Decentralized Finance uses the blockchain to reshape traditional financial sectors, such as lending-borrowing, exchanges, insurance and investment. It also originated a new way of monetizing crypto ownership called farming.
Decentralized finance, or DeFi, is an ecosystem of financial services that is based on a blockchain and uses smart contracts. The DeFi transforms classic finance thanks to decentralization, transparency, transaction efficiency, immutability, ability to control your data and accessibility to everyone. The first DeFi applications appeared on Ethereum blockchain, which still keeps its leader position. Some interesting projects are also being created on BSC (Binance Smart Chain), and basically every other smart contracts platform is aiming at developing this sector.
Decentralized finance operates in sectors that have traditionally been occupied by banks and traditional financial institutions, such as exchanges, lending–borrowing, creation of investment products, as well as completely new sectors proper to the DeFi, such as farming.
To use a DeFi service of lending & borrowing one has to simply deposit a cryptoasset into a specialized wallet. From there two possibilities exist:
The deposited funds are managed by DApp’s smart contract, which must be open source and audited by specialists to avoid unpleasant surprises.
DeFi also enables a specific type of borrowing called flash loan. It allows to borrow the whole amount available without any collateral, insofar as the loan and its repayment are made within one transaction, which is possible using smart contracts. Flash loans are still very complex though, and their usage is essentially limited to professionals with advanced technical skills (even if tools for beginners are being developed).
The DeFi loans users’ main risks are liquidation (when the collateral amount falls below a minimum threshold) and smart contract code vulnerabilities (just like for any other DApp).
Some of the most famous lending & borrowing DApps are Aave, Compound and Maker DAO. The sector is evolving very quickly though, so we’ve created a separate list of DeFi projects that we’ll update regularly. You can refer to it here.
A decentralized finance must have decentralized exchanges, or DEX. In the beginning, all crypto exchanges were centralized, with all the flaws that this implies: private keys managed by the exchange, hacking risk… etc. A DEX allows its users to exchange cryptoassets directly on a blockchain, without having to entrust anyone with their private keys. So while an attack on a centralized exchange could endanger user data and funds, a DEX does not control neither the funds, nor the user data, which enjoy the security provided by the blockchain. #notyourkeysnotyourcoins
In order to use a DEX one has to download a compatible wallet, which will generate private keys accessible only to its owner and will send orders to a DEX.
First decentralized exchanges appeared thanks to the possibilities of smart contracts, but they had hard times establishing themselves: unlike centralized exchanges, they didn’t have enough liquidity or market makers. A new generation of DEX solved this problem, mostly thanks to liquidity pools (LP) and automated market making (AMM).
Liquidity pools are types of smart contract that allow to deposit tokens that will be used by a DEX when needed for an exchange. People who deposit tokens act as market makers and are rewarded by a part of the fees gathered by an exchange. Furthermore, they receive LP tokens (liquidity pool tokens) that represent their participation in the liquidity pool. These LP tokens often can be deposited too (in the DEX DApp or even other DApps), allowing to gain a supplementary reward, thus creating more incentive to provide liquidity.
Automated Market Makers. AMM is a program that allows, using math formulas and depending on supply and demand, to determine a quotation for token exchange. It’s done automatically and without any human intervention. There are several types of AMM today, the first one operated liquidity pools by pairs of tokens, where equal amounts of each token must be deposited (it is used by Uniswap – the first DEX to have conquered a significant market share).
DEXes also have their share of disadvantages, notably their incapacity to exchange crypto against fiat money or cryptoassets from different blockchains. Another disadvantage is a risk of loss specific to DEXes called “impermanent loss”. It is also worth noting that DEXes are often quite difficult to use for an average person.
Solutions to counter these disadvantages exist. While integration of fiat money still seems impossible, other issues are subject to constant improvements. Exchanges of tokens from different blockchains can now be possible with cross-chain DEXes, impermanent loss can be tackled with different techniques of LP and AMM, and more user-friendly DEXes appear.
The main DEXed today are Uniswap, Sushiswap, 1inch, Pancakeswap, Balancer and Curve.
Decentralized finance is booming, the amounts blocked in DeFi protocols will soon reach hundreds of billions of dollars, and the number of users grows steadily. Such a success must not let us forget that DeFi is a very young sector and is still in a discovery phase. It consists of smart contracts and decentralized protocols, hence it’s vulnerable to mistakes of code, hacks and unforeseen usages steaming from interconnectivity between the protocols. All this can cost DeFi users significant losses, so quite naturally a new DeFi sector appeared to counter them – insurance.
Insurance DApps act in a way like traditional insurance: clients pay a premium to protect themselves against a specific risk (linked to smart contracts, exchanges, stablecoins…) The price of this premium depends on the risk type, amount to insure and on the platform on which the amount was invested. New ways of determining the premium and the insurer’s fees are being constantly developed. Incidentally, insurance DApps can themselves carry the risk against which they are supposed to insure…
Generally, insurance DApps can also be used by traditional insurers, using blockchain qualities to speed up the paperwork and create additional guarantees for the clients.
The main DeFi insurance DApps are Cover protocol, Nexus mutual, Tidal finance, Union UNN finance, Etherisk, Nsure et Bridge Mutual.
The DeFi allows to easily invest one’s money in various products and under various forms.
With the DeFi one can invest in numerous products:
As in traditional finance, there are DeFi DApps that allow buying derivatives on cryptoassets: futures, swaps, options… (e.g. Hegic)
DeFi has enabled a new and exclusive way of investment, which is now developing at high speed – farming. Farming is a generic term describing different possibilities of monetizing cryptoasset ownership: it can be lended, it can serve as a collateral to borrow, it can supply liquidity pools, while the LP (Liquidity Provider) tokens received as a counterpart can themselves be deposited to gain interest in the form of other tokens… DeFi composability allows numerous combinations and the imagination of DApps creator is limitless. Some popular farming DApps include Alpha Homora, Beefy and Harvest.
DeFi is booming, and new projects appear all the time, driving ever more interest to this domain. Traditional finance does not stay aside, and many projects combine the centralized and decentralized approaches. It is important however to stay alert and aware of the risks DeFi carries, such as code vulnerabilities.