DeFi is inspired by blockchain, the technology behind the digital currency bitcoin, which allows multiple entities to hold a copy of a transaction history, implying that it is not controlled by a single, central source. This is significant because centralized systems and human gatekeepers can limit transaction speed and sophistication while giving users less direct control over their money. DeFi is unique in that it extends the use of blockchain beyond simple value transfer to more complex financial use cases.
Bitcoin and many other digital-native assets distinguish themselves from legacy digital payment methods, such as those offered by Visa and PayPal, in that they eliminate all middlemen from transactions. When you pay for coffee with a credit card at a cafe, a financial institution sits between you and the business, controlling the transaction and retaining the authority to stop or pause it and record it in its private ledger. These institutions are no longer a part of the equation with bitcoin.
Big companies are in charge of more than just direct purchases; they also oversee financial applications such as loans, insurance, crowdfunding, derivatives, betting, and more. One of the primary benefits of DeFi is the elimination of middlemen in all types of transactions.
Before it was known as decentralized finance, the concept of DeFi was often referred to as “open finance.”
Most “DeFi” applications are built on Ethereum, the world’s second-largest cryptocurrency platform, which differs from the Bitcoin platform in that it is easier to use to build other types of decentralized applications beyond simple transactions. These more complex financial use cases were even mentioned by Ethereum creator Vitalik Buterin in the original Ethereum white paper back in 2013.
This is due to the fact that Ethereum’s platform for smart contracts – which automatically execute transactions if certain conditions are met – provides significantly more flexibility. Ethereum programming languages, such as Solidity, are specifically designed for the creation and deployment of smart contracts.
For example, suppose a user wishes to send money to a friend on Tuesday, but only if the temperature rises above 90 degrees Fahrenheit, as predicted by weather.com. Such rules can be incorporated into a smart contract.
Hundreds of DeFi applications are running on Ethereum, with smart contracts at their core, some of which are explored below. Ethereum 2.0, a forthcoming upgrade to Ethereum’s underlying network, could help these apps by addressing Ethereum’s scalability issues.
The following are the most common types of DeFi applications:
Decentralized exchanges (DEXs): Online exchanges allow users to exchange one currency for another, such as US dollars for bitcoin or ether for DAI. DEXs are a popular type of exchange that connects users directly so they can trade cryptocurrencies with one another without entrusting their money to an intermediary.
Stablecoins: A cryptocurrency that is linked to a non-cryptocurrency asset (such as the dollar or euro) in order to stabilize its price.
Lending platforms: These platforms use smart contracts to replace intermediaries in the lending process, such as banks.
“Wrapped” bitcoins (WBTC): A method of sending bitcoin to the Ethereum network that allows it to be used directly in Ethereum’s DeFi system. WBTCs enable users to earn interest on bitcoin loans made through the decentralized lending platforms described above.
Prediction markets are markets where people can bet on the outcome of future events such as elections. The goal of DeFi versions of prediction markets is to provide the same functionality as traditional prediction markets but without the use of intermediaries.
In addition to these apps, new DeFi concepts have emerged in their wake:
Yield farming: Yield farming is a strategy for knowledgeable traders who are willing to take on risk, in which users sift through various DeFi tokens in search of opportunities for higher returns.
When DeFi applications entice users to their platform by giving them free tokens, this is referred to as liquidity mining. This has been the most talked-about type of yield farming to date.
Composability: DeFi apps are open source, which means that the code underlying them is available for anyone to view. As a result, these apps can be used to “compose” new apps using the code as a foundation.
Money legos: To put the concept of “composability” another way, DeFi apps are similar to Legos, the toy blocks that children click together to build structures, vehicles, and so on. DeFi apps can be assembled similarly to “money legos” to create new financial products.
DeFi Platforms for lending
Lending markets are a popular type of DeFi that connects borrowers to cryptocurrency lenders. Compound, a popular platform, allows users to borrow cryptocurrencies or make their own loans. Users can earn money by lending out their money and earning interest. Compound sets interest rates algorithmically, so if there is a greater demand to borrow a cryptocurrency, interest rates will rise.
DeFi lending is collateral-based, which means that in order to obtain a loan, a user must put up collateral, which is frequently ether, the Ethereum token. This means that users do not have to reveal their identity or associated credit score in order to obtain a loan, as is the case with traditional, non-DeFi loans.
The stablecoin is another type of DeFi. Cryptocurrencies frequently experience sharper price fluctuations than fiat currencies, which isn’t ideal for people who want to know how much their money will be worth in a week’s time. Stablecoins are cryptocurrencies that are pegged to non-cryptocurrencies, such as the US dollar, in order to keep the price under control. Stablecoins, as the name suggests, seek to provide price “stability.”
Markets for forecasting
One of the oldest DeFi applications on Ethereum is a so-called “prediction market,” in which users wager on the outcome of a specific event, such as “Will Donald Trump win the 2020 presidential election?”
The goal of the participants is obviously to make money, though prediction markets can sometimes outperform traditional methods such as polling. Intrade and PredictIt are two centralized prediction markets with a good track record in this regard. DeFi has the potential to increase interest in prediction markets, which are traditionally frowned upon by governments and frequently shut down when run centralized.