent loss and wild price swings can leave investors at a loss if they’re not careful. However, those with a keen eye for trends and price movements stand to benefit from being a step ahead of the curve and maximizing their gains.
Token wrapping services and protocols enable assets to operate on multiple blockchains. For example, Wrapped Bitcoin (WBTC) takes Bitcoin (BTC) and “wraps” it so that it can operate on the Ethereum blockchain using the Ethereum ERC-20 token standard.
Bridging the gap between blockchains in this way has multiple benefits. Firstly, it enables BTC holders to take advantage of the DeFi ecosystem on Ethereum without selling their BTC. Secondly, it draws some of the immense liquidity from Bitcoin to Ethereum-based protocols.
The first wave of DeFi protocols was primarily built on Ethereum. As the number-one smart contract-enabled blockchain and the second-largest blockchain in the industry, Ethereum has paved the way for much of the development and innovation in DeFi. However, several other smart contract-enabled blockchains have risen to prominence to compete against Ethereum.
Accordingly, an array of decentralized applications (dApps) exist outside of Ethereum. Binance Smart Chain (BSC), Polygon, Solana, and Avalanche are among an ever-growing number of DeFi-centric blockchain networks. Furthermore, many decentralized applications (dApps) seek cross-chain compatibility to cater to a broader user base and draw more liquidity from multiple exchanges. Not only does cross-chain compatibility provide traders with access to a wider range of assets, but it also helps traders to avoid high gas fees during times of high network congestion. Moreover, exchanges such as SushiSwap and QuickSwap enable DeFi traders to access a range of tokens on multiple networks from one convenient location.
DeFi Explained – Risks
Despite the various advantages of DeFi, it is inherently risky. Whereas centralized custodial services take control of user funds, DeFi users take full ownership of their assets on the blockchain. While this appeals to many, it can be a challenge for some. Limited technical knowledge and understanding can put users at risk of losing their funds without the safety net of a regulated custodian. As such, consider weather or not self-custody is the right option for you.
Furthermore, as the space is largely unregulated, there are all kinds of scams and rug-pulls out there. Additionally, the technical risk of interacting with smart contract-based applications can result in a loss of funds. Accordingly, when interacting with these protocols for the first time, we recommend taking the utmost caution to avoid losses. Always do your own research (DYOR) and only invest what you can afford to lose. If you have questions about anything DeFi related, you can find a wealth of information and related topics at the Moralis Academy blog!
What is DeFi? DeFi Explained – Summary
If you’ve had DeFi explained to you in a way that was overly complex or technical, the chances are that you may be thinking that it’s not for you. However, at Moralis Academy, we want to assure you that anyone can participate in DeFi regardless of experience, status or wealth.
Decentralized finance is democratizing finance. With DeFi, a Wall Street banker has access to the same financial instruments as a farmer in rural Africa. Furthermore, DeFi promotes financial freedom in countries where capital control is rife. Many parts of many countries have little to no access to basic financial tools. This could be down to insufficient paperwork, infrastructure, knowledge, or availability. However, DeFi is inclusive and open to all. Whether you’re just trying to beat inflation, or you want to put your idle assets to work, there have never been so many options to do so outside of the traditional financial system, free from intermediaries. Also, many enterprises and financial institutions are adopting DeFi tools and services. Accordingly, DeFi is one of the key components of the mass adoption of blockchain and crypto.
DeFi, crypto, and blockchain are at the forefront of a shifting financial paradigm. If you want to learn about the foundations of decentralized finance, be sure to check out the Ethereum 101 course at Moralis Academy. Also, don’t forget to follow us on Twitter @Moralis.Academy. We’d love to hear your thoughts about this “What is DeFi? – DeFi Explained” article!