TL;DR: DeFi is the Future — for a summary, check the last section of this article.
There are many questions surrounding DeFi, a phenomenon 3 years in the making. For newcomers, DeFi offers an exciting way to understand the impact of cryptocurrencies – the pioneering implementation of Blockchain technology, now over a decade old. For avid Crypto enthusiasts, DeFi is the new frontier, a new paradigm to make money with Crypto. As common sense dictates, it is important to understand something before plunging in and dedicating time and resources. The truth is, DeFi is very new and evolving so fast, that we all need a refresher. So, what is DeFi? And, How does DeFi work? More importantly, why is DeFi important?
DeFi is short for decentralized finance, an interconnected set of decentralized applications that recreate the financial system (with its credit, derivatives, and equities markets) on the Blockchain, imbuing this new financial system with the ethos of Crypto – its open, trustless, and permissionless nature.
There is a lot of context packed in that definition. We will answer questions like Let us take the following layers apart and tackle them one by one:
- DeFi & Blockchain
- DeFi & Ethereum
- DeFi & CeFi
- DeFi & dApps
- Summary: DeFi is the Future.
Blockchain is a topic that’s become bigger than Crypto. Although there is a whole enterprise Blockchain solutions sector, using hybrid and private Blockchain networks for a variety of use cases and industries, including banking and financial services, when we talk about DeFi we will talk about public Blockchain networks*. These include Bitcoin, Ethereum, Cosmos, Polkadot, and Cardano, among others. So, are all of these chains “DeFi”? If not, which Crypto are DeFi? Whether a particular project is part of DeFi or not has to do with its application. In each of these public networks, many are working to build versions of *open finance, peer-to-peer (P2P) finance, and lending, swapping and stablecoin protocols. Some protocols are at the development stage with no public releases, some are at the experimental stage with few users, and others have acquired product-market fit and have thousands of users every day.
So, who invented DeFi? Well, DeFi has been a concept that’s been touted in Crypto since the very beginning, as a theoretical outcome for a programmable money of the future. The first DeFi applications came to scale on Ethereum, and the word DeFi is so-closely associated with the Ethereum network that other public chain ecosystems sometimes feel the need to use a different word like TronFi for TRON and Tezfin for Tezos . That is to say, only Ethereum has protocols with product-market fit in all types of DeFi apps. Ethereum is at the forefront of DeFi development.
Since Ethereum is currently the only public Blockchain network where all types of DeFi apps can be found at scale, this is where you’d go if you want to participate in DeFi, perhaps make some money.
How to earn with DeFi? Three ways to earn in DeFi (earn yield) are depositing cryptoassets in a lending protocol like Compound
, adding liquidity to a swap market in Uniswap
, and farming yield in a liquidity mining program like those run by stable-assets protocol mStable
or the Synthethix
derivatives market. You may also participate in the minting and stabilization of DeFi stablecoins like DAI
. In fact, Ethereum’s choice of stablecoins (tether
, USD coin
) and interoperable assets from other chains like wrapped-Bitcoin (
renBTC by Ren
, others) wrapped-ZCash (
renZEC by REN
) and wrapped-DASH (
wDASH by DASH
in collaboration with StakeHound) is second to none.
The main reason for Ethereum’s DeFi success is the fact that Ethereum is the first network where smart contracts or programs running on the Blockchain were supported at scale. Solidity, the development language of Ethereum’s smart contracts, and the Ethereum virtual machine (EVM) are familiar to a large number of Blockchain developers, who form a tight-knit community. These network effects are compounded by DeFi composability, the interconnected and inter-functional nature of the DeFi ecosystem itself. This also explains why other chain ecosystems looking to bootstrap DeFi development on their networks are building Ethereum bridges or EVM-compatibility into their network architecture.
Then, are all of DeFi users in Ethereum? Virtually, yes, although these same users may also use other chains, DeFi at scale is currently happening exclusively on Ethereum. However, to be clear the answer to “who is using DeFi?” is more helpful: A subset of Ethereum users. According to research by ConsenSys , about 300k unique active addresses have participated in DeFi, so between 15–50% of active addresses in Ethereum depending on estimates for total active addresses for the same period. Other surveys support the lower end of the range, some 15–20% of Ethereum users are DeFi users. Moreover, DeFi itself is driven by “super-users” with 100+ transactions in DeFi protocols.
DeFi in some ways represents an evolution to traditional finance, or what is known in Crypto as centralized finance (CeFi). CeFi includes not only traditional banks for borrowing and lending, fund managers for chasing returns, and brokers to trade anything from stocks to commodities; but also centralized Cryptocurrency exchanges who are currently the main gateway or on-ramp for users to Crypto. The idea is that DeFi can be a better CeFi: with more censorship-resistance, with fewer barriers-to-entry, and with better-functioning markets.
CeFi argues that DeFi is too new and chaotic and users need guidance and guarantees. Some platforms like Binance famously play both sides and the middle – a hybrid they call CeDeFi*. As the largest exchange in Crypto, Binance has benefited from every pump-and-dump imaginable, and naturally, they want people to “buy DeFi” through Binance. The billion-dollar question is: Can you buy DeFi? Surely, you can buy a governance token, and many do. But this is not the point of DeFi. Since DeFi is in its early-stage, many new protocols hungry for liquidity are offering a better deal: Yield Farming. Yield Farming allows users to participate in a *liquidity mining program, and put their capital to work in a protocol in exchange for rewards in the form of governance tokens.
Of course, Binance wouldn’t be left behind and now it also offers “yield farming” through its novel Launchpool division. Users can stake Binance ecosystem tokens like BNB and BUSD and get new governance tokens, usually from clones of Ethereum dApps but running in the EVM-compatible Binance Smart Chain (BSC), a dual-chain to the now-old Binance Chain (BC), which was optimized for trading and thus cannot run smart contracts. So, essentially, that’s CeDeFi – a “walled garden” like the app stores of yore.
No doubt, confused users will stay in CeFi and CeDeFi, and great UX and safer protocols and ecosystems should be one of the main drivers of increased usage in Crypto going forward. Yet, DeFi has a superb advantage over CeDeFi – fair launches*. As DeFi has somewhat matured, many farmers have become choosy about where to park their liquidity. When a distribution of governance tokens isn’t *fair – when there are pre-mines, VC money (or Binance money/favors), or tokensales as part of the distribution – wise or “chad” farmers take a hard pass on that project/protocol. Conversely, fair launches have become some of the most significant events for DeFi farmers. DeFi isn’t about backroom deals, it’s about community-oriented protocols!
There is a lot of confusion about this. As mentioned in our definition of DeFi, DeFi is an interconnected set of decentralized applications (dApps). Basically, DeFi is a stack of financial dApps. These include:
- decentralized lending protocols: Compound , Aave , and [Cream], to name a few.
- decentralized exchanges (DEXs)*: Uniswap, Balancer, and Curve are different DEXs with an *automated market maker (AMM) model, Uniswap has great volume, Balancer adds programmability to liquidity itself with flexible multi-asset and weight-indexed pools, and Curve uses a modified bonding curve for ultra-low-slippage stable-asset trading (stablecoins different versions of wrapped assets). Other DEXs in DeFi’s new wave include community-owned SushiSwap and neo-orderbook Loopring which uses zkRoolups and off-chain relayers to keep transaction costs down.
- decentralized asset management protocols*: yEarn Finance pioneered this segment by engineering the *yVault, a smart contract running an investment strategy that can be updated by governance. Other protocols like Pickle Finance with elastic stablecoin farming and Harvest Finance that focus on auto-compounding have also entered this space. The main advantages of these protocols are saving on gas costs and 24/7 activity, but most also productize the deep research and yield-maximization strategies used by advanced investors.
There is a lot to cover, but understanding how DeFi loans work is important since a lot of yield throughout DeFi originates from the credit markets. Remember the old story of the bank takes your money from deposits and lends it out and that’s how they can pay you interest? Well, it’s not really true anymore – our fiat monetary system is based on fractional reserve banking and traditional banks print money from thin air every time they approve a loan.
DeFi loans work almost like in grandma’s story. Some users deposit money for yield. Other users want to borrow and pay back interest to do so but have to deposit collateral to get a loan. Loans get liquidated if their collateral falls below a certain threshold. All deposits and loans happen through smart contracts, which determine the yield and interest rates continuously and programmatically. The system works because it is overcollateralized. No intermediaries – no loan applications or credit checks. Nothing is printed from thin air – there is no money printer go BRRR in DeFi!
DEXs are also an important piece of the DeFi puzzle – often called “money LEGOs”. The AMM model has allowed for users without deep pockets to aggregate their holdings and create a market for any token in Ethereum in a permissionless and trustless manner. Users share in the trading fees, which is another way to put assets to work using DeFi.
Yield Farming is built on top of these basic blocks of financial dApps. Other non-DeFi dApps in Ethereum may find that DeFi at scale makes it simpler for them to swap their tokens (or help their users swap into their tokens), create liquidity for their cryptoasset(s), and provide a way to earn revenue on their treasury holdings or manage their treasury risks. The DeFi wave has revitalized gaming dApps, lottery dApps, and insurance dApps – it has even brought interest in non-fungible tokens (NFTs) like Crypto art, collectibles, and digital real estate to all-time highs.
Summary: DeFi is the Future
DeFi is going to change the world forever. Bringing productive assets into the Blockchain is a significant upgrade on the road to the Internet of Value. You may be wanting to learn more about DeFi to find if any DeFi tokens are worth buying. Remember, you do not need to buy anything this time – these are not the ICO times. Try your hand at farming, or simply move your fiat savings into Crypto stablecoins for much better interest rates than your bank.
There are many ways to earn with DeFi: lending, providing liquidity, auto-investing to name a few – there are even derivatives, insurance risk pools, and collateral for payment networks in DeFi.
Finally, remember DeFi is just getting started. How many are using DeFi is not yet as important as who is using DeFi, and those are the pioneers that can see an exceptional upside to joining this movement early on.
If you are interested in the farming/investing side of DeFi, don’t forget to check our Making Money with DeFi Basics video series: