What is DeFi? Everything you need to know about the future of decentralized finance

DeFi is a catchy little term that represents a big facet in the blockchain universe. Here's what you need to know, for starters.
Written by Marc Wojno, Senior Editor

Decentralized finance (DeFi) is a financial system that runs on a decentralized network of computers rather than a single server. DeFi is an emerging digital financial infrastructure that theoretically eliminates the need for a central bank or government agency to approve financial transactions. Regarded by many as an umbrella term for a new wave of financial services innovation, DeFi is deeply connected with blockchain -- the decentralized, immutable, public ledger on which Bitcoin is based -- that enables all computers (or nodes) on a network to hold a copy of the history of transactions. The idea is that no single entity has control over, or can alter, that ledger of transactions.

Most of the financial services that could be defined as DeFi can be found on the Ethereum network, the second-largest cryptocurrency marketplace, which also acts as a platform that allows other blockchain apps to be built on it (Ethereum's cryptocurrency, Ether, is used to pay transaction costs). By utilizing decentralized apps, or dApps, two or more parties can exchange, lend, borrow, and trade directly using blockchain technology and smart contracts without middlemen's involvement and costs. It's a fair, free and open digital marketplace -- at least in theory. In practice, at least for now, that's not always the reality. To learn more about this new, digital financial marketplace, read on.

How is DeFi different from Bitcoin?

While Bitcoin is a decentralized digital currency that operates on its own blockchain and is used mostly as a store of value, DeFi is a concept that describes financial services that are built on public blockchains, such as Bitcoin and Ethereum, that for example, enable users to earn interest or borrow against their cryptocurrency holdings. DeFi is comprised of a variety of applications around financial services such as trading, borrowing, lending and derivatives.

How does DeFi work?

DeFi uses cryptocurrencies and smart contracts to provide financial services to eliminate the need for intermediaries such as guarantors. Such services include lending (where users can lend out their cryptocurrency and earn interest in minutes rather than once a month), receiving a loan instantly, making peer-to-peer trades without a broker, saving cryptocurrency and earning a better interest rate than from a bank, and buying derivatives such as stock options and futures contracts.

To facilitate peer-to-peer business transactions, users utilize dApps, most of which can be found on the Ethereum network. Among the more widely used DeFi services and dApps are coins (Ether, Polkadot, Solana), stablecoins (whose value is pegged to a currency such as the US Dollar), tokens, digital wallets (Coinbase, MetaMask), DeFi mining (a.k.a. liquidity mining), yield farming, staking, trading, and borrowing, lending, and saving using smart contracts.

DeFi is open source, meaning that protocols and apps are theoretically open for users to inspect and to innovate upon. As a result, users can mix and match protocols to unlock unique combinations of opportunities by developing their own dApps.

What is a smart contract?

It's computer code that acts as a digital agreement between two parties. A smart contract runs on a blockchain and is stored on a public database, and can't be altered. Because the blockchain processes smart contracts, they can be sent automatically without a third party. The peer-to-peer transaction is closed only when the conditions in the agreement are met.

The obvious benefit of smart contracts is that they can be created for you to borrow and lend your cryptocurrency without the use of an intermediary, which sidesteps a lot of the risks involved in traditional lending. If, for example, a borrower can't meet their obligations in a loan, their lender can simply take their funds back, making the need for collateral unnecessary. What's more, DeFi saving accounts could function in the same way as savings accounts at banks but might offer higher interest rates or could pay out either daily, weekly or monthly, depending on the platform.

Who created DeFi?

No one person created the concept of decentralized finance. Bitcoin is said to have been created by Satoshi Nakamoto, a pseudonym for a person, or people, behind the world's first cryptocurrency and financial blockchain. The true identity, or identities behind Satoshi Nakamoto, remain unknown.

See also: New global DeFi adoption index finds US, Vietnam, China, UK and India leading the way.

Ethereum, the platform inspired by Bitcoin, and the one on which a majority of DeFi services run, was developed by programmer-turned-entrepreneur Vitalik Buterin. In 2013, at the age of 19, the Russian-Canadian wrote a white paper outlining an alternative platform to Bitcoin that would enable programmers to develop their own apps using a built-in programming language. Thus, Ethereum was born, and over the past nine years, it has grown exponentially. As of mid-January 2022, the market cap for Ethereum's cryptocurrency, Ether, is $385 billion. It's the second-largest cryptocurrency by market cap behind Bitcoin, which still reigns as the biggest cryptocurrency with a market cap valued at $805 billion, according to CoinMarketCap.

What can you do with DeFi?

As mentioned above, DeFi uses cryptocurrencies and smart contracts to provide financial services without the involvement of banks. With the addition of more dApps, the possibilities of what you can do with DeFi continue to grow. The more popular uses of DeFi include sending money anywhere in the world (in little time and affordably); storing money using crypto wallets (and earn higher yields than at a traditional bank); borrow and lend on a peer-to-peer level; trade cryptocurrencies anonymously and at any time 24/7; trade tokenized versions of investments such as stocks, funds, other financial assets and non-fungible tokens (NFTs); crowdfunding; and buying insurance with the help of companies such as Etherisc.

How do people make money in DeFi?

There's more than one way that people are attempting to capitalize on the growth of DeFi. One strategy is generating passive income using Ethereum-based lending apps. Essentially users loan out their money and generate interest from the loans. Another strategy being used is yield farming, a riskier practice by more advanced traders, in which users scan through a myriad of DeFi tokens in the hopes of finding opportunities for larger returns, but it is complicated and can lack transparency.  

How risky is DeFi?

Like all other new decentralized blockchain networks trading in cryptocurrencies, DeFi is very risky, especially as you're using a new technology that aims to disrupt an established institution such as a centralized bank. It's even riskier for novices lured by the potential gains of yield farming and passive income. Ethereum has security and scam prevention guidelines as there are also broader potential risks.  

Fraud and crime continues to be a significant issue; according to calculations by blockchain data platform Chainalysis, $14 billion in cryptocurrency was sent to illicit addresses in 2021, nearly double the figure seen in 2020. 

See also: $2.2 billion in cryptocurrency stolen from DeFi platforms in 2021.

About $2.2 billion was outright stolen from DeFi protocols in 2021. While the analysis suggests cybercriminals raked in $7.8 billion in cryptocurrency from victims, about $2.8 billion of that figure came from a scam they call 'rug pulls'. In these scams, developers create apparently legitimate cryptocurrency projects before stealing investor money and disappearing. Chainalysis warned that many attacks on DeFi exchanges over the past year can be traced back to errors in the smart contract code governing those protocols, which hackers exploit to steal funds.

"The most important takeaway is to avoid new tokens that haven't undergone a code audit. Code audits are a process through which a third-party firm analyzes the code of the smart contract behind a new token or other DeFi project and publicly confirms that the contract's governance rules are iron clad and contain no mechanisms that would allow for the developers to make off with investors' funds," Chainalysis said.

So, what's a Dogecoin?

This dog-meme-based cryptocurrency is just one of the many cryptocurrencies around but has received attention thanks to Elon Musk and his appearance on Saturday Night Live. As of mid-January 2022, it is trading at around 15 cents a coin. Compare that to $3,115 a coin for Ether and $41,638 for Bitcoin. And for a decentralized cryptocurrency that's based on a dog and started as a joke, some will argue that the price of 15 cents a dogecoin is about right. Then again, Bitcoin started at a fraction of a penny.

Despite Dogecoin's publicity, it's currently ranked 12th on a list of cryptocurrencies priced by market cap. Bitcoin is comfortably ranked #1 as the biggest cryptocurrency based on market cap, followed by Ether, Tether (a stablecoin pegged to the US Dollar), BNB, Solana, USD Coin (another stablecoin), Cardano, XRP, Terra, and Polkadot.    

What's the difference between "Proof of Work" and "Proof of Stake?"

These are known as "consensus mechanisms" and are central when confirming transactions on a blockchain. This is what cryptocurrency miners do when validating transactions. Miners in a blockchain network compete to find a cryptographic hash used in specifying a transaction. Although the hash is difficult to find, it's easy to verify. Once verified, that transaction is added to the blockchain and is a fait accompli. The work that goes into verifying that hidden hash is called the "proof of work." The computer on the network that completes the proof of work first gets rewarded in cryptocurrency. In the case of Bitcoin, it's 6.5 Bitcoin. This is known as mining Bitcoin.

"Proof of stake" is an alternative form of consensus mechanism and key to the second generation of Ethereum (Ethereum 2.0). In this case, the staking of an asset on the next block in a blockchain replaces the mining of blocks as it is done under proof of work. One major downside of proof of work is energy. To find that rare cryptographic hash requires a lot of computing power. Dozens, even hundreds, of computers coalesce to form one high-speed brain to solve complex mathematical equations to be the first to do the proof of work and earn a block. That proof of work consumes a lot of energy and is the reason why environmental groups are upset over blockchain and cryptocurrency mining.

However, in proof of stake, validators stake some amount of their cryptocurrency to prove that the block is valid. Once they stake their crypto assets, they are randomly selected to propose a block to validate. That block then needs to be authenticated by a majority of other validators -- those who validate profit by both proposing a block and authenticating others' proposed blocks.

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