Decentralized Finance, or DeFi, is a groundbreaking movement that aims to recreate the traditional financial systems that have endured for generations. Unlike centralized finance, DeFi uses the blockchain and smart contracts to eliminate reliance on banks, financial institutions, and governments, making financial activities more accessible and giving participants full control over their assets.
Every version of traditional finance — whether it be investing, trading, or simply borrowing/lending funds — has a central authority that dictates policy and controls transactions. These authorities have the power to restrict access, impose high fees, and even change the rules as they see fit. This results in an inequitable financial system that favors the few at the expense of the many.
Blockchain technology and self-executing smart contracts are inherently decentralized, meaning no one entity has control over the system.
By moving financial activities onto the blockchain, DeFi is ushering in a new financial system that offers a level playing field to anyone who wishes to participate.
DeFi relies on three main technologies: cryptography, blockchain, and smart contracts.
Cryptography: This technology ensures secure transactions by encrypting data. It maintains privacy and integrity in every transaction, protecting users’ identities and assets from hackers and fraud.Blockchain: A decentralized ledger that uses a network of computers to record all transactions. Each block is linked to the previous one, creating a chain that is immutable and publicly accessible.Smart contracts: Self-executing contracts with the terms of the agreement written directly into code. They automatically execute and enforce agreements when predefined conditions are met, eliminating the need for intermediaries and minimizing the risk of human error or manipulation.
Together, these technologies make a wide range of financial services possible. These services are not only more accessible than their traditional counterparts but also tend to be cheaper and faster, making DeFi an attractive option for many users.
Stablecoins, like Tether (USDT) and USD Coin (USDC), are cryptocurrencies whose value is tied to a fiat currency. For instance, one USDT is always worth one US dollar. Their stable value makes them an ideal medium of exchange within the DeFi ecosystem.
How stablecoins work
Some stablecoins maintain their value through a minting and burning mechanism, where new coins are created when people buy them, and existing coins are burned when they are sold or exchanged. However, other methods, like backing the coins with reserves, are also used to stabilize value.
Stablecoins bridge the gap between the volatile world of cryptocurrencies and the need for consistency in financial services. Like any cryptocurrency, they allow for quick and inexpensive transactions. However, they hold a fixed value, providing the stability necessary for effective lending, borrowing, and investing in the DeFi ecosystem.
The global impact of stablecoins
In many countries, traditional banking systems are riddled with restrictions, such as limits on transaction sizes or approval requirements. Stablecoins bypass these constraints, allowing users to move any amount of money across borders without bank approval.
All in all, stablecoins connect traditional and decentralized finance, allowing every citizen of the world to participate in the global financial system.
Lending and borrowing money are among the most common financial activities people participate in. Have a surplus of money? Deposit it with your financial institution and let them lend it in exchange for a cut of the interest they collect. Need to make a major purchase? Ask for a loan or charge it to your credit card.
However, over-reliance on banks and financial institutions (and the regulatory bodies that oversee them) means lending and borrowing are subjected to a plethora of red tape. From high fees to restricted access due to regulations or credit checks, many people are locked out of these basic financial services that could vastly improve their lives.
With DeFi, financial institutions are removed from the process, and lenders and borrowers are connected directly. Agreements between each party are coded into smart contracts, which automate the entire process, including disbursing loans, managing repayments, and generating interest.
How DeFi lending works
Users deposit their crypto assets (e.g., stablecoins or a specific cryptocurrency) into a lending pool on a DeFi protocol. These funds are then made available for other users to borrow. In return for providing liquidity, lenders earn interest on their deposited assets, which is automatically calculated and distributed by smart contracts. This interest is typically paid in the form of a stablecoin or the protocol’s native cryptocurrency (which likely fluctuates in value).
DeFi lending unlocks passive income streams for those with an excess of funds. Many long-time participants in the world of cryptocurrency have amassed wealth through speculation, and DeFi offers better interest rates than those available through many traditional investment mediums.
How DeFI borrowing works
On the other side of the liquidity pool are the borrowers. They access funds by providing an excess of collateral to secure their loan. This concept, known as “over-collateralization,” requires borrowers to deposit assets worth more than the loan amount they receive.
For example, a borrower might deposit $100 worth of cryptocurrency to borrow $50. If the value of the collateral drops below a certain threshold, a liquidation event occurs. The smart contract automatically sells the collateral to repay the loan. This mechanism protects lenders from losses due to borrower default.
Over-collateralization is a key feature that distinguishes DeFi lending from traditional finance. By eliminating the need for credit checks and intermediaries, DeFi platforms offer borrowers faster, more accessible loans.
While borrowers must lock up more assets than they receive, over-collateralization still provides them with several advantages. They can secure lower interest rates, larger loan amounts, and more flexible repayment terms. But perhaps most importantly, it opens up access to credit for individuals who are typically unable to get a loan through conventional means.
Flash loans: A unique DeFi feature
Flash loans are a distinct feature in DeFi that allows users to borrow large sums without collateral, provided the loan is repaid within a single transaction block. These loans are mainly used for advanced trading strategies, such as arbitrage, where traders exploit price differences across platforms within the same transaction.
The instantaneous nature of the blockchain ensures that if the loan isn’t repaid instantly, the entire transaction fails, making it a risk-free proposition for lenders. While flash loans are not something most people would use, they demonstrate how innovative DeFi can be thanks to the power of blockchain technology.
Margin trading: Amplifying positions with borrowed funds
Margin trading is a powerful yet risky strategy used by experienced traders looking to enhance their returns. By borrowing funds through DeFi lending platforms, these traders can increase their exposure to specific assets, magnifying gains if their trade wins while incurring major losses if they’re wrong.
In the traditional financial system, margin trading is often restricted to licensed brokers. DeFi makes it accessible to anyone, however, the risks are significant, and only traders with a deep understanding of market dynamics and a high tolerance for risk should participate.
While lending is an excellent way to generate passive income through DeFi, there are other approaches savvy individuals take advantage of. Specifically, “yield farming” and “staking” are empowering DeFi participants to steadily grow their net worths.
Yield farming
You can think of yield farming (also known as “liquidity mining”) as an advanced form of lending. It’s the strategy of lending or stacking cryptocurrencies across a variety of DeFi protocols to maximize returns. Yield farmers are very active in the cryptocurrency and DeFi ecosystems — as this approach requires them to continuously research emerging protocols, monitor fluctuating interest rates and reward mechanisms, and actively move their funds to the liquidity pools that offer the most yield.
A yield farming strategy starts with depositing cryptocurrency (e.g., stablecoins or another crypto asset) on a protocol that offers attractive returns. Users are then rewarded for providing liquidity, increasing their funds. But as conditions change — and other protocols start to offer better returns — they’ll move their initial investment and possibly profits. In theory, yield farmers continuously generate steady returns and grow their accounts over time.
Emphasis on “in theory” here. In reality, yield farming is not a can’t-lose investment strategy. It’s highly risky, especially in the Wild West of DeFi. Yield farmers face impermanent loss (where their lent/staked assets drop in value) and even smart contract vulnerabilities. Some DeFi protocols have collapsed (see the great Terra Luna crash of May 2022), and others have been outright scams. Most of the unfortunate users who participated in these liquidity pools lost all the funds they put in.
If you want to go down the path of yield farming, be prepared to put in the work. It requires daily monitoring of market conditions, thorough due diligence of new protocols, and consistently being active on-chain.
Staking
In a previous article, we broke down how blockchains work and briefly touched on the Proof of Stake (PoS) model. On these chains, users lock up or “stake” their crypto assets to validate transactions and secure the network, ultimately supporting the entire blockchain. In return for doing this critical work, stakers earn rewards, typically in the form of additional tokens native to the chain.
The process of staking generally involves selecting a blockchain network that supports the users desired cryptocurrency (as they’ll need to have a significant amount of these tokens to participate) and offers attractive returns. Stakers then delegate or lock their tokens within the network for a specified period, earning rewards based on the amount staked and the duration of their lockup. Rewards tend to be distributed incrementally (daily, weekly, or monthly) depending on the protocol.
Staking isn’t as risky as yield farming and requires less work. Ethereum (the most notable PoS blockchain) is highly unlikely to collapse at this point. All you have to do is lock your tokens and, sit back and reap the rewards.
That said, staking requires a hefty initial investment, and returns can be rather small. Running a validator node on the Ethereum network requires staking 32 ETH (that’s just over $100k at the time of writing), and the average yield is only around 4–6%. But if you’re a long-term investor in ETH, you might as well put your tokens to use and stake the network.
Staking not only generates passive income but also supports the overall health and efficiency of the blockchain ecosystem. By participating in staking, users help secure the network against attacks, validate transactions, and ensure decentralization — all while getting compensated for their participation. It’s an ideal way to generate passive income for community members who are passionate about specific blockchains and believe in the network’s long-term potential.
Decentralized Exchanges (DEXs) offer a unique alternative to the Centralized Exchanges (CEXs) most cryptocurrency traders and investors are familiar with. They also have an interesting DeFi component that we’ll explore shortly.
But first, what sets a DEX apart from a CEX? A traditional CEX is operated by a single entity or company and acts as an intermediary that facilitates the exchange of tokens between buyers and sellers. A DEX, on the other hand, is built on top of the blockchain, so there is no centralized authority. This means transactions are peer-to-peer (tokens are swapped directly between buyer and seller).
Automated Market-Marking (AMM) protocols on DEXs
In order to truly understand how DEXs operate (and their DeFi component), you first need to understand the nuances of a typical exchange. On a CEX, all the open bids (the maximum price the buyer is willing to pay) and open asks (the minimum price the seller is willing to accept) for a specific asset are compiled in the order book. As the price of the asset fluctuates, the CEX matches bids and asks within the order book and executes the exchange of tokens.
DEXs take a more innovative approach. Users provide liquidity by depositing token pairs into pools on the exchange. There is liquidity for countless tokens on DEXs, and most are denominated (paired) against the blockchain token the DEX operates on (Ethereum and Solana being the most popular) or a stablecoin. That means there are two different pools, and users can buy and sell between each one.
The exchange then uses Automated Market-Making (AMM) protocols — a complex mathematical formula to determine the price of an asset at a given time based on the liquidity ratio in each pool. It’s essentially the old supply and demand theory but with a sophisticated algorithm that ensures seamless and fair exchange, creating a more dynamic and efficient market.
Let’s now bring this back to DeFi. In exchange for providing liquidity, users receive a portion of the trading fees generated by the DEX. This creates an incentive for users to contribute their assets to the pool, enhancing liquidity and ensuring that the market (and really the DEX) remains active.
Moreover, this system democratizes the trading process, allowing anyone to become a market maker and earn rewards, thus decentralizing the control traditionally held by centralized exchanges.
The ethos of DeFi — and really the entire cryptocurrency and Web3 landscape — is decentralization. It’s all about taking control away from the few and dispersing it among every participant.
DeFi brings this concept to life. Unlike traditional financial systems, where decisions are often made by executives in a boardroom, DeFi governance leverages blockchain and smart contract technology to distribute power among a broad base of participants.
Token-based voting
DeFi governance is driven by a token-based voting system. Each of a protocol’s native tokens typically represents one vote, allowing holders to propose and vote on changes.
Voting can take place on a wide range of proposals, including:
Lending and borrowing parameters: Changes to interest rates, borrowing limits, or liquidation thresholds.Fee structure: Adjustments to transaction fees or revenue-sharing models.Tokenomics adjustments: Modifying token distribution, inflation rates, or staking rewards.Incentive programs: Designing and implementing programs to attract users and liquidity.Protocol expansion: Introducing new assets, markets, or services to the platform.Fund allocation: Deciding how to spend protocol treasury funds, such as for development, marketing, or community initiatives.Smart contract updates: Modifying the core logic of the protocol to introduce new features, fix bugs, or enhance security.
Token-based voting ensures that those who have skin in the game get a say in how a DeFi protocol operates and evolves. In theory, what’s best for governance token holders is also what’s best for the protocol, so this system aligns everyone’s collective interests.
Decentralized Autonomous Organizations (DAOs)
Many DeFi protocols operate as Decentralized Autonomous Organizations (DAOs). DAOs use smart contracts to automate and completely decentralize proposals and voting.
These smart contracts codify the rules for proposing and voting on changes, ensuring that the process is transparent and tamper-proof. When token holders vote, their decisions are automatically executed by the smart contracts, eliminating the need for a central authority to enforce the outcome.
The role of DAOs in token-based voting includes:
Proposal management: DAOs provide a platform for members to submit proposals, whether they pertain to financial decisions, technical upgrades, or strategic initiatives. This guarantees that every voice in the community is heard and considered.Voting mechanism: DAOs standardize the voting process, ensuring that each token holder’s vote is counted fairly and accurately. The results of the votes are publicly verifiable on the blockchain, enhancing transparency and trust.Implementation of decisions: Once a proposal is approved, the DAO’s smart contracts automatically implement the changes. This reduces delays and ensures that outcomes are executed as intended without manual intervention.
DAOs foster a sense of ownership and responsibility among token holders. Their inclusive approach helps align the protocol’s growth with the interests of its community.
By integrating token-based voting within a DAO structure, DeFi platforms can leverage the benefits of decentralized governance more effectively. DAOs ensure that the decision-making process is not only democratic but also efficient and resilient.
A big theme of this article has been that DeFi removes barriers to entry for those who are typically frozen out of the traditional financial system. But so far, we’ve only focused on how it provides access to the emerging cryptocurrency/Web3 markets.
What about the conventional financial assets many people cannot access due to their location, starting capital, or regulatory hurdles they face?
Synthetic assets offer a solution by replicating real-world assets such as stocks, commodities, or fiat currencies on a DeFi protocol. That means participants can gain exposure to these assets without owning them physically.
How synthetic assets work
Synthetic assets are created using smart contracts and collateral. Users deposit collateral, typically in the form of a cryptocurrency, to mint synthetic assets. These assets are pegged to the value of their real-world counterparts through oracles — a mechanism within the platform that collects and imports real-time data on asset values. Oracles ensure that a synthetic asset accurately reflects the price of the underlying real-world asset, enabling users to trade or invest in it within the DeFi ecosystem.
Benefits of synthetic assets
Synthetic assets offer several advantages for DeFi participants, including:
Direct access to markets: Synthetic assets eliminate the need for traditional intermediaries such as brokers and financial institutions, which reduces costs and streamlines the trading process.24/7 accessibility: Unlike traditional financial markets with limited trading hours, synthetic assets can be traded around the clock, providing more flexibility and opportunities for investors.Diversification: Synthetic assets offer exposure to a wide variety of assets, including those that may be difficult to access through conventional means, enabling greater diversification of investment portfolios.No minimum investments: Synthetic assets provide access to participants who have any amount of starting capital.
Risks and considerations
While synthetic assets offer numerous benefits, they also come with risks:
Oracle accuracy: The value of synthetic assets relies on the accuracy of oracles. Any discrepancies or failures in Oracle data can impact the value of synthetic assets and lead to potential losses.Collateral stability: Fluctuations in the collateral value used to back the synthetic asset may result in impermanent loss or liquidation (note: in most cases, stablecoins are the safest form of collateral).Market risks: Changes in market dynamics (both in the traditional and cryptocurrency markets) require users to manage their positions carefully and be aware of risks.
Synthetic assets provide a bridge between the traditional financial markets and the world of DeFi and Web3. By removing barriers to entry, this form of DeFi opens the door to markets that have long been out of reach for so many.
DeFi is still in its early stages. The term itself was only coined in 2018, and many of the applications we’ve discussed emerged around 2020. As the ecosystem evolves, significant developments are required for DeFi to reach its full potential.
Growing adoption
The DeFi growth has slowed since its initial boom a few years ago. For widespread adoption to continue, several challenges need to be addressed:
User education: Many potential users are still unfamiliar with the concept of DeFi and how it differs from traditional finance. Comprehensive educational resources and user-friendly platforms are essential to help new users navigate the DeFi landscape.Scalability: As more people enter the DeFi space, scalability becomes a critical issue. Current blockchain networks, like Ethereum, struggle with high transaction volumes, leading to congestion and exorbitant fees. Layer 2 solutions, sidechains, and other scalability enhancements will be needed to accommodate growing user bases.Mainstream awareness: While DeFi is well-known within the Web3/cryptocurrency community, it remains a niche topic for the general public. Strategic marketing efforts, partnerships with mainstream financial institutions, and real-world success stories will help bring DeFi to the forefront of global financial discussions.
Integration with traditional finance
Yes, a core advantage of DeFi is that it removes the intermediaries that have far too much control over our financial system. However, integrating protocols with traditional institutions could drive broader adoption and long-term sustainability. This integration could unfold in several ways:
Bridging the gap: Traditional financial institutions are beginning to explore how DeFi technologies can complement their existing services. For example, decentralized lending platforms could integrate with traditional banks to offer more competitive interest rates or automate services. This blending of old and new finance could make DeFi accessible to the masses while retaining the trust and security associated with established institutions.Tokenization of traditional assets: DeFi can facilitate the tokenization of traditional assets like stocks, bonds, and real estate, enabling fractional ownership and 24/7 trading. This would create new avenues for passive income and make these assets more accessible to a global audience. Over time, we could see a seamless interface where users can manage both DeFi and traditional assets from a single platform.Hybrid financial products: As DeFi and traditional finance integrate, hybrid financial products could emerge, offering the best of both worlds. For instance, a savings account might offer a base interest rate from the traditional bank, with the option to earn additional yield through staking in a DeFi protocol. Such products would appeal to conservative investors while introducing them to the benefits of DeFi.
Advancements in technology
Blockchain technology is advancing rapidly, and continued innovation will usher in better experiences and new DeFi use cases. We can expect to see advancements in the following areas in the coming years:
Interoperability: Many DeFi platforms currently operate in silos and are unable to interact with each other. Advancements in interoperability protocols will enable seamless interaction between different blockchains and DeFi platforms, allowing users to move assets and data across ecosystems. This will not only enhance the user experience but also create new opportunities for cross-platform passive income generation.Improved security: As DeFi grows, so does the importance of security. Smart contract vulnerabilities, hacking, and fraud remain significant risks. Future developments in cryptography and blockchain technology will be essential to making DeFi platforms safer and more trustworthy.Enhanced user experience: DeFi platforms need to be as intuitive and user-friendly as traditional financial apps. Advancements in user interface design, onboarding processes, customer support, and mobile accessibility will help DeFi reach a wider user base.
Regulatory developments
And lastly, regulation will be needed to unlock mass adoption of DeFi. It’s a double-edged sword, as these regulations will impose restrictions on what DeFi can do while also legitimizing the concept and putting protections in place for users:
Regulatory clarity: As DeFi grows, governments and regulatory bodies are beginning to pay closer attention. Clear and consistent regulatory frameworks are needed to address issues such as compliance, taxation, and consumer protection — and really just define what is and isn’t allowed. This clarity will help attract institutional investors and large-scale adoption by providing a legal foundation for DeFi activities.Balancing innovation and compliance: Regulators will need to strike a delicate balance between encouraging innovation and ensuring consumer protection. Overly restrictive regulations could stifle growth, while too little oversight could lead to more scams and instability in the space. A collaborative effort between regulators and the DeFi/Web3 community is crucial as we move forward.Global coordination: DeFi operates on a global scale, which complicates regulatory efforts. International cooperation and standardized regulations will be necessary to create a cohesive environment where DeFi can thrive across borders. This will also help prevent regulatory arbitrage, where companies move to jurisdictions with the most lenient regulations.
The word “revolution” gets thrown around, particularly when discussing Web3. But the implications of DeFi really are profound.
By stripping away the layers of control that have long been held by traditional institutions, DeFi places financial empowerment in the hands of anyone with an internet connection. For the first time ever, we’re seeing the emergence of a new financial system that serves the interests of every citizen of the world.
