What is DeFi?

Definition

DeFi (or “decentralized finance”) is an umbrella term for financial services on public blockchains, primarily Ethereum. With DeFi, you can do most of the things that banks support — earn interest, borrow, lend, buy insurance, trade derivatives, trade assets, and more — but it’s faster and doesn’t require paperwork or a third party. As with crypto generally, DeFi is global, peer-to-peer (meaning directly between two people, not routed through a centralized system), pseudonymous, and open to all.

DeFi draws inspiration from blockchain, the technology behind the digital currency bitcoin, which allows several entities to hold a copy of a history of transactions, meaning it isn’t controlled by a single, central source. That’s important because centralized systems and human gatekeepers can limit the speed and sophistication of transactions while offering users less direct control over their money. DeFi is distinct because it expands the use of blockchain from simple value transfer to more complex financial use cases.

Bitcoin and many other digital-native assets stand out from legacy digital payment methods, such as those run by Visa and PayPal, in that they remove all middlemen from transactions. When you pay with a credit card for coffee at a cafe, a financial institution sits between you and the business, with control over the transaction, retaining the authority to stop or pause it and record it in its private ledger. With bitcoin, those institutions are cut out of the picture. Cutting out middlemen from all kinds of transactions is one of the primary advantages of DeFi.

The most popular types of DeFi applications include:

• Decentralized exchanges (DEXs): Online exchanges help users exchange currencies for other currencies, whether U.S. dollars for bitcoin or ether for DAI. DEXs are a hot type of exchange, which connects users directly so they can trade cryptocurrencies with one another without trusting an intermediary with their money.

• Stablecoins: A cryptocurrency that's tied to an asset outside of cryptocurrency (the dollar or euro, for example) to stabilize the price.

• Lending platforms: These platforms use smart contracts to replace intermediaries such as banks that manage lending in the middle.

• "Wrapped" bitcoins (WBTC): A way of sending bitcoin to the Ethereum network so the bitcoin can be used directly in Ethereum's DeFi system. WBTCs allow users to earn interest on the bitcoin they lend out via the decentralized lending platforms described above.

• Prediction markets: Markets for betting on the outcome of future events, such as elections. The goal of DeFi versions of prediction markets is to offer the same functionality but without intermediaries.

In addition, new DeFi concepts have sprung up around them:

• Yield farming: For knowledgeable traders who are willing to take on risk, there's yield farming, where users scan through various DeFi tokens in search of opportunities for larger returns.

• Liquidity mining: When DeFi applications entice users to their platform by giving them free tokens. This has been the buzziest form of yield farming yet.

• Composability: DeFi apps are open source, meaning the code behind them is public for anyone to view. As such, these apps can be used to "compose" new apps with the code as building blocks.

• Money legos: Putting the concept "composability" another way, DeFi apps are like Legos, the toy blocks children click together to construct buildings, vehicles and so on. DeFi apps can be similarly snapped together like "money legos" to build new financial products.

DeFi FAQ

How do I make money with DeFi?

The value locked up in Ethereum DeFi projects has been exploding. Using Ethereum-based lending apps, users can generate “passive income” by loaning out their money and generating interest from the loans. Yield farming, has the potential for even larger returns, but with larger risk. It allows for users to leverage the lending aspect of DeFi to put their crypto assets to work generating the best possible returns.

When will DeFi go mainstream?

While more and more people are being drawn to these DeFi applications, it’s hard to say where they’ll go. Much of that depends on who finds them useful and why. Many believe various DeFi projects have the potential to become the next Robinhood, drawing in hordes of new users by making financial applications more inclusive and open to those who don’t traditionally have access to such platforms. This financial technology is new, experimental and isn’t without problems, especially with regard to security or scalability. Developers hope to eventually rectify these problems.