DeFi Explained - everything you should know

Decentralization, Why it matters, and Use Cases.

Sep 30, 2021

Money is one of the greatest inventions of humanity. It is one of the strongest beliefs we created and gave immense meaning to, and is at the core of how our lives and societies function. Because of this, over the years the Finance ecosystem has become really robust.

Today, we see a lot of new crypto applications impacting different industries, with Finance being the first that has been heavily disrupted, which tells us something about how relevant DeFi is.

Defi is short for Decentralized Finance, a collective term used to describe the financial products and services that are built on blockchain techonology, and are permissionless and censorship-resistant. It aims to be an open and global financial system built for the internet age.

What problem does it aim to solve?

Well, as Decentralized Finance, it naturally solves the centralization problem.

The existing Financial System is centralized:

This means that government, banks, and large institutions control it: they can print more money if they want to, they can stop it if they want to, they can stop you from having a bank account if they want to.
If you own a business, they can tell you if you can or cannot send money abroad, which is very limiting in a highly globalized world. In the case you can go ahead, they also tell you under which conditions you can do it, and more often than not, it turns out to be quite expensive and inefficient.

This is not just referring to government and financial institutions. The centralization issue is equally applicable to how much power we give private companies when dealing with our money. Let’s refresh our memories and recall what happened with Robinhood and the GameStop example.
The reason why Robinhood was able to change the rules out of nowhere and went from being the hero to being the traitor overnight is that ultimately they own the company and are entitled to make the decisions behind closed doors.

These are just some of the examples of how outdated and malfunctioning this system is, and it impacts everyone’s life. History offers plenty of lessons we can learn from.

In this context, DeFi emerges.

How did it all start?

Well, Bitcoin. We can argue if Bitcoin should be considered part of DeFi or not, but what’s pretty clear is that it marked the beginning of it, given the fact that Bitcoin was created as a response to the ineffective financial system (read more about Bitcoin here).

Even though today Bitcoin is treated more as a store of value, when it was first created, it provided the world with the first peer-to-peer electronic cash system. It also proved that there is an option, a possibility of creating another way of doing things. The challenge was that the programming language used by Bitcoin’s platform was limiting for advanced Smart Contracts coding, which is the backbone of DeFi projects.

Enters Ethereum. With Solidity, Ethereum’s native programming language, and ERC-20 Token standards, it materialized the goal of becoming the supercomputer that offered a programmable blockchain for like-minded people to build products on it (read more about Ethereum here).

This is how, DeFi boom started on Ethereum’s network, and the rest is history. Today, competitors of Ethereum are being built, so you might find projects that are created on other blockchain platforms, but Ethereum remains the leader, with the most robust DeFi ecosystem in its network.

Below is a chart to give you a sense of the size of DeFi and how much it has grown in the period of 5 years. Today, we have over 80 Billion USD locked.

Crypto, and in this case DeFi, is undeniable. I strongly recommend everyone to spend some time to understand and get educated in this space.

How does DeFi work?

There are 3 key building blocks that support DeFi:

Blockchain
Cryptography
Smart Contracts

All projects in the crypto space are built on blockchains and use cryptography, but not all of them uses Smart Contracts.
Therefore, the key differentiator of Decentralization, and ergo DeFi, lays with Smart Contracts. These are protocols that outline the terms of the agreements between two parties, and will self execute once these conditions are met (read more about Smart Contracts here).

This way, they enable the peer to peer nature of DeFi by removing the need for intermediaries, and therefore becoming decentralized.

Key features of Defi

As part of the crypto space, DeFi offers the same attributes that come with the fact of being built on blockchain, such as speed, 24-7 operations, transparency, cost-saving, etc.

However, following what I was explaining there are major benefits that come along Decentralization:

Permissionless: anyone that has access to the internet can make use of DeFi products or services, as there is no centralized authority that will determine whether you can or cannot have access to something. There are no particular KYC, documentations, and/or requirements. This point is particularly relevant for developing countries where the unbanked population is really high.
Censorship Resistant: because the network is decentralized and distributed across the globe, there is no one party in particular that can make unilateral decisions and shut it down.
Anonymity: activities can happen in pseudonyms, there is no need for tight KYC and identifications.
Peer to Peer: again, this is enabled by the lack of intermediaries in DeFi.
Borderless: DeFi aims to build a global financial system of the internet age, and with this, nation-states frontiers do not matter to DeFi projects, as long as you have internet, you can access them.

Main Usecases of DeFi

DeFi ecosystem reflects the existing traditional financial system, so the portfolio of products and services offered is similarly diverse.

Some of the most popular Use Cases are as follow:

Lending and Borrowing money: few examples in this space are Maker Dao, Compound, Avee.
Send money around the world
Decentralized Exchanges (DEX): different from the typical centralized crypto exchange platforms, DEXs are decentralized and permissionless, and there is no need to give up custody of the coins. Some of the most famous examples are Uniswap, Kyber Network, Balancer.
Insurance: these are services that guarantee certain compensation in exchange for the payment of a premium. Typical ones are protection against Smart Contracts failure, or deposits, but it also applies to applications outside of crypto world.
Crowdfunding
Other Financial Use Cases: Derivatives, Margin Tradings, etc.

The powerful part of DeFi and its multiple use cases is that the open-source nature of blockchain platforms enables leverage and collaboration among the network.

The easiest way to understand what I mean, is to think of DeFi as legos pieces that can be combined and build on top of each other.More complicated DeFi projects can be built on existing applications.

What are some Risks and Challenges?

Increased Responsibility of the User: with the removal of intermediaries, decentralized projects give this ownership back to each and everyone of us. By doing so, there is normally much lesser hand-holding, and the user’s responsibility tends to increase,
How Decentralized it really is: a big part of crypto space is finance-focused, however, just because a project is part of the financial industry, doesn’t mean it’s part of DeFi. This sometimes causes confusion. For example, Binance, Coinbase, crypto.com, etc are all crypto exchange platforms, and even though they are very relevant players in this space, enabling the trading of cryptocurrencies, they are not decentralized. They are companies, run in a similar organizational structure than any other regular company we know.
Even within DeFi, if you care about decentralization, you should always understand how particular project functions to determine how decentralized it is.
Volatility: DeFi tends to offer the same or higher volatility than overall cryptocurrencies, especially if you are also investing in the lending part of DeFi, where supply and demand fluctuation can play an important role.
Smart Contracts malfunctioning: as the backbone of DeFi’s operations, malfunctionings can happen due to errors in the protocol’s code, issues with properly capturing real-world data, blockchain platform upgrades impacting on it, etc.
Scalability and Systemic Risks: similar to the rest of the crypto space, high volume can cause network congestions, and network attacks are also potential risks.

DeFi is a complex space within crypto, as not only does it combined crypto and finance which are 2 vast worlds by themselves, but it also adds up the decentralization component that we are not familiar with.

However, precisely because of this unique combination, it’s able to build a financial system that is more appropriate to today’s globalize and digitized world, in order to serve our needs better.

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