DeFi, short for decentralized finance, is a booming ecosystem of financial applications built using blockchain technology - usually Ethereum. DeFi promises a viable (and in some cases far more lucrative) alternative to traditional finance by offering faster transactions, higher yields on deposits, and full control of one’s finances. However lofty the ambitions of DeFi pioneers are, they have achieved many of their goals so far.
The term itself came about in a Telegram chat between entrepreneurs and Ethereum devs who liked its closeness to the pronunciation and spelling of ‘defy.’ After all, DeFi does exactly that - it defies the ambiguous gatekeeping and rigid hierarchy of traditional finance.
DeFi aims to tackle common issues in traditional finance, such as accessibility and transparency, with the aim of shifting control away from central authorities and towards a distributed network of users. This is achieved through the use of blockchain, an immutable, transparent, and decentralized digital ledger system, as well as smart contracts.
While Bitcoin was technically the first to decentralize an essential financial service - basic peer-to-peer transacting - it was Ethereum that truly kickstarted the movement with smart contract functionality and decentralized applications (dApps). These applications have a range of use cases, from borrowing and lending platforms, to decentralized exchanges and stablecoins.
The functionality of the innovations has afforded humanity a range of financial tools built on concepts once thought impossible. DeFi is therefore revolutionary because of several defining elements:
Participation in DeFi is open to anyone - whether as a user or a builder. Unlike TradFi with its regulations and requirements, anyone with internet access and a crypto wallet can use DeFi services. Under a permissionless system, you do not have to provide proof of identity that would otherwise exclude individuals who cannot obtain it. While this may cause some headache for law enforcement, it boosts financial efficiency to levels never before seen.
Keeping your money in a bank gives the bank custody over your assets. In DeFi, your funds are held by you via your private key and managed by a smart contract. Users therefore retain full control over their assets, which importantly prevents counterparty risk. The smart contract, which you can audit yourself for security, merely executes the designated functions, while you retain self-custody.
DeFi protocols exist on a blockchain, which means that authority is dispersed among a network of users. Many DeFi projects are also meant to be governed entirely by the community, with protocol founders eventually granting the community full governance control. Delegates may be, and in many cases are, spread out across the globe. Decentralization also serves as a hedge against single points of failure in a system.
Also a very distinct feature of DeFi and blockchain, this enables anyone to view and audit transactions and protocol code. This is one of the pillars that DeFi is built on, and is integral to mainstream adoption as it supports a degree of accountability while preserving user privacy.
Last but not least, projects within the DeFi ecosystem are optimized for interoperability and the ability to build off one another. This is largely thanks to the open-source code, allowing developers to leverage and integrate pre-existing tools into new products.
Let’s have a closer look at some DeFi use cases and notable examples!
DeFi Use Cases
There are a growing number of use cases for DeFi, especially on blockchains other than Ethereum that offer flexible smart contract functionality. This is what allows developers to build platforms with more complex functions that rival traditional financial services. At the time of writing, the total value locked (TVL) in DeFi protocols is $61B.
As the market has continued to stay hot since summer 2020, the growth potential remains quite strong. Since then, several blockchain networks have emerged as competitors, or at least as handlers of the spillover, to Ethereum. Such new entrants include BSC, Polygon, and Solana. With that in mind, assume that any DeFi project can be deployed with equal functionality on any of those networks. Let’s go through some of the major use cases for DeFi and the key players cornering that section of the ecosystem.
MakerDAO was one of the earliest DeFi projects, with its launch dating back to 2015. It has two tokens: MKR and DAI. MKR is its governance token while DAI is a stablecoin soft-pegged to the U.S. dollar. Stablecoins are cryptocurrencies whose value is linked to an external asset like fiat currency or, in the case of DAI, a basket of cryptocurrencies. Read more about stablecoins here.
The governance model of MakerDAO aims to put all the decision-making power into the hands of stakeholders. To participate in protocol governance, all you have to do is hold MKR tokens. Maker doubled-down on its commitment to true decentralized governance by announcing it would abolish the Maker Foundation altogether.
Lending protocols are another popular type of platform in DeFi, allowing any user to lend or borrow their assets. Launched in 2018, Compound Finance is a prime example of this. The smart contract automatically pairs borrowers with lenders, and the interest rates fluctuate based on supply and demand.
By supplying liquidity to the Compound protocol, lenders earn cTokens - representing their deposit - and COMP, the protocol’s governance token. COMP is distributed evenly to both borrowers and lenders, ensuring that the community has control over critical decisions.
Compound loans are overcollateralized, which means borrowers must provide an amount whose value exceeds that of the loan. If the value of collateral falls below a certain amount, it is liquidated. This is the case for most DeFi lending protocols, and allows them to operate automatically without an intermediary.
AAVE is another lending protocol that similarly uses two token types: AAVE, for governance, and aTokens, allowing users to earn interest. Unlike Compound, AAVE also offers a type of automatic, uncollateralized loan called a flash loan. This enables borrowers to forgo collateral, with the one condition being that they pay the loan back within the period of one Ethereum transaction. Failure to do this simply results in the transaction being voided.
Automated Market Making (AMM)
Uniswap is one of the leading decentralized exchanges (DEX), which initially made DeFi trading easy for investors. Founded by Hayden Adams in 2018, Uniswap is a notable example of an Automated Market Maker (AMM).
Unlike traditional exchanges that use an order book to match makers and takers, or even other DEXes that execute peer-to-peer trades between user wallets, AMMs use an algorithm to automatically assign price to assets. Liquidity is maintained thanks to LPs (liquidity providers), who pool their funds on Uniswap in return for a portion of the transaction fees.
The power of Uniswap’s AMM has been demonstrated through countless battle tests at high transaction volume and low liquidity. Advanced multi-hops also make swapping on Uniswap a smoother function than on others.
Launched in 2020, Curve Finance is also an automated market maker protocol, built specifically for trading stablecoins. As a result, it helps to reduce slippage for traders and mitigate impermanent loss for liquidity providers.
Curve Finance uses a governance token, CRV, to reward LPs and pave the way for community governance. Curve v2 will introduce the use of a dynamic peg.
Launched in 2020 by the pseudonymous Chef Nomi, SushiSwap is a fork of Uniswap - a key difference being the native SUSHI token that grants the community both governance and a share of protocol fees. Unlike on Uniswap, LPs do not need to be actively providing liquidity to passively earn fees.
SushiSwap offers a variety of functions on its platform, distinguishing it from competitors that focus purely on AMMs and swaps. Along with AMM on several chains other than Ethereum, SushiSwap also provides lending, leverage, dApp usage rewards, staking of governance tokens, public sale marketplace, and self-made liquidity pools called Onsens.
While Uniswap is its main competitor and the market's #1 DEX in on-chain swaps, Sushiswap can be considered more of a shopping mall for the DeFi trader.
The Future Of DeFi
So what next? DeFi is becoming an appealing alternative to TradFi. Not only is it a transparent, efficient, and accessible option, but it is also characterized by its composability. By this we mean that its evolution as a sector is exponential because DeFi projects can build off of its predecessors' successes.
Many DeFi protocols are also starting to aim for decentralized governance, meaning that founders and devs will eventually relinquish control over to respective communities.
However, DeFi still faces some significant challenges to mainstream adoption - problems with bugs, malfeasance or rug pulls from some bad actors, and considerably high barriers to entry. These issues make centralized exchanges more attractive than their decentralized counterparts.
And yet, DeFi is quite literally the future of cryptocurrency, with new projects consistently engaged in healthy competition with each other to provide more features and better solutions. With scalability and sustainability at the forefront of these efforts, the DeFi movement has set in motion a major socioeconomic shift.