What is DeFi?

Learning outcomes: 

By the end of this article you will understand:

1. What DeFi is
2. The importance of DeFi
3. How DeFi works
4. The advantages and disadvantages of DeFi
5. How to get started in DeFi 

What is DeFi?

DeFi is an abbreviation for decentralised finance, a new breed of financial services accessed through blockchain technology rather than through an intermediary like a bank.

DeFi is considered a game-changer because it opens financial services to anyone with an internet connection, while anyone with coding skills can build applications.

Compound is an example DeFi service, allowing users to connect their cryptocurrency wallets to a digital application (dApp) built on the Ethereum blockchain to earn a yield from or borrow against their crypto assets. 

DeFi: Programmable money 

Bitcoin provided the technology to send and store value without a central authority.
Ethereum added the ability to program complex financial services through smart contracts, which is why DeFi is often described as programmable money.

Smart contracts are agreements defined in code. In the case of Ethereum, code is written in a specific language called Solidity and executed in part of the Ethereum network known as the EVM – Ethereum Virtual Machine. Ethereum charges fees based on the complexity of the smart contract.

Below we compare the main characteristics of DeFi services to traditional financial services (TradFi). 

TradFi	DeFi
Centralised: Formal business structure, data stored in servers	Decentralised: no formal business structure, offices or employees, data stored on the blockchain
Permissioned: Application process, KYC requirement, geographic restrictions	Permissionless: open to anyone with an internet connection, no application process or KYC
Opaque: Operational model known only to those in charge and regulators	Transparent: Anyone can view transactions and code behind DeFi applications
9-5: Services are limited to specific operational hours	24/7: As DeFi is just code, there are no opening/closing times

How DeFi works 

Two concepts help us understand how DeFi works and explain much of the associated jargon: composability and the layers of the DeFi Stack. 

DeFi composability 

A simple way to understand the term composability is money Lego. 

Ethereum’s use of common standards means that all the components of DeFi fit together like Lego blocks, enabling an ecosystem of interconnected dApps to grow quickly. 

The layers of the DeFi Stack

It becomes easier to understand how DeFi services work by breaking the system down into a series of functional layers.

• Settlement layer –Where the blockchain stores assets and executes state changes of smart contracts in a decentralised manner. In a broader discussion of blockchain function, you’ll often see the settlement layer described as Layer 1. 

• Asset layer –These are the currencies and units of value being settled. For Ethereum, this includes its native token, ether, and any tokens that follow its standard e.g. ERC-20 and ERC-721 (the common NFT format). 

• Protocol layer –This is the code-based logic built into smart contracts that defines their service. 

• Application layer –This is the interface a user sees and interacts with, commonly referred to as digital applications (dApps). They look just like any functional website or mobile application, but their interaction with the layers below differentiates them. 

• Aggregation layer –Aggregators simplify the management of an increasing number of competing/complementary protocols. DEX aggregators connect you to the best value decentralised exchange; DeFi portfolio managers pull all your DeFi activity into one dashboard. 

What services does DeFi offer? 

Ethereum, and blockchains that follow a similar EVM model, can execute any agreement that can be defined mathematically and presented in a website or app user interface. Let’s look at the most common DeFi services and their benefits.

Earning interest on your crypto 

By depositing your crypto with a DeFi service, you can earn interest, which varies depending on the specific coin.

Borrowing against your crypto 

The three models for borrowing crypto from DeFi services are: 

• Peer-to-peer: Borrowing directly from a lender using existing crypto as collateral 
• Pool-based: Borrowing from a pool of funds using existing crypto as collateral 
• Flash loans: Borrowing and returning within the space of one block confirmation without the need for collateral 

Complex decentralised trading 

Buying and selling crypto along with complex derivatives from decentralised exchanges (DEX)

Decentralised insurance products 

Insuring against loss due to the failure of a smart contract. 

Getting started with DeFi 

Though it’s helpful to understand the layers that make up DeFi to know how it works, as a user you will only need to interact with the application layer or dApp.

A dApp will look like a regular website, but what goes on behind the scenes (in the various layers) is completely different. The main difference at the user level is the need to connect a crypto wallet, which acts like your portable identity within the crypto ecosystem but contains no personal information.

The most popular crypto wallets for DeFi are browser-based, like MetaMask. dApps and browser wallets simplify the process of engaging with smart contracts; in just a few clicks you can confirm transactions and agree to pay the fee charged by the underlying blockchain. 

In the case of earning interest, the transaction will transfer funds and confirm an agreement for the dApp to automatically pay you interest.

As DeFi is open and permissionless, you can end the agreement whenever you want, though this will incur a further transaction fee. 

The pros and cons of DeFi 

Now you understand what DeFi is, how it works, and the types of services offered, we can end by comparing the benefits with some of the less obvious drawbacks.

The pros of DeFi 

• It is open to anyone with an internet connection.
• Its design allows for rapid innovation, with new services created all the time. 
• It’s pseudonymous, so users don’t need to share personal information.
• It’s transparent, so all transactions are viewable as is the logic behind DeFi services. 
• It functions 24/7 without any border restrictions. 

The cons of DeFi 

• Its open nature means users are fully responsible for all their actions, including wallet security, with no safety net.
• Competition for transaction confirmation can drive up fees on Ethereum beyond the budget of many users. 
• Smart contracts are liable to human error, as well as malicious intent, exposing users to potential losses and fraud.
• The way DeFi services work isn’t intuitive, which can put new users off. 

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