DeFi is an abbreviation of the phrase decentralized finance which generally refers to the digital assets and financial smart contracts, protocols, and decentralized applications (DApps) built on Ethereum. In simpler terms, it’s financial software built on the blockchain that can be pieced together like Money Legos.
To get a feel for the products and services that exist in the Ethereum DeFi ecosystem, you can check out our DeFi rankings which tracks the current value locked into popular DeFi smart contracts.
Computers have disrupted nearly every industry over the years. Each innovation builds on the previous one, and digital products and services become more sophisticated. Through technology, we’ve catered the world to fit our needs. From digital assistants to home automation, programs now affect many aspects of your daily life. So why would money be any different?
What is decentralized finance and who is it for?
To better understand DeFi, we should first take a look at how traditional finance came about. Although it sometimes feels like money has always been around, that’s simply not the case.
Humans originally bartered for the goods and services. But as human societies formed and developed, so did our economies. We invented currency to make exchanging things of value easier. Subsequently, currency helped usher in new innovations and higher levels of economic productivity. However, progress didn’t come without its cost.
Historically, central authorities such as governments have issued the currencies that underpin our economies. Central banks and institutions were expected to carefully manage and regulate the supply of currency in circulation. As the size and complexity of our economies grew, these central authorities gained more power as more people placed trust in them.
You trust your government to not print more money overnight. You trust your bank to safely store your money. And, when it comes to investing, you trust your assets to a financial adviser. By handing control of your money over to others, you hope to earn a profit. But the sad truth about our current financial system is that the power that comes along with this trust isn’t always rewarded.
We often have very little say in how corporations handle our investments, or even how our governments manage the economy. And in most cases, investors only receive a fraction of the returns generated from the risks taken by these central authorities.
DeFi is trying to build something different
Decentralized finance aims to create a financial system that’s open to everyone and minimizes one’s need to trust and rely on central authorities. Technologies like the internet, cryptography, and blockchain give us the tools to collectively build and control a financial system without the need for central authorities.
There’s a saying in the blockchain space: “Don’t trust, verify.” Because with a blockchain network, you as an individual can verify any and every transaction that occurs on the blockchain.
DeFi allows everyone to take charge of their financial well-being
Almost all DeFi applications are built on the Ethereum blockchain, the world’s most popular programmable blockchain. Ethereum is a blockchain network that maintains a shared ledger of digital value. Instead of a central authority, the participants that comprise the network control the issuance of ether (ETH), the network’s native cryptocurrency, in a decentralized manner.
Developers can program applications on Ethereum that can create, store, and manage digital assets, also called tokens, on the blockchain. These are called smart contracts or decentralized applications (DApps). They’re contracts or agreements enforced by the Ethereum blockchain. Or rather, applications or scripts that run only as programmed on the Ethereum network. You can build complex irreversible agreements without the need for a middle man.
Decentralized finance has the opportunity to bring about a more resilient and transparent financial system. Anyone with an internet connection is able to access and interact with smart contracts built on the Ethereum blockchain. Many smart contracts are built to be open-source and interoperable with existing smart contracts. So, users can verify the smart contracts’ code and choose which services work best for them.
What are some examples of popular DeFi applications?
There are many different DeFi products and services, some of which you may find familiar to existing financial services but with a decentralized twist.
Arguably, the most popular and fasting growing sector of DeFi is borrowing and lending platforms. Similar to a bank, users deposit money and earn interest from other users borrowing their assets. However, in this case the assets are digital and smart contracts connect the lenders to borrowers, enforce the terms of the loans, and distribute the interest. And it all happens without the need to trust one another or middleman bank. And, by cutting out the middleman, lenders can earn higher returns and more clearly understand the risks thanks to the transparency blockchain provides.
Tokens called stablecoins are also important to the DeFi ecosystem. You may be under the impression that all cryptocurrency is volatile. However, stablecoins are tokens designed to hold a specific value and are typically pegged to fiat currency like the US dollar. For example, DAI is a stablecoin pegged to USD and backed by ether (ETH). For every DAI, there is $1.50 of ETH locked into the MakerDAO smart contract as collateral.
Another type of popular DeFi application is what’s called a decentralized exchange, or DEX for short. DEXes are cryptocurrency exchanges that use smart contracts to enforce the trading rules, execute trades, and securely handle funds when necessary. When you trade on a DEX, there is no exchange operator, no sign-ups, no identity verification, or withdrawal fees.
DeFi is like smart money Legos
With Legos, you start out with a bunch of small bricks. It’s up to you how you piece together the Lego bricks to build something new. The same is true about smart contracts. With each new project, product, or service launched on Ethereum, you have one more money Lego in your collection. And by piecing together existing components of DeFi, you can combine, modify, or create powerful new finance tools out of these money legos.
cDAI is a perfect example of money Legos in action. Compound is a money market or, in other words, a lending service on Ethereum. When you supply DAI to Compound, you receive cDAI tokens which represent both your DAI in Compound and any interest you’ve earned from lending. Since cDAI is a token, you can send, receive, or even use cDAI in other smart contracts. Money Legos in action: ETH into MakerDAO to mint DAI tokens, DAI being supplied to Compound, cDAI tokens can be used in other DApps.
For example, you can swap ETH for cDAI on a DEX and instantly start earning interest for just holding cDAI. And because you choose how you interact with smart contracts on the blockchain, you can use a DEX aggregator like DEX.AG to compare and trade at the best prices across all the popular DEXes, all within seconds.
*Decentralization may vary
There are varying degrees of decentralization when it comes to DeFi services. Because the truth is, not everything can be or needs to be fully decentralized.
As previously mentioned, stablecoins are popular in DeFi. But, not all stablecoins are as decentralized as DAI. Many of them are actually tokens representing fiat currency deposits. For example, for every USDC token, there is 1 USD being held in a bank somewhere. You can theoretically “tokenize” or create a token to represent any real world asset. This is where things become a little less black and white, because while you can trade, send, and receive these tokens on the blockchain, you cannot completely eliminate the need to physically manage or redeem the real world asset.
Take for example, purchasing a home on the blockchain. Say someone tokenizes the deed to their home, places it on a decentralized exchange, and you buy it. Without the proper legal setup and the law on your side, you cannot simply force this person from their home regardless if you own the digital version. As it currently stands, you’d need to fall back on the court system of your home country to settle the dispute.
In short, there are limitations to the technology and sometimes the lines of DeFi begin to blur. In due time, laws will adapt to the changing financial landscape and DeFi’s place in the world will become clearer. That being said, one thing is clear: DeFi is here to stay.
DeFi isn’t stopping anytime soon
If you believe the future has digital money, then come explore what DeFi has to offer. At the time of writing this, the entire decentralized finance market is worth $494.6M. Ethereum has become the blockchain of choice for many companies to build their financial products. And more and more DeFi applications are built every day.
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