A Beginners Guide to DeFi
The term Decentralised Finance, or DeFi, has been popping up all over the internet and news outlets with growing frequency over the last few months. As an ignorant yet very interested individual in all things cryptocurrency and blockchain related I decided to delve deeper into the topic to see what all the hype was about. What I learned was that this technology has the potential to completely transform the way today’s financial institutions operate from less archaic methods to a more transparent and fairer system. In this article I hope to give you a quick rundown on all things DeFi, its applications, where it came from and where it’s going in the future.
Definition of DeFi
Wikipedia defines DeFi as the following;
“Decentralised Finance (DeFi) is a blockchain-based form of finance that does not rely on central financial intermediaries such as brokerages, exchanges, or banks to offer traditional financial instruments and instead utilises smart contracts on blockchains, the most common being Ethereum”
That definition is a bit of a mouthful but it can be summarised as a collective term for financial products and services that are accessible to anyone with an internet connection, with no centralised authorities, where all services are handled by code (not people) that anyone can inspect and scrutinise.
Problems with Traditional Finance
I think one of the easiest ways to convey the potential of DeFi is to get an understanding of some of the problems we face with traditional financial systems that exist today.
- There are 1.7 billion adults unbanked around the world with the majority coming from developing economies. In most cases this is not by choice, they aren’t granted access to set up a bank account/use financial services for a number of reasons. These include lack of a permanent address, no proof of identity, etc. This obviously puts these people at a distinct disadvantage compared to banked individuals and for many people, being locked out of the global economy is a reality. I touched on this topic in a previous article linked here.
- Financial services have the power to block you from getting paid. PayPal is a prime example of this. They are notorious for freezing people’s business accounts and it can take up to 180 days for them to complete a review of your account and decide whether they will release the funds to you.
- A hidden charge of financial services is your own personal data. As someone who has just purchased their first home I can vouch for this first hand. I had to provide my mortgage provider with proof of my identity, payslips from my employer, my last 12 months bank statements, my Revolut account statements, amongst more. Handing all this sensitive information over to my mortgage provider felt like a real invasion of my privacy.
- Trading hours are often limited to business hours of specific time zones. The New York Stock Exchange, for example, is only available between 9:30am to 4:00pm Monday to Friday. You are unable to make a trade on this exchange outside of these times.
- There is a premium to financial services because intermediary institutions need their cut. Banking fees, ATM fees, etc., are prime examples of this.
These are just a few examples of the many issues we face everyday when using traditional finance methods. In the next section I’m going to compare DeFi to traditional finance and you will see how some of the above issues are solved by using DeFi.
DeFi vs. Traditional Finance
As you can see from the above table DeFi puts you in the driving seat when managing your finances and transactions. There is no third party involved in your financial activities which allows you to break free from the archaic rules implied on you by traditional financial institutions. It is 100% your money and you can control exactly how, where and who by it is used.
A Brief History of DeFi
Now that we have a grasp of what DeFi is and how it compares to traditional finance I want to give you a brief history of its origins.
Although DeFi is a relatively new technology, it certainly didn’t appear overnight. There is no one-agreed upon date for the inception of DeFi , there are however a few important events that took place that made it possible.
The first of which is of course the creation of the world’s first, and most famous cryptocurrency, Bitcoin in 2009 by the mysterious Satoshi Nakamoto. Bitcoin enabled us to send money/payments around the globe in a decentralised fashion without rigorous control from third parties which of course is one of the key characteristics of DeFi. Although, payments is just one small aspect of DeFi, Bitcoin was the key enabler for the entire cryptocurrency industry which DeFi is part of. More importantly, Bitcoin enabled the creation of Ethereum — the default blockchain for all top DeFi protocols.
Ethereum was created by Vitalik Buterin and launched in 2015. One of the main driving factors for Vitalik to create/launch Ethereum was due to the limited programming language Bitcoin utilises called Script (since then however there has been a massive upgrade with Bitcoin smart contracts in the taproot upgrade). Script did enable you to create payment applications to send money around the globe but in-terms of DeFi, that was about it. Ethereum utilises a turing-complete programming language called Solidity and the ECR20 standard for creating new tokens. Ethereum quickly became the go-to smart contract to build on and attracted more and more developers who wanted to build all kinds of decentralised applications — ranging from games such as CryptoKitties to financial applications.
From here DeFi began to flourish, notable projects included Maker, EtherDelta, ICOs (Initial Coin Offerings) and many more. These projects rapidly increased in numbers and culminated in a notable event referred to as the DeFi Summer of 2020 when users piled into DeFi, token prices increased and DeFi activity in general skyrocketed.
It would be impossible for me to cover the complete history of DeFi in this short article but Finetics have a YouTube video which nicely sums it up. I have linked their video below and I definitely recommend anyone who wants to learn about the origins of DeFi give it a watch.
The Growth Metrics
Don’t just take my word for it when I say DeFi flourished in the summer of 2020. I also have key metrics that demonstrate this. The first being the TVL (Total Value Locked) in DeFi. This represents the total value of all tokens locked in various DeFi protocols including, lending platforms, decentralised exchanges, and derivatives protocols. This figure has grown from $1 billion in April 2020 to over $233 billion in November 2021!
Another important metric is the trading volume across decentralised exchanges (DEXs). This figure has increased from $0.5 billion in April 2020 to over $50 billion in January 2021, a 100 times increase. I don’t have the figures for 2021 as a whole but when I checked the DEX volume for the last 7 days alone (when writing this in December 2021) on dune.xyz it stated the trade volume was $26 billion dollars!
Finally, the figure for the total value settled on Ethereum reached over $1 trillion dollars in 2020. This is more than Paypal, which is considered a titan of the traditional finance and FinTech world.
So What Can You Do With DeFi?
Now that you have a grasp of what DeFi is and where it came from, now it’s time to talk about what you can actually do with it.
In theory, DeFi can do all things traditional finance can. Below you will find a few examples;
- Send money around the world: DeFi blockchains, such as Ethereum (apologies to Eth purest as I know Eth was conceived before DeFi and has many more capabilities beyond DeFi), makes sending money (securely) as easy as sending an email. All you need to do is enter your recipient’s ENS name (like dave.eth) or their account address from your wallet and your payment will go directly to them in minutes (usually).
- Stream money around the world: Just like Spotify allows you to stream your favourite artists tracks, DeFi apps can enable you to stream your money. For example, you can pay someone their salary in real-time by the second giving them access to their money when they need it. The DeFi app Sablier enables you to do this.
- Access stable currencies: The volatile nature of cryptocurrencies can be an issue for a lot of financial products and general spending. The DeFi community has solved this through the use of stablecoins. Their value stays locked to another asset, usually a popular currency like US dollars. For example, stablecoins like Dai or USDC have values that usually stay within a few cents of a dollar.
- Borrowing: Unlike traditional finance, DeFi lending works without either party having to identify themselves. Instead the borrower must put up collateral that the lender will receive once the loan is repaid. Some lenders even accept NFTs as collateral. NFTs are a deed to a unique asset, like a painting or music track. If you want to learn more about NFTs, here’s a link to a previous article I wrote on the topic. One of the most exciting aspects of DeFi lending are Flash loans. They are an uncollateralised loan that’s usually only capped at how much the protocol has of the loaning asset. The catch is that they need to be paid back in the same block or the loan transaction will fail (So these can only be done if you write a smart contract currently but it’s very easy). This allows anyone to find arbitrage in the market, without needing massive funds of their own.
- Savings: You can earn interest on your crypto portfolio by lending it and seeing it grow in real time. Currently, interest rates are much higher than what you would get from your local bank meaning your return on investment is much greater. Aave is an example of a DeFi app that allows you to do this. No-loss lotteries like PoolTogether is another fun yet innovative way to save money and earn interest using DeFi.
- Exchange tokens: Decentralised exchanges (DEXs) enable you to trade different tokens whenever you want. You never give up control of your assets. This is similar to using a currency exchange when you go on holidays. However, unlike traditional financial exchanges, DeFi exchanges never close. The markets operate 24/7 365 days per year and the technology guarantees that there will always be someone there to accept the trade. Uniswap is a prime example of one of these token exchanges.
- Grow your portfolio: There are fund management apps built on the Ethereum blockchain that allows you to grow your crypto portfolio based on a strategy of your choosing. This is automatic, open to everyone, and does not require the interference of a human fund manager that will of course have to take a cut of your profits. A good example of one such app is the DeFi Pulse Index Fund (DPI).
- Insurance: DeFi insurance aims to make insurance cheaper, more accessible, faster to payout and more transparent. Unlike traditional insurance, the data used to decide your claim is completely transparent. Ethereum products, like any software, can suffer from bugs and exploits. So currently, a lot of the insurance related DeFi apps in the space focus on protecting their users against loss of funds due to bugs/exploits in smart contracts. Nexus Mutual is an example of a DeFi insurance app that protects its users from this.
- Manage your portfolio: With all the possibilities DeFi brings to the table such as borrowing, saving, trading, etc., there are a host of DeFi apps that let you coordinate your DeFi activity from one place. The Zapper app for example enables you to track your portfolio and utilise a range of DeFi products from a single interface.
The above list is just a small example of what you can do with DeFi. I believe that the current capabilities of DeFi are just scratching the surface of what the future of DeFi will become.
The Future of DeFi
What I hope you gathered from my article so far is that DeFi protocols democratise access to financial services since anyone with an internet connection can access them. The first leap for the democratisation of financial services was the internet. Instead of being restricted to the services in your locality, people can now access and contribute value from anywhere in the world. However, what we’ve lacked so far is an effective way to transfer this value in an-internet native way. This is where DeFi infrastructure comes in.
Looking to the future, many DeFi contributors believe that all sources of value will be tokenised so that values can flow freely across the globe. Individuals from traditional finance backgrounds are often sceptical about DeFi because it’s all about tokens. But they are missing the point in that anything of value can be tokenised be it real estate assets, employment contracts, fine art, the list goes on.
This token concept gives rise to an entirely new paradigm in how value can be transacted. Within the next decade it entirely possible for you to enter your favourite store and choose to pay for your goods with a digital wallet composed of a combination of digital assets that you own (e.g. a fiat currency such as dollars, bitcoin, a NFT collection) or even create an instantaneous debt (a DeFi loan) to cover the costs. You will be in complete control of your assets and have little to no restrictions in how you use them.
Although the history of DeFi is short, the effects on how we can now carry out financial services is staggering. I am extremely excited to see where this space will bring us in the future as this is just the beginning and the possibilities for this tech are endless.
References
https://nairametrics.com/2021/10/21/decentralized-finance-tvl-hits-233-million-sets-new-record/
https://ethereum.org/en/defi/#what-is-defi
https://finematics.com/history-of-defi-explained/
https://www.youtube.com/watch?v=qFBYB4W2tqU&ab_channel=Finematics
https://www.orchid.black/articles-path/the-future-of-defi-beyond-crypto
https://dune.xyz/hagaetc/dex-metrics
Further Reading
If you enjoyed this article on DeFi, I have written several more articles on the topic of crypto. These are linked below;
