Decentralised finance (DeFi) is a fundamental aspect of crypto, one that is constantly changing in line with new projects and continuing innovation. Learn what DeFi is, how it works, and how it compares to the traditional finance sector.
Decentralised finance is one of the most important elements regarding the mainstream adoption of crypto. It continuously evolves in line with technological innovation and it is important that crypto investors understand exactly what implications it might have for the wider market.
What is DeFi?
DeFi describes a decentralised financial system based upon blockchain technology. It removes intermediaries and centralised institutions by facilitating peer-to-peer transactions.
While DeFi originated as a movement simply designed to emulate traditional financial instruments using decentralised infrastructure, as the underlying technology has evolved, it has transformed into a new market of financial goods and services.
What is DeFi used for?
DeFi is an umbrella term that encompasses a wide range of blockchain-based financial instruments.
DeFi includes new models of traditional concepts such as borrowing and lending, while also introducing investors to entirely new concepts, such as staking and yield farming.
For crypto investors, using a decentralised exchange (DEX) is a popular way of facilitating peer-to-peer trades.
Difference between DeFi and TradFi?
DeFi offers an alternative to mainstream traditional finance (TradFi) systems. There are many reasons individuals may prefer to engage with DeFi rather than TradFi.
- Inclusion and accessibility: A significant portion of the global population is unbanked. By using decentralised networks and open-source protocols, DeFi presents a universally accessible financial system in which the only barrier to entry is the need for an Internet connection.
- Removal of intermediary control: TradFi systems are controlled by third-parties and intermediary institutions, such as central banks. Removing the need for third-parties offers DeFi users ultimate control over their assets, and can also help to reduce the admin costs typical to centralised transactions.
- High security: The very nature of blockchain technology makes it incredibly secure, which often appeals to individuals looking to protect their assets from risk.
- Anonymity: It is usually possible to engage with DeFi protocols without providing a name, email address or any other personal information.
How does DeFi work?
DeFi utilises smart contracts; self-executing programs that run automatically when the terms of an agreement are met. Smart contracts power decentralised applications (dApps) and allow developers to create lending, borrowing and trading protocols that operate without the need for third-party intermediaries. DApps provide the user interface that enables investors to engage with a particular DeFi protocol.
Not all crypto networks are able to support decentralised finance protocols. Bitcoin, for example, did not have smart contract functionality until late 2021. Generally, DeFi instruments are built upon the Ethereum network and utilise ERC20 tokens which are designed to support the development and expansion of the platform.
At the time of writing, there is a huge range of crypto networks that offer smart contract functionality.
The link between DeFi and crypto
As a decentralised model of currency, crypto is inextricably linked to DeFi. Crypto investors can utilise DeFi instruments as part of a wider crypto investment strategy optimised for diversified returns:
- Yield farming: Users deposit their assets into a liquidity pool, a collection of crypto tokens that are locked into a smart contract. These liquidity pools are used to facilitate trades on a DEX, and those that provide liquidity to the platform are rewarded with interest as a result.
- Staking: Users lock their crypto tokens into a network that utilises a Proof of Stake consensus mechanism. By providing security to the network and helping to validate transactions, users earn interest on their locked tokens.
- Lending and borrowing: Investors can earn interest by lending cryptoassets to other users, directly through a DeFi protocol. It is also possible to borrow cryptoassets from other lenders.
Examples of DeFi coins and tokens
Certain cryptocurrencies are used to power decentralised finance applications. Some of the most popular DeFi coins and tokens include:
| Avalanche (AVAX) | A layer 1 blockchain platform that utilises smart contracts and decentralised applications. It is considered a rival to Ethereum. |
| Chainlink (LINK) | A decentralised oracle network that connects smart contracts with real world data. |
| Uniswap (UNI) | The current largest decentralised exchange, built on Ethereum. |
| Aave (AAVE) | One of the world’s largest decentralised applications, designed to enable lending and borrowing between users. It is built on top of the Ethereum network. |
| dYdx (DYDX) | An Ethereum-based decentralised exchange that offers perpetuals trading with up to 20x leverage. |
The future of decentralised finance
DeFi remains an emerging technology, but its potential for use in the future is practically limitless. While the evolution of the regulatory landscape will impact the long-term viability and success of some DeFi protocols, and traditional banking systems are likely to present resistance to change, DeFi has the capacity to disrupt the entire financial services industry through decentralisation, accessibility and the immutable nature of its transactions.
Final thoughts
Decentralised finance is reshaping the financial landscape by providing accessible and innovative financial protocols without the need for third-party intermediaries. Although complicated, and a far from perfect solution in its current state, DeFi has the potential to change the way in which we view finance.
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Quiz
FAQs
- What makes a good DeFi coin or token?
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Popular DeFi tokens tend to have high liquidityand a well-engaged community, as well as an original and disruptive utility potential. Most DeFi projects are based on the Ethereum network, so considering Ethereum (ETH) or Ethereum-based tokens can be a good starting point for investors seeking exposure to DeFi.
- Is Ethereum a DeFi coin?
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Ethereum itself is not a DeFi coin or project. Instead, it is a layer 1 blockchain platform that securely executes and verifies smart contracts. It has its own native cryptocurrency called ether (ETH), which allows the network to run efficiently.
- What are DeFi fees?
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There are two main fees associated with DeFi transactions, the rate of which will depend on the individual platform. Typically, a standard fee is charged by DeFi protocols to facilitate transactions. In addition, a gas fee may apply to transactions undertaken on Ethereum-based networks.
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