DeFi Basics: Decentralized Finance and How it Works

DeFi's role in democratizing finance, offering autonomy, and challenging traditional banking.

Expert verified
Expert verified
defi explained definition
Last updated:
January 29, 2024

tl;dr

  • DeFi's Democratization of Finance: DeFi represents a major shift in finance, aiming to democratize access to financial services and eliminate traditional banking barriers through blockchain technology​​.
  • Autonomy and Lower Costs: DeFi removes intermediaries, lowering costs and barriers, and gives individuals complete control over their assets​​.
  • Decentralization and Democratic Governance: In DeFi, power resides with the community or network participants, fostering security and democratizing decision-making through smart contracts and token-based governance​​.
  • Impact on Traditional Finance: DeFi challenges traditional financial structures, offering inclusivity and the potential to serve the unbanked and underbanked, suggesting a possible shift away from conventional banks​​.

Decentralized finance, commonly known as DeFi, represents a seismic shift in the world of finance, promising to democratize access to financial services and dismantle traditional banking barriers. Operating predominantly on blockchain platforms, DeFi applications offer a range of services—from lending and borrowing to asset trading—without the need for intermediaries like banks or financial institutions.

But how does this burgeoning ecosystem function, and what sets it apart from the conventional financial system? This article will introduce you to the foundational concepts of DeFi, exploring its mechanisms, advantages, and the transformative potential it holds for the financial landscape.

{{cta-banner-generic-en="/elements/reusable-components"}}

The evolution of finance: From traditional to decentralized

The realm of finance has continually evolved, mirroring society's advancements and technological leaps. For decades, traditional finance, often termed as 'CeFi' (Centralized Finance), has been the backbone of global economies with centralized institutions like banks, brokerages, and insurance companies playing pivotal roles. 

Decentralized Finance (DeFi), in contrast, removes these intermediaries, operating instead on computer code within blockchain platforms. 

With DeFi, all transactions and agreements are dictated by algorithms and smart contracts. This system ensures rigorous conditions for financial activities; for example, there are precise scenarios in which a borrower's collateral is liquidated in DeFi platforms. 

These safeguards minimize risks like bad debt and human error. So, while CeFi operates on trust in institutions, DeFi shifts this trust to its code and foundational technology.

Read on: The History of DeFi

Understanding the value proposition: Why DeFi?

DeFi democratizes financial access, removing intermediaries and thereby lowering costs and barriers. Individuals gain complete autonomy over their assets, addressing gaps left by traditional banks. 

With DeFi's blockchain foundation, transactions that once took days now conclude in mere minutes, an essential edge in dynamic financial markets. 

Beyond speed, DeFi revolutionizes investment through tokenization. Real-world assets, from real estate to art, are represented as tradeable blockchain tokens, democratizing investments and boosting liquidity in traditionally stagnant markets. 

In short, with its rapid transactions and diverse investment avenues, DeFi presents a transformative alternative to conventional finance.

DeFi Basics: Blockchain and smart contracts

The foundation of decentralized finance

Decentralization: Power to the people

Decentralization ensures no single entity dominates. In DeFi, it's the community or network participants that wield power, fostering security and democratizing decision-making. 

With smart contracts, DeFi products can incorporate democratic elements, enabling collective decisions on governance, product modifications, or distribution by token holders. This democratic approach makes users active stakeholders, not just passive consumers. 

By melding blockchain with democratic governance, DeFi promises a transparent, inclusive, and responsive financial ecosystem.

Trustless systems and peer-to-peer transactions

DeFi's hallmark is 'trustless' transactions, where parties transact without needing mutual trust, guaranteed by blockchain. This trustlessness is vital not only for human transactions but also for machine-to-machine interactions. 

As our world leans more into the Internet of Things (IoT) and autonomous systems, machines will frequently transact amongst themselves, requiring immediate and transparent trustless transactions. 

DeFi facilitates this, paving the way for an era where machines act as both consumers and service providers.

Public and Transparent Ledger: Blockchain's Role

Blockchain serves as DeFi's public and transparent ledger, allowing anyone to audit or verify transactions, enhancing fairness and trust. Underpinning these DeFi fundamentals – decentralization, trustless transactions, and transparent blockchain – are smart contracts. 

These self-executing contracts embed agreement terms into code lines. In DeFi, smart contracts automate financial arrangements, ensuring adherence to set rules without middlemen, solidifying DeFi's stance as a significant financial disruptor.

Core Components of DeFi

Stablecoins: Bridging traditional currency and crypto

Stablecoins aim to mirror the value of traditional currencies, providing a stable medium of exchange and a unit of measure in the otherwise volatile crypto market. The pegging to traditional currencies can be achieved through various means, and understanding these mechanisms helps in assessing the stability and risk associated with each type:

Cash or cash equivalents stablecoins

These stablecoins anchor their value by maintaining reserves of traditional fiat currency or cash equivalents. For every stablecoin minted, there's a corresponding value held as collateral in these assets. Regular audits ensure transparency. Such stablecoins incorporate not just fiat but also assets like low-risk government securities, such as Treasury Bills, reinforcing their stability and trustworthiness in the market. 

Examples are USDC and Tether (USDT)


Crypto-collateralized stablecoins

These stablecoins are over-collateralized by other cryptocurrencies, like Ether. If the collateral's value drops, the smart contract liquidates enough collateral to ensure the stablecoin’s peg remains intact.

Example: DAI uses over-collateralized assets like Ether.

Basket-collateralized stablecoins

Instead of being pegged to a single currency or asset, these stablecoins are pegged to a basket of assets. The basket can comprise various fiat currencies, commodities, or other assets, diversifying the collateral and potentially reducing volatility and risk.

Example: Libra (now known as Diem) initially proposed a model where its value would be pegged to a basket of international fiat currencies and short-term government securities.

Algorithmic stablecoins

These stablecoins use algorithms and smart contracts to automatically adjust the supply based on demand, keeping the price stable without any backing collateral.

Example: Terra’s (LUNA) stablecoin UST was the most prominent example

Decentralized exchanges (DEX)

Unlike centralized exchanges that act as intermediaries, DEXs allow peer-to-peer trades.

How they work: Automated market makers (AMMs)

Automated market makers (AMMs) represent a revolutionary approach to digital asset trading, a departure from traditional finance and its reliance on order books. In traditional exchanges, buyers and sellers place orders at different prices, and trades are executed when there's a match. AMMs, however, use a mathematical formula to set the price of an asset, enabling instant trades without the need for a counterparty.

At the heart of AMMs are liquidity pools. Instead of matching buyers and sellers, users trade against these pools. Anyone can become a liquidity provider by depositing their assets into these pools, and in return, they receive liquidity tokens. These tokens can later be redeemed for their share of the pooled assets, plus a portion of the trading fees.

Benefits:

  1. Permissionless: Anyone can create a market by providing liquidity.
  2. Constant liquidity: Unlike order book-based exchanges, as long as there's some liquidity, trades can happen.
  3. Reduced slippage: With enough liquidity, AMMs can offer comparable, if not better, rates to traditional exchanges.


Drawbacks:

  1. Impermanent loss: Liquidity providers might face losses if the price of their deposited assets changes compared to when they were deposited.
  2. Slippage: Large trades might still face significant price slippage in pools with low liquidity.

Popular platforms: Uniswap, SushiSwap, and Balancer

Uniswap: A trailblazer in the AMM space, Uniswap is among the most popular decentralized trading platforms. It uses a simple formula for price determination and offers a wide variety of tokens. Uniswap V3 introduced concentrated liquidity, allowing liquidity providers to set price ranges, potentially reducing impermanent loss.

SushiSwap: Originally a fork of Uniswap, SushiSwap has since introduced various features to differentiate itself. It includes a community-driven approach with a governance token, enabling token holders to have a say in the protocol's direction.

Balancer: More than just a simple AMM, Balancer allows for the creation of liquidity pools with multiple tokens with different weights. This feature makes it a combination of an AMM and a portfolio manager, letting liquidity providers create pools that can act as self-balancing portfolios.

Lending and borrowing platforms

Lending and borrowing platforms are crucial components of the DeFi ecosystem, allowing users to lend assets to earn interest or borrow assets for various needs, all without intermediaries like traditional banks.

Collateralized loans and interest rates

One of the foundational principles of DeFi lending is the concept of collateralization. To borrow assets, users must lock up collateral, typically in the form of another cryptocurrency. This collateral is used as a guarantee for the loan.

Over-Collateralization: Almost all crypto loans in the DeFi space are over-collateralized, meaning borrowers provide collateral worth more than the amount they are borrowing. This ensures that lenders are protected against market volatility and borrower defaults. Over-collateralization is essential because of the inherent price volatility of many crypto assets.

Loan-to-Value (LTV) Ratio: This ratio represents the size of the loan compared to the value of the collateral. For example, if a user deposits $100 worth of Ethereum as collateral and borrows $50, the LTV is 50%. Platforms typically have maximum LTV ratios to ensure loans are always over-collateralized.

Interest Rates: DeFi platforms utilize dynamic interest rates, which adjust based on supply and demand. When the demand to borrow a particular asset increases, its interest rate goes up, incentivizing more lenders to deposit the asset and earn interest.

Liquidation: If the value of the collateral falls below a certain threshold (typically determined by the platform's LTV ratio), the platform might automatically liquidate a portion or all of the borrower's collateral to ensure the loan remains covered. This system ensures lenders always have security on their lent assets.

Platforms like Aave and Compound

Both Aave and Compound have played pivotal roles in the evolution of DeFi lending, setting standards for transparency, user experience, and innovation. 

Aave

A leading DeFi lending protocol, Aave offers several unique features:

  1. Flash Loans: Borrowers can take out loans without collateral, as long as they repay them within a single transaction.
  2. Rate Switching: Users can switch between stable and variable interest rates based on market conditions.
  3. Safety Module: A pool of funds set aside to act as insurance against potential smart contract vulnerabilities.

Compound
A pioneer in the DeFi lending space, Compound allows users to lend and borrow various cryptocurrencies:

  1. cTokens: When users deposit assets into Compound, they receive cTokens in return, which continuously earn interest.
  2. Governance: Compound has a decentralized governance system, allowing COMP token holders to propose and vote on protocol changes.

Learn more about this: Advanced DeFi Applications

Potential Risks and Challenges

While DeFi has garnered attention for its promise of democratizing finance, it's essential to recognize the inherent risks and challenges that accompany this emerging sector. A thorough understanding of these risks aids users in navigating the DeFi space with increased safety and awareness.

Smart Contract Vulnerabilities

At the core of DeFi platforms lie smart contracts, automated contracts with terms directly written into lines of code.

Bugs and Flaws: Just like any software, smart contracts can have bugs or exhibit unintended behaviors. If these vulnerabilities are exploited, they can lead to significant financial losses.

Audits and Formal Verification: Many DeFi projects undergo audits to identify and rectify vulnerabilities. However, audits are not always foolproof. Certain interactions between contracts can be challenging to predict and audit fully. For instance, the infamous reentrancy attack, where an attacker can withdraw funds repeatedly before the original transaction is approved, illustrates the complexity of ensuring complete security in smart contract interactions.

Centralization Concerns in "Decentralized" Platforms

One of the core appeals of DeFi is decentralization, yet not every platform fully adheres to this principle:

Admin Keys: Some projects keep administrative rights that allow intervention in the protocol, introducing a central control point and potential failure.

Infrastructure Reliance: Several DeFi applications are dependent on centralized infrastructures for aspects like oracles or hosting, introducing potential centralized failure points.

Concentration of Liquidity: Occasionally, a minor group of large holders or "whales" can exert a disproportionate influence on a platform or its decision-making process.

Regulatory Concerns and Evolving Landscapes

Unclear Regulations: Many regions are still determining how to classify and oversee DeFi platforms and offerings.

Compliance Issues: Some platforms might unintentionally breach existing financial regulations, leading to potential legal consequences.

Market and Systemic Risks

Liquidity Crisis: A core tenet of DeFi is liquidity. An abrupt mass withdrawal or "bank run" could shake platforms, especially those operating with high leverage.

Interconnectivity Risks: With DeFi platforms often intertwined, sourcing liquidity from each other, a hiccup in one can ripple across the ecosystem.

Market Manipulation: The open nature of DeFi presents opportunities for malicious actors to manipulate markets, exemplified by tactics like flash loan attacks.

{{cta-banner-generic-en="/elements/reusable-components"}}

The Future of DeFi

DeFi is swiftly altering the landscape of financial services, ushering in a new age of transparent and decentralized financial systems. Its implications extend far beyond just blockchain technology, showcasing potential to reform the global financial infrastructure.

Emerging trends: DAOs, cross-chain interoperability, and more

The DeFi sector is filled with promising innovations. At the forefront is the ascent of Decentralized Autonomous Organizations (DAOs). Unlike conventional organizations, DAOs operate based on pre-set rules on the blockchain, giving individual participants more power and enhancing transparency in decision-making.

Along with the burgeoning growth of multiple blockchain ecosystems, there’s an evident demand for cross-chain interoperability. Future DeFi platforms are set to break the confines of singular blockchains, pooling liquidity and functionalities from diverse sources. 

Adding to this trend, Layer 2 solutions, which tackle issues like Ethereum's high transaction fees, are set to make operations quicker and more cost-effective, paving the way for DeFi's broader adoption.

Real-world use cases and adoption outside crypto

Moving beyond purely digital interactions, DeFi's reach is expanding into real-world sectors. One clear illustration is the tokenization of physical assets, ranging from real estate properties to artworks and even stocks. 

This tokenization process allows these assets to be fractionally owned and traded on global DeFi platforms, making them more accessible to a wider audience and opening up fresh avenues for international trade.

Furthermore, industries such as insurance are undergoing transformations due to DeFi. For instance, decentralized insurance platforms can harness smart contracts to expedite claims processing, ensuring swift payouts while reducing overheads. 

Within supply chain finance, DeFi offers transparent mechanisms that guarantee timely payments for suppliers and liquidity maintenance for buyers.

Potential impact on global finance and banking systems

As DeFi rises in prominence, traditional financial structures are presented with both challenges and opportunities. One notable effect could be a shift away from conventional banks as more people tap into DeFi services. 

However, it’s not just about disruption. DeFi also promises inclusivity, potentially becoming the financial bridge for the unbanked and underbanked. 

Yet, as DeFi continues to grow, regulators will undoubtedly keep a close watch, leading to evolving financial frameworks that aim to protect consumers without stifling innovation.

On this page
About the author

Peter is deeply engaged with the revolutionary world of decentralized, unconfiscatable blockchain technology. His expertise in on-chain analysis and data engineering empowers him to provide in-depth, data-informed insights into the dynamic realm of cryptocurrency.

Disclaimer: The information provided in this blog post is for general information purposes only. The information was completed to the best of our knowledge and does not claim either correctness or accuracy. For detailed information on crypto regulations, we recommend contacting a certified legal advisor in the respective country.