What Is Decentralised Finance (DeFi)?
Decentralised finance (DeFi) is a term that describes a suite of crypto projects that are decentralising financial services. To build DeFi projects, developers make use of technologies such as blockchain and smart contracts.
The current financial system relies on institutions and banks to serve as its trust layer. With the help of law enforcement, these trusted intermediaries help keep the financial system working. For doing so, we pay them fees and agree to terms about how we use these intermediaries’ services.
With decentralised finance (DeFi), there’s no need to trust a middleman. DeFi describes a suite of crypto projects that use a blend of cryptography, smart contracts and blockchain technology to keep their platforms regulated instead of a central body.
The term ‘DeFi’ was conceived in mid-2018. By Feb. 2020, the value of cryptocurrencies locked in the entire DeFi space hit US$1 billion for the first time. By the end of 2020, that figure was over $15 billion. As of June 2021, total value locked is $62 billion. (All according to DeFi Pulse.)
Read: What is a Decentralised Exchange (DEX)?
DeFi vs Traditional Finance
Compared to the current financial services industry, DeFi promises to be more accessible, interoperable and efficient. Below are some of the main differences between DeFi and the traditional financial system.
|Anyone||Eligibility||Subject to application process|
|24/7||Market Availability||Weekdays during business hours|
|No (you control your money)||Intermediaries||Yes|
|Smart contracts, on behalf of a user’s assets||Transaction Execution||Various intermediaries process transactions between parties|
Transparency and control
DeFi introduces a new level of transparency and control to the financial system. All (reputable) protocols have open-source code allowing anyone to audit the code to understand how funds are utilised. The transparency of DeFi is a significant improvement over traditional finance, where users are usually only left with a rough idea of how their capital is being utilised.
DeFi protocols are very lean systems that use smart contracts to automate many cumbersome tasks burdening traditional financial institutions. For example, DeFi borrowers can take out a new loan in seconds versus waiting days to be approved through conventional institutions.
The increased automation results in faster execution and significant cost savings. The cost savings allow protocols to have much smaller take rates leading to more value accruing to end users.
The digital nature of DeFi enables anyone with internet access to utilise DeFi protocols. This massively increases the reach of financial products. Furthermore, the significant cost savings from smart contracts make servicing lower-income users a profitable service.
In summary, DeFi increases accessibility by servicing users excluded from traditional finance for geographic or socioeconomic reasons.
DeFi Use Cases
Think of all the financial services that exist such as lending, borrowing, exchanging and insurance. The DeFi ecosystem is largely made up of decentralised alternatives to the financial services we use today. These are being used every day by people from all over the world.
Lending and borrowing
Of all the use cases in DeFi, lending and borrowing are among the most popular. Through something called a ‘decentralised lending protocol’, anyone can lend their cryptocurrency and earn interest. This interest comes from borrowers, who must pay interest on the amount they borrow from the protocol.
Examples of decentralised lending protocols are Aave (AAVE) and Compound (COMP), each of which has several billions of dollars worth of cryptocurrencies flowing through them.
Decentralised exchanges let you swap one cryptocurrency for another. The action of exchanging one currency for another is nothing new. For example, if you’ve ever travelled overseas, you would have converted your Australian dollars for a foreign currency through a bank or currency exchange.
With decentralised exchanges, you can swap cryptocurrencies without having to trust an intermediary or share personal details. The most widely used decentralised exchange, Uniswap (UNI), does billions of dollars worth of weekly trading volume.
The user experience in DeFi leaves a lot to be desired, increasing the chance for mistakes. When things do go wrong—for example, you send your cryptocurrency to the wrong address—there is no support team to help ‘undo’ your mistake.
This is in contrast to the help you’d get from a bank. For example, if your account was hacked or you sent money to the wrong account, your bank will usually step in to fix the situation.
Whilst DeFi’s user experience has improved in recent years, plenty more work must be done before the average person feels comfortable with bearing the responsibility of ‘being their own bank’.
DeFi protocols and apps are designed to be decentralised and permissionless, meaning anyone from any country can use them. Whilst this has its benefits, it raises immense challenges when it comes to regulating money laundering and terrorism financing.
Public blockchains like Bitcoin and Ethereum are limited by how many transactions they can record at once. Ethereum is the blockchain upon which most DeFi apps are built.
In early 2021, strong growth in these apps overwhelmed the Ethereum network, causing transaction fees to surge to record highs. When activity is particularly high, you can end up paying US$50–$125 in fees just to complete a transaction.
The Future of DeFi
DeFi is among the most exciting areas of innovation in the world of cryptocurrencies and blockchain. Every week, a new DeFi app or protocol is launched. Like any new technology, DeFi faces several major challenges. These are being worked on by developers and entrepreneurs from all around the world in an effort to disrupt the financial services we use today.
Want to learn more about DeFi? We strongly recommend ‘DeFi Beyond the Hype’, a 20-page report by the Wharton Blockchain and Digital Asset Project, in collaboration with the World Economic Forum (WEF).
The Role of Stablecoins in DeFi
DeFi apps uphold some of the same components as traditional financial products, making them attractive to some retail investors. For example, stablecoins—a crypto asset pegged to a real-world asset such as the U.S. dollar (USD)—can offer stronger stability than cryptocurrencies, which are relatively more volatile.
That’s because their value is pegged to that of another currency or asset. For example, the USDC stablecoin is almost always worth US$0.99–$1.01.
Stablecoins are becoming an increasingly popular component of the crypto ecosystem and are typically used for liquidity mining, lending and borrowing.
Read: What Are Stablecoins?