What is DeFi ?— For Dummies

What is DeFi?— For Dummies

Okay, so you keep hearing the buzz term DeFi, you know it stands for decentralised finance, but what does that actually mean?

Firstly, before I begin, I just want to say that I am by no means an expert, in fact, the whole purpose of this blog is to act as an online document, whereby I can gauge and monitor my learning progress within the Web3 space. Eventually, if I reach the point where more and more users engage in my posts, hopefully, I can receive real-time feedback in relation to gaps in my knowledge, thus steepening my learning curve.

Throughout my journey within the crypto space, I have found very few resources actually break down concepts into their bare bones. A lot of the time, explanations will assume you have some degree of prior knowledge, especially within the finance space. My aim is to break each concept down into its simplest form so that an individual with no prior knowledge would be able to understand. My belief & past experience dictate that you truly have grasped a thorough understanding of a topic if you are able to teach and explain it to someone else who has no prior knowledge.

What is DeFi?

Definition: blockchain-based financial ecosystem that enables access to various financial services such as lending, borrowing, and trading without relying on centralised intermediaries.

DeFi stands for DECENTRALISED finance.

What does decentralised mean in the context of finance?

• Without a central authority/intermediary i.e. typically this means without the use of a bank or a major company. For example, most financial transactions involve the use of an intermediary, most notably a bank. If I wish to send someone money, I have to access my online bank account, find their bank details, and send money to their bank account. This whole process involves a CENTRALISED authority ( a bank).

So how does decentralised finance work?

Decentralised finance uses blockchain technology to cut out the middleman (central authority). Smart contracts are contained on the blockchain and help automate financial processes without the need for central authorities/ intermediaries.

Okay, wait a minute, what is blockchain and what are smart contracts?

I could spend hours and hours explaining what blockchain and smart contracts are, but in the context of DeFi here’s what you need to know:

• Blockchain — immutable decentralised ledger which records transactions, through P2P networks (peer to peer) i.e. without the need for a central authority
• Smart contracts- pieces of pre-written code for terms of agreement, which automatically execute when the terms of agreement are fulfilled.

Okay, so we have established that DeFi is finance without the use of a central authority, and it is able to operate through the use of smart contracts & blockchain technology, therefore the common features of DeFi are:

• Permissionless — open to anyone with an internet connection
• Transparency — smart contracts and transactions on the blockchain are transparent and verifiable by anyone
• Programmability — smart contracts programmed to execute automatically, eliminating the need for intermediaries
• Interoperability — DeFi applications often work together

Examples of DeFi applications/protocols

1. Decentralised Exchanges (DEX)

Example: UniSwap

UniSwap — a decentralised exchange where users can trade various cryptocurrencies using their digital wallets.

2. Decentralised Lending and Borrowing

Example: Aave

Aave is a decentralised lending platform where users can lend or borrow various cryptocurrencies using smart contracts.

3. Stablecoins

Example: Maker DAO (DAI)

Maker DAO is a decentralised autonomous organisation that issues the stablecoin DAI. The reason we use stablecoins in DeFi is because they are STABLE. Therefore prices of them will not change, as they are not as volatile as other cryptocurrencies such as BTC and ETH, thus making them more reliable.

4. Yield Farming (provide liquidity i.e. lend crypto asset to a decentralised network in return for rewards in the form of tokens)

Example: Compound

Compound is a lending protocol that allows users to earn interest on their crypto assets or borrow against them. E.g. I lend 1 Ethereum (ETH) to Compound. I will receive 1cETH in return (Compounds token representing the 1 ETH I have lent them). Compound will also reward me with additional tokens for lending them 1ETH, so I also receive 1 COMP. So currently I have lent 1ETH out, and I have received 1cETH + 1 COMP. I can then choose to stake my 1COMP on the Compound network and receive even more rewards in the form of additional tokens.

5. Decentralised Autonomous Organisation (DAOs)

Example: Decentral Games

DAO — organisations governed by smart contracts and votes from token holders.

Components of DeFi Ecosystem

I have defined what DeFi is, the common features of DeFi, and real-world use case examples of DeFi. I will now be exploring the common components which make up the DeFi ecosystem.

Simplified version of components of DeFi ecosystem:

• Decentralised infrastructure (Ethereum)
• Decentralised money (DAI)
• Decentralised financial services: DEX, money markets, insurance etc.

Detailed version of components of DeFi ecosystem:

1. Smart contracts — self-executing contracts with terms of agreement written into code.
2. Decentralised Exchanges- platforms that facilitate p2p trading of cryptocurrencies without the need for centralised intermediaries.
3. Decentralised lending and borrowing protocols/platforms- platforms that allow users to lend cryptocurrencies to earn interest, or to borrow assets through providing collateral, all of which is executed through the use of smart contracts.
4. Stablecoins — crypto pegged to value of traditional fiat currencies, providing price stability + reliable medium of exchange.
5. Yield Farming and Liquidity Mining — users provide liquidity (cryptocurrency/assets) to centralised platforms in exchange for rewards, usually in the form of tokens.
6. Oracles — data messengers that feed external data into smart contracts, thus enabling them to make decisions in real-time. E.g. A decentralised application that automatically pays out insurance claims based on the weather would use an oracle to check real-world weather data to see if it rained today or not. This data would then be fed into a smart contract on the blockchain of the Dapp, and the smart contract would automatically execute the insurance policy. For example, it did rain today, so the Dapp would automatically pay out insurance claims to policyholders.
7. Decentralised Autonomous Organisations (DAOs) — organisations governed by smart contracts and token-holder voting, enabling decentralised decision-making and governance within the DeFi ecosystem.
8. Insurance Protocols — platforms that provide decentralised insurance services to mitigate risk associated with smart contract vulnerabilities, hacks, or other unforeseen events
9. Cross-chain Platforms — protocols/platforms which facilitate interoperability between different blockchain networks, for the purpose of allowing data and assets to move across different blockchain networks.

For example: Alice and Bob wish to trade assets on 2 different blockchains: Etherum and Binance Smart Chain. Alice has Etherum-based tokens (ERC-20 tokens) and Bob has Binance Smart Chain based tokens (BEP-20 tokens). The cross-chain platform would act as a bridge whereby both Alice and Bob can place their respective tokens on the cross-chain platform and thus swap their tokens.

Why can’t Alice and Bob trade their assets directly? — Different assets operate on different blockchain networks, and therefore certain networks are not compatible so trading cannot occur.

10. Wallets and User Interfaces — interfaces that enable users to interact with DeFi protocols, manage their assets, and execute transactions securely.

DeFi vs TradFi

Note: TradFi, is just another way of saying traditional finance services, i.e. financial services we currently operate in. Sometimes TradFi is also referred to as CeFi.

1. Lending and Borrowing

• DeFi e.g. Aave, Compound — users lend cryptocurrency assets and earn interest or borrow assets by providing collateral in a decentralised manner through smart contracts
• Traditional Finance — lending and borrowing through intermediaries such as banks, which typically assess credit scores, set interest rates, and require extensive documentation

2) Decentralised Exchanges (DEX)

• DeFi, e.g. UniSwap — users trade cryptocurrencies from their wallets without the need for centralised exchanges
• Traditional finance — centralised exchanges managed by intermediaries

3) Stablecoins

• DeFi e.g. MakerDAO, DAI — Stablecoins provide price stability as their value is pegged to traditional fiat currencies, thus reducing volatility and acting as a reliable store of value
• Traditional Finance- fiat currency issued by the government

4) Yield Farming and Liquidity Mining

• DeFi e.g. Yearn Finance — users provide liquidity to platforms and earn additional tokens or rewards
• Traditional finance — savings accounts offer interest but rates are usually set and centralised by financial institutions

5) Decentralised Autonomous Organisation (DAOs)

• DeFi e.g. Decentral Games — organisations governed by smart contracts and token-holder voting, thus allowing for decentralised decision-making.
• Traditional Finance — companies governed by centralised board of directors and shareholders who vote on major decisions

6) Insurance Protocols

• DeFi e.g. Nexus Mutual, Cover Protocol — users participate in decentralised insurance protocols, providing coverage against smart contract vulnerabilities, hacks, or other unforeseen events.
• Traditional Finance — traditional insurance companies offer coverage but involve intermediaries.

7) Cross Chain Platforms

• DeFi e.g. Polkadot, Cosmos — platforms facilitate interoperability between different blockchains, allowing assets + data to move across different blockchains e.g. Bitcoin and Ethereum
• Traditional Finance — cross-border transactions in multiple intermediaries and are slow, inefficient, and have a lack of transparency.

What is DeFi ?— For Dummies was originally published in The Dark Side on Medium, where people are continuing the conversation by highlighting and responding to this story.

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