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What is DeFi? Telling about decentralized finances in simple words
What is DeFi_
Defi101
07.09.2021
Updated 12.03.2022
14:38

The boom of DeFi has become one of the most significant events of 2020 when the growing market of decentralized services attracted the attention of millions of users, many of whom were not familiar with the cryptocurrency industry before. After reading this article, you will get to know what decentralized finances are, what features they have, how to receive income, and what risks DeFi holders face.

What is DeFi?

Decentralized finances (DeFi) are a globally distributed ecosystem of platforms and services providing financial services on blockchains. As it goes from the name, DeFi does not have centralized regulators that would control the work of the whole system or require trust from the community.

The DeFi ecosystem is built around autonomous blockchains operating on smart contracts. The most popular and in-demand among them is Ethereum, but decentralized apps are available in other networks as well: Binance Smart Chain, Cosmos Network, Solana, Polygon, and others.

There is no centralized mediator in the process of deals between users – that is why they exchange assets among themselves directly (P2P), and a smart contract ensures the fulfillment of the obligations by the parties. DeFi platforms provide several financial services:

What role DeFi ecosystem plays in crypto space?

The principle of decentralization and equal relations among participants of the blockchain system is laid in the ideology of cryptocurrencies itself and is implemented in decentralized payment systems, such as Bitcoin, Ethereum, Binance Smart Chain, etc. Similar to them, DeFi provides a peer-to-peer infrastructure of decentralized services and tools, which offer financial services known in a traditional sector: without intermediaries and the need to trust centralized bodies.

Let us select the criteria and compare decentralized and traditional financial services to find out why the demand for DeFi products is growing so rapidly.

Criterion Centralized Finances (CeFi) Decentralized finances (DeFi)
Availability According to The World Bank, more than a billion people of the adult population worldwide do not have access to banking services. It is especially relevant for countries with underdeveloped and unstable economies. DeFi platforms are available to anyone, regardless of age, nationality, and location. There are no limitations.
Trust Banks may block accounts of clients and use their funds at their discretion. Users fully possess and control their wallets.

Nobody can use the funds without the permission of the holder.

Profitability Banking deposits offer average rates from 4% to 5,3%, depending on the deposit term. And in the US, the rate is even lower – only 0,03% – 0,09%. The profitability of yield farming may exceed 1000% and 20% on stablecoins.
Access to products Only deposits and trading are available among financial services. Private investors have no access to liquidity, and getting a loan requires legal documents. The community is free to use decentralized products, such as crypto loans, staking and deposits, farming and mining of liquidity.

Advantages of DeFi

Transparency

Platforms contain open source, and any transactions can be tracked. It allows to audit platforms and develop solutions that will help to track the state of the infrastructure, for example, when investors actively deposit or withdraw funds.

Accessibility

Decentralized services cannot restrict access to somebody – that is why any person from any point of the world can get access to them. On the other hand, it increases risks for users themselves, who do not have enough experience in using such products and cannot evaluate risks.

Decentralized management 

All operations on DeFi platforms are executed by smart contracts, thanks to which intermediaries in the face of companies or groups of people owning the protocol are eliminated. It makes platforms autonomous, and the participation of the person is not required for effective functioning.

Flexibility

DeFi provides a wide range of products and interfaces to work with decentralized platforms. Users can freely switch between various interfaces, and developers can create their apps with the help of API.

Where are DeFi products applied?

The capabilities of the blockchain open virtually any development directions for decentralized financial services, some of which were not available to private users not long ago.

Decentralized exchanges (DEX)

Decentralized trading platforms allow users to trade digital assets using their crypto wallets. That is safer and more convenient compared to the exchange on centralized crypto exchanges (CEX). First, users of exchanges must pass the KYC (Know Your Customer) verification of their identity, which poses a threat to anonymity, and they have to trust a company storing their funds on its accounts and wallets. Secondly, users do not need to pay fees for replenishment or withdrawal of funds.

Uniswap, based on the Ethereum blockchain, has become one of the first and most successful decentralized projects for trading crypto assets on and liquidity mining. The platform also offers crypto loans, and there may also appear new functions in the future. One more interesting platform is dYdX which provides traders decentralized trading of crypto derivatives with leverage. Other DEX exchanges in the DeFi ecosystem are:

Lending 

Smart contracts are applied for the creation of decentralized lending platforms, on which users can borrow cryptocurrency from each other without the participation of mediators represented by banks and other financial organizations. Smart contracts, which implement the need for the collateral and manage the liquidation, fully control the risks.

One of the first platforms for non-custodial lending became MakerDAO allowing to give out loans in ETH and some ERC20 tokens. Having followed the Maker, other lending platforms appeared:

Stablecoins

Decentralized protocols maintain the stability of the rate and serve as issuers of stablecoins – digital coins, the rate of which is bound to the base currency: USD or EUR.

Tether (USDT) is released by a centralized company that stores the currency in personal accounts and can issue an unlimited number of stablecoins. Decentralized platforms, such as the Maker, use a different model: to generate DAI tokens, it is required to deposit ETH as collateral. In other words, DAI is secured stablecoins, similar to how cryptocurrencies were backed by gold in the past.

Such an approach saves users from completing the KYC/AML procedure and prevents the freezing of accounts in custodial services. The Maker users block some number of ETH coins or other ERC20 tokens via a smart contract and receive DAI in return. The only disadvantage of this method is that due to volatility, the cost of the collateral may drop, which poses a risk for investors.

One more example of a non-custodial platform for the emission of stablecoins is Anchor Protocol where bLUNA holders (tokenized LUNA) may add their tokens and get UST tokens instead.

Decentralized management 

The prevailing majority of platforms are formed on the principle of Decentralized Autonomous Organization (DAO) that provides the community the right to decide what amendments are to be done in the protocol. The Maker is also an example of one of such DeFi platforms.

Besides DAI, the Maker offers MKR tokens used as an analog of Gas within the Ethereum network and empowers holders to participate in voting on the platform. It allows the community to define the functionality and logic of the work of the Maker in order to improve the infrastructure.

Synthetic and tokenized assets

DeFi protocols allow tokenizing any assets of the real world known to us: stocks, gold and silver, oil, land and other property, intellectual rights, and many more. It is enough to transform the real item into a token only once to trade it unlimitedly further.

It solves many problems related to the storage and relocation of assets. For example, after the change of an owner, works of art need to be transported to a buyer after each auction. With tokenization, there is no need to do that: it is possible to freely exchange the NFT token until its owner decides to burn it and get the real asset.

Similar to how traditional stocks do, tokenized stocks solve the issue with depositaries during the registration and transfer of rights of stocks’ owners. It will help the companies and exchanges to reduce operational costs. Bright representatives of platforms that release synthetic and tokenized assets are Synthetix, Nexus Mutual, UMA, and dXDY.

ICO holding

To create new tokens and publish them via Initial Coin Offering (or ICO), smart contracts are used. One of the examples of crowdsales, similar to IPO in the stock market, serves Security Token Offering (STO), in which tokens having the characteristics of securities are released.

Owners of STO tokens claim on the part of profits generated by a decentralized platform, while tokens themselves may serve as a debt or investment tool and derivative. STO tokens do not require depositaries for storing assets, and they can be divided into fractional shares, which increases the availability of trading for small investors.

Yield Farming 

Yield farming is called a set of products allowing to get income with the help of decentralized tools. It includes crypto lending, adding coins and tokens into liquidity pools, farming and voting, for which holders also get rewards.

As a rule, platforms give users rewards for providing liquidity and other ways of getting yield in native tokens. For instance, Uniswap accrues its users UNI tokens, 1inch – 1INCH, PancakeSwap – CAKE, аnd Synthetix – SNX.

Popular DeFi platforms

Disadvantages of DeFi

Like any system, decentralized finances have their disadvantages. DeFi is a young yet promising sector. Along with its development, the functionality of platforms will improve, but it is unlikely risks will be fully eliminated.

Complexity of use 

Not all DeFi products are simple and clear to use. Most often, users need to take time to find out how some services work: staking, lending, and liquidity mining. The mechanics of these services is complex. For example, staking has a locking period, and mining of liquidity requires additional actions to add tokens to the pool. Users may face difficulties when using DeFi without guidance.

Interoperability

Different blockchains are not compatible with each other. For example, you will not be able to transfer assets from Ethereum to the Binance Smart Chain network. This issue has partly been solved by assets’ tokenization. For example, in Binance Smart Chain, you can lock Bitcoin and receive an equivalent number of BTCB tokens; and WBTC in Ethereum. Thanks to this, Bitcoin holders can get income from yield farming.

Impermanent loss

The term represents losses during liquidity mining that users bear due to the volatility of crypto assets. As long as coins are in a pool, you can get rid of these losses. But if a user has already withdrawn assets from the pool, the losses will become permanent.

Risks of hacking 

Theoretically, a smart contract can be hacked. Besides, developers of DeFi platforms may deliberately leave backdoors (vulnerable spots in the source code) in order to withdraw funds from the contract. Even the audit conducted by trustworthy companies cannot guarantee 100% safety of users.

Centralization of data flow

Even though platforms function in a decentralized way, the data about cryptocurrency rates is provided by centralized oracles – special nodes broadcasting information from external sources to the blockchain so that it can be understood by it. Oracles may act maliciously, so a smart contract may execute a deal incorrectly since it is subordinate to specific rules of work. The solution to this problem is being developed with the help of decentralized oracles, for example, in the Chainlink project.

Control of developers 

Almost all DeFi platforms are open source, but the development and modification remain in the hands of developers of a project who fully control the process. Not all platforms support this kind of model, and modern platforms seek to focus on decentralized management (DAO).

Market risks 

The last disadvantage relates to the volatility of cryptocurrencies. The market is cyclic, and it has periods of active growth and downturn (correction). During a bull run, there is hype around the crypto industry, and the TVL (total sum of locked assets or liquidity) of DeFi platforms starts rising. So does the profitability of investments. But during the correction phase, the situation changes, and users bear losses. That is what happened in May 2021, when the correction occurred in the crypto market. This situation reminds us of a сryptocurrency bubble in 2017: some altcoins dropped in price by more than 90%, leaving its investors without even a chance to rehabilitate.

Where to monitor DeFi protocols? 

To track decentralized platforms and services, special monitoring services are created:

Conclusion

DeFi is a young but rapidly developing field that modernizes digital financial services and makes them more affordable to users all around the world.

Compared to traditional markets, the capitalization of decentralized platforms is relatively low – that is why they are at a greater risk of manipulations from large players (whales). A bright example is Yearn Finance token (YFI), the rate of which skyrocketed by more than 30 000% only within a month.