What is Decentralized Finance?

DeFi explained

It is difficult to imagine the future of finance without the traditional financial intermediaries we rely upon today. But the emerging area of decentralized finance (DeFi) has the potential to upend the entire financial ecosystem as we know it. DeFi is a disruptive digital finance movement offering global, inclusive financial service functions with incomparable enhancements in speed, cost, and accessibility. DeFi, built primarily on Ethereum’s protocol, opens up entirely new possibilities for economies and individuals worldwide.

DeFi is a global, open alternative to traditional financial services.

Advancements in blockchain technology are empowering DeFi developers to recreate the architecture of legacy financial systems with a code-based digital infrastructure of DeFi apps. These apps replicate traditional financial functions such as borrowing, lending, and exchanging assets. Furthermore, DeFi has expanded to include perpetual futures, leveraged products, automatically rebalanced indexes, decentralized options, insurance and more – everything that existed in the traditional finance world is now being built in the DeFi world. They do so in a permissionless manner without relying on traditional financial intermediaries.

As the usage of DeFi apps surges, the disruptive nature of DeFi is attracting savvy investors looking to be part of the revolution. And with new technological advancements come new ways of generating returns. DeFi is creating brand new opportunities in spot borrowing and lending, call overwriting, yield farming, and liquidity mining. This move away from traditional financial intermediaries is revolutionary.

What are DeFi killer apps?

You’ll often hear DeFi apps referred to as “killer apps.” In order to be a “killer app,” the app must be both disruptive and widely adopted. Most DeFi apps utilize Ethereum’s smart contracts, which implement automated if/then logic to enable more complex functions, also known as “general programmability”. They’re powered by native digital assets that operate as built-in incentive mechanisms. These digital assets have been increasingly attracting attention since DeFi’s explosion in mid-2020, with some touting market caps in the billions that rival those of fast-growing tech startups.

How do DeFi apps intersect?

One of the unique features of DeFi is that all of these projects can use and leverage each other, a trait commonly referred to as “composability.” More importantly, other developers can use all of these when they build their own products. This level of permissionless interoperability is significant to the continued growth of the entire space. That said, all of this interoperability is enabled because these projects build on Ethereum. Composability is currently only possible between projects that operate within the same blockchain ecosystem, such as Ethereum, and becomes increasingly difficult when trying to communicate between two different blockchains. While other blockchains are making efforts to bring forward DeFi applications, the DeFi ecosystem originally developed on Ethereum. Thus, DeFi is still mostly confined to Ethereum.

Initial DeFi growth: liquidity mining AKA yield farming

What is Liquidity Mining? A number of DeFi protocols, led by Compound - a money market protocol that allows users to deposit crypto assets into smart contracts that pool assets and earn a yield while being borrowed - have started rewarding the protocol users with their own tokens. One way to think about these rewards is like mining rewards in Proof of Work systems. Since Compound’s token was launched, the protocol has been rewarding users with COMP tokens. Users earn a pro-rata share of tokens based on how much they borrow or lend. This provides an additional yield to users, such that actively participating in a protocol now produces a yield denominated in the protocol’s token (although some may provide yield in ETH or other tokens).

This initially led to a 'yield farming' craze, as the prevailing yields exceeded 30% (annualized) in some cases. Simply put, news circulated quickly about how some users were able to realize double-digit annual yields by lending or borrowing crypto assets, including stablecoins, increasing the popularity of ‘yield farming.’ Stablecoins are digital assets created to act as a unit of account or store of value, typically by being pegged to a fiat currency such as the U.S. dollar.

But what are these tokens, and what inherently gives them value? In most cases, and the instance of COMP, these tokens are most commonly referred to as “Governance Tokens.” Governance Tokens allow the holder to vote on changes to the protocol or delegate their vote to someone else (similar to a proxy advisor). In addition, many of these protocols generate cash flows which most commonly accrue to a treasury vault overseen or governed by the token holders. Simply put, the ability to vote on protocol changes is the ability to vote on how the protocol accrues value or how it directs those cash flows.

The future of DeFi

The ethos of decentralized finance has far-reaching and revolutionary implications. DeFi is actively innovating to rebuild the current financial infrastructure in a way that is not only faster and more cost-efficient but also fully transparent. This is a future where transaction settlement is not only instant but openly verifiable and one in which counterparty risk is significantly mitigated. DeFi is the future of finance.