An Introduction to Decentralized Finance (DeFi)
Everything you need to know about the recent hype in the crypto ecosystem
This is the first part of our new educational series on the latest trends in crypto.
Table of Contents
- Definition
- Origin
- What’s DeFi about?
- How does DeFi work?
- Characteristics of DeFi
- Difference to other hypes
It all started with ICOs (Initial Coin Offerings) in 2017, followed by STOs in 2018 (Security Token Offerings) and IEOs (Initial Exchange Offerings) in 2019. You can say a lot of things about crypto, but it definitely doesn’t become boring. It’s 2020 now and, of course, we see another hype emerging: This time it’s DeFi, short for Decentralized Finance.
What exactly DeFi means, how it works and why it’s different from the previous hypes, will be answered in this article. Have a good read!
Definition
Decentralized Finance (DeFi) is the open ecosystem of financial applications built on blockchain technology.
Origin
The term was first conceptualized two years ago. Ethereum developers and entrepreneurs came up with it in a Telegram group.
However, the foundation of DeFi was laid back in 2015 by the MakerDAO protocol. Its’ stablecoin (DAI), reflecting the value of the US dollar 1 to 1, differs from other stablecoins. Instead of depositing physical collaterals in banks, MakerDAO deposits digital collaterals by using Smart Contracts on the Ethereum blockchain (more info on that below).
What’s DeFi about?
Traditional finance exists to smooth trade and economic activity. Basically, it’s made possible by supplying economic players with capital. For example, people can only arrange bigger investments by borrowing money from the bank. Finance moves capital to those players and activities which yield the biggest economic benefit.
That’s also what DeFi is doing. But on the Internet and only starting a few years ago. It provides liquidity to decentralized application and actors in p2p networks, so that people can trade digitally all over the world.
DeFi’s objective is to provide liquidity and other financial tools to decentralized digital platforms.
How does DeFi work?
One of DeFi’s principal feature is that no intermediary is needed for the financial applications. No bank or other financial institution is involved. Rather, the applications are developed on public and programmable blockchain networks. Programmable means that the network offers smart contracts, which are a requirement for DeFI protocols.
A smart contract is a deterministic software that can automatically execute rules and predefined conditions. Take a decentralized exchange (DEX) as an example: With it, you can trade crypto currencies with others — just by means of smart contracts.
It works like this: Alice wants to exchange 100 Ether to DAI. On a DEX, she finds Bob’s bid, offering 370 DAIs for 100 Ether. Alice is happy with the exchange rate and sends her Ether to a blockchain address, which is stored in a smart contract. The smart contract recognizes that all conditions are met for it to execute. Bob receives the Ether, Alice the DAIs. All this happens automatically and without human intervention.
Characteristics of DeFi
DeFi is more than just a digitized finance industry. While there are classical financial applications being part of DeFi (for example, you can lend digital tokens with Compound Finance and receive an interest), there are also new, distinctive features, that offer advantages over traditional finance:
Decentral
DeFi protocols are developed on public blockchain networks. Ethereum is the blockchain with the most DeFi applications and is supported by more than 8.500 (as of September 2020) nodes all around the world.
There is no central institution who could ban applications. There are no central servers who could be paralyzed. Applications in a blockchain network are available 24/7 and more secure than applications developed by a central provider.
In addition, DeFi lives from the involvement of the community. Owning a digital token of a protocol often gives you a say in the further development of the application, together with all other token owners.
Openly accessible
Our traditional finance industry is exclusive. Many people don’t even have access to financial tools, as they don’t have any means of opening up a bank account. All you need to participate in DeFi applications is an Internet connection! You can picture DeFi as openly accessible as the Internet. The difference is that instead of sharing information you exchange value: Think of the Internet of value!
Transparent
All protocols are published under an open source license, so that others can audit the integrity of the source code. Thanks to this transparent approach, mature and frequently used applications behave properly and can be seen as quite trustworthy.
Money legos
You might hear the term money legos if you dive into DeFi. This means that developers can use existing applications to develop their very own use case — just like lego bricks, which build on top of each other. If you like the idea of a use case but feel like the code is just bad, you can copy and improve it! This modular structure of the DeFi ecosystem is a prospering ground for innovation.
Non-custodial
In a decentralized network, you are responsible to manage and secure your digital assets. As a user, you have to keep your private key secure, as you could lose all your assets irrevocably. This makes you much more independent from third parties, but comes at the cost of more self-responsibility.
Why does it differ from previous hypes?
If you look at the current values that are locked in DeFi applications, then you might come to the conclusion: Another hype bubble!
Since mid-June 2020, the values have skyrocketed: From 1 billion US dollar to over 8 billion US dollar in a few months. But numbers only say so much about the development of the ecosystem. It is clear that decentralized financial applications offer real benefits to other decentralized applications. With the provided liquidity, the governance of applications can be controlled, enabling the development of stable decentralized applications.
With ICOs, STOs, IEOs, one party always benefited the most from the offerings. Most of the time, the issuer of the digital assets benefited — at the expense of investors, if the project turned out to be unsustainable. This happened especially during the ICO hysteria between 2017 and 2018. With DeFi applications, developers, users and the ecosystem as a whole benefit. Due to its open source nature, other innovative applications can be built on top of the ecosystem.
And last but not least: Always keep in mind that DeFi is still new and that speculators and opportunists — lured by past hypes — will try to enrich themselves at the expense of others. If you have an eye on DeFi applications yourself, be careful! Especially, what tokens you buy and how the ecosystem develops. The credo for every crypto-related investment also applies here: Do Your Own Research!
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