Decentralized finance (DeFi) is changing the way we think about banking. One of its most impressive traits, however, is actually its ability to mimic traditional finance. We’ve become accustomed to a certain relationship with banks, with customers borrowing and banks lending. DeFi flips finance on its head by allowing users to be borrowers and lenders, effectively taking out the middleman.
You probably found your way here because you want to better understand DeFi and what it means. How does DeFi work? Where does the money come from? Where does it live? These are good, fundamental questions, and most of them have surprisingly simple answers.
Since DeFi redefines the way we have to think about money and banking, don’t worry if it’s a bit overwhelming at first. DeFi doesn’t need to be difficult, and we’ll tell you why. To help out, before reading on, be sure to review our glossary of Top 15 DeFi Terms, as many of them will be mentioned below.
To get a broader understanding of DeFi, we need to look at the bigger picture. At its core, decentralized finance shares a lot of characteristics of traditional finance like borrowing, lending and interest. The key difference, however, is that everything on DeFi happens on the blockchain through protocols. Blockchains are essential to DeFi because it makes all transactions transparent and censorship-resistant, and guards against manipulation or incompetence of central actors. DeFi is a catch-all term for every protocol, or service, that makes up the diverse ecosystem of financial platforms on the blockchain.
Bitcoin is the first and most recognizable blockchain. It’s also arguably the first DeFi tool, but only in a broad sense. The surge of DeFi protocols in 2020 needed somewhere to live, and Bitcoin can’t host them. Instead, Ethereum became the go-to “server” for most applications and platforms in DeFi. Right now, it’s safe to assume that most decentralized applications (dApps) and protocols are hosted on Ethereum.
At some point, a lot of the money circulating in DeFi entered the ecosystem through centralized exchanges (CEXs) like Coinbase, Binance or Kraken. Users have these “on-ramps” and “off-ramps” to buy and sell crypto with their bank account. Crypto wants to be autonomous, but the reality is that users need convenient ways to exchange crypto or cash, and those services have to be centralized due to licensing and regulations.
So far, we’ve bought some crypto. Now what? Where’s DeFi? The main way users interact with a blockchain is through their wallet. MetaMask is commonly used as a hot wallet of choice for Ethereum, but each cryptocurrency blockchain requires its own. Since most DeFi runs on Ethereum, MetaMask (along with cold storage wallets like a Ledger or Trezor) or some equivalent can be used for everything. A wallet is like a personal bank account that only you control and requires your permission to interact with.
It serves as a gateway to understanding DeFi since every retail users’ transactions go through one. If we want to use the Ethereum network, we need an Ethereum wallet and we also need to pay the people who keep it running (as fees). Wallets are one of DeFi’s pillars because any action requires the use of one. Other DeFi pillars include smart contracts, dApps, and decentralized exchanges (DEXs).
Smart contracts are a key component of how Ethereum works. Smart contracts can be understood as unchangeable agreements in the form of a transaction. For example, when a user trades Token X for Token Y, a smart contract is generated that completes the transaction. A fee is paid by whoever generated the smart contract, and miners write it into Ethereum’s main chain forever. It can never be changed, reversed or altered. Smart contracts are used for things big and small, from completing a $50 trade to securing liquidity pools worth billions of dollars.
There’s a lot going on underneath the hood of Ethereum and DeFi, but users will mostly interact with dApps. dApps allow users to deploy smart contracts for the protocol, such as putting up collateral for a loan or staking tokens. Just like an app on your phone, dApps are the outer layer that users interact with. Beneath that layer is a lot of code that makes everything work. DeFi lending platforms like Compound and Aave, for instance, work by deploying smart contracts, but each has a user interface for people to easily transact with the protocol.
DeFi consists of a huge variety of protocols and dApps. Some are borrowing and lending platforms, while others are stablecoins like DAI. Some are relatively safe and tested while others push the boundaries of what most would consider a “safe” investment. Unfortunately, no clear line defines what is or is not DeFi. Crypto is inherently speculative already. The easiest way to think of DeFi is as a cluster of various dApps and protocols that resemble traditional finance in some way, whether by mimicking it or rebuking it.
One rebuke of the status quo in traditional finance, and another pillar of DeFi and crypto, is decentralized exchanges. DEXs like Uniswap and SushiSwap are game-changing for traders and developers. Instead of keeping your funds on an exchange’s servers, you only interact with the blockchain directly for peer-to-peer trading of tokens. This once again cuts out the middleman, resulting in more security and autonomy. Big, centralized exchanges have most volume in crypto, but DEXs have quietly become the go-to place to find new, promising, under-the-radar projects. It also gives investors an unprecedented role in shaping the market.
Uniswap, for instance, allows anybody to add liquidity to a pair of Ethereum tokens. By making users provide liquidity, Uniswap avoids the security issues and cumbersome, bureaucratic decision-making of CEXs. On the other hand, Uniswap’s team bears no responsibility if users get scammed or lose funds since they do not control the exchange or listings, they only further its development. The market dictates everything on a DEX – from token volume to price and liquidity – except the underlying code.
When users add liquidity to Uniswap, SushiSwap or other liquidity pools, they receive rewards from trading fees, interest or newly minted tokens. This is called liquidity mining (or yield farming). Liquidity mining is a complex, essential pillar of DeFi that will be discussed at length later in this series.
Learning how to navigate the DeFi ecosystem is no easy task. It largely consists of disparate parts that build on top of one another and, of course, there’s no center. Platforms interact with one another in unique ways, and the list of new protocols grows by the day. DeFi also presents hazards for users: smart contracts can be exploited, simple errors can cause enormous issues, and liquidity mining isn’t usually cost-effective for average users.
DeFi could very well be the biggest thing in crypto since Bitcoin itself. As it continues to grow, many feel they have missed out on big gains, but are justifiably concerned about putting their money on the line in something so novel. YIELD bridges that gap and changes how users approach DeFi, simplifying and streamlining it to offer diverse investment plans and industry-leading APY rates. Since individual users pool their funds together, they benefit from the outstanding interest DeFi offers without huge risks or fees. This ties together the unfocused DeFi ecosystem and takes it to its next logical step: bringing it to the mainstream.