What can you do with DeFi?

Decentralized finance, or DeFi, allows anyone with an internet connection to access a rapidly growing ecosystem of permissionless and open financial products.

Many of these products are similar to services found in the traditional financial industry, but aim to offer greater:

• Freedom

• Transparency

• Inclusion

This rapidly evolving part of the cryptocurrency industry offers many opportunities for new and experienced crypto users alike. 

But with so many possibilities, it can be challenging to know what you can actually do with these products and which DeFi services may fit your unique financial goals.

DeFi trading takes place on decentralized exchanges (DEXs), which are automated trading platforms that operate without an intermediary company managing its operations.

Instead, they operate based on code that anyone in the world can audit and verify for themselves.

Just like their centralized counterparts, many DEXs offer:

• Spot trading where traders buy and sell crypto assets
• Futures where traders speculate on the future price of assets
• Crypto derivatives which offer more more customized financial products

Some of the most popular spot DEXs include Uniswap (UNI), Curve (CRV), and Balancer (BAL).

Other popular DEXs on Solana include Jupiter (JUP), Raydium (RAY) and Orca (ORCA).

DEXs have several important differences when compared to centralized exchanges (CEXs):

• DEX users transact from their non-custodial crypto wallets, meaning they retain full control and sovereignty of their crypto assets when trading.
• There are no Know Your Customer (KYC) requirements to trade on DEXs, meaning users do not need to turn over their personal information to use the platform.
• DEXs often use an Automated Market Maker (AMM) rather than a centralized order book, so DEX users can swap assets instantly from liquidity pools without needing an individual counterparty.

In addition to liquidity providing, several DeFi platforms offer extra incentives, like the ability to stake the LP tokens they have earned for extra rewards. 

Typically, when you stake LP tokens, you lock them in a smart contract controlled by a DeFi protocol.

There are different reasons why DeFi platforms incentivize staking, some of which can get quite complicated. 

However, a simple reason why a DeFi platform might incentivize staking is that keeping LP tokens locked up reduces the circulating supply of those tokens.

This ultimately reduces their availability in the market, which in turn can raise their market value. 

In addition to the rewards earned for providing liquidity and simply holding LP tokens, traders can earn extra rewards for staking your LP tokens.

By locking away their LP tokens, holders can earn additional rewards beyond the LP tokens they received in the first place.

This complex strategy of optimizing yields across multiple different DeFi platforms is simply known as yield farming.

You can learn more about this strategy with our Kraken Learn Center article, What is yield farming?

It’s worth noting that yields can vary dramatically between platforms.

Additionally, yields decrease as more users join and contribute liquidity to a platform. While using a newly launched DeFi protocol has its advantages, it also carries greater risks of potential fraud and exploitation.

Check out our Kraken Learn Center article, How to stay safe in DeFi, for more information.

 Liquidity pools (often referred to as just “pools”) are community-funded collections of crypto assets.

DEX users voluntarily provide these assets while smart contracts manage the assets according to their hard coded rules. 

Each pool contains a pair of crypto assets, like Ether (ETH) and Dai (DAI) or Solana (SOL) and Tether (USDT). 

The smart contracts store and manage the crypto assets in each pool. Most DEXs charge users a flat fee for each transaction they make using a liquidity pool.

When trading with a liquidity pool, a person exchanges one asset kept in the pool for the other asset kept in the pool. They do this by adding some of one crypto asset to the pool and removing some of the other. 

For example, you might trade in an ETH-DAI pool by adding some DAI and withdrawing the equivalent value of ETH. 

Here, “providing liquidity” means lending crypto assets to a DEX pool which others can use to trade and exchange between. Crypto holders who provide this essential liquidity earn crypto-based rewards in return. 

Liquidity providers are often rewarded with liquidity provider (LP) tokens. These tokens represent the liquidity provider’s share of crypto assets in a pool. 

They also grant holders a proportionate share of any trading fees the platform earns from the pool. So, if you contributed 5% of all the assets held in the pool, you are entitled to receive 5% of the trading fees generated from that pool.

Want to learn more about liquidity pools and the important role they play in the crypto ecosystem? Check out the Kraken Learn Center article, What is a liquidity pool and how to use one?

Compared to the traditional financial system, DeFi platforms offer a simplified and less intrusive way of connecting lenders and borrowers. 

Anyone can take out a DeFi loan by posting an amount of digital assets as collateral. This can be useful for a person who holds crypto and needs cash, but doesn’t necessarily want to sell their crypto. 

For example, someone might hold Ether (ETH) and believe its price will rise in the future. They need capital to pay an unexpected bill, but don’t want to sell their ETH. Using a DeFi loan, they can: 

• Deposit their ETH as collateral and receive funds (such as USDC)
• “Cash out” into fiat on Kraken 
• Transfer fiat to their bank account
• Pay their bill

Just like a traditional loan, the loan must be paid back (plus a small amount of interest) in order to access the collateral once again. There are two main types of DeFi lending protocols – money markets and collateralized debt position (CDP) protocols.

Lending markets

In lending market platforms like Compound (COMP) and Aave (AAVE), users can lend out their assets to earn income or borrow against them. As of January 2024, these two platforms have over $8 billion in outstanding loans.

CDPs

On CDP platforms such as Maker (MKR) and Liquity (LQTY), users post various types of crypto assets as collateral, against which they can mint new stablecoins. As of January 2024, users have deposited over $6.3 billion worth of assets on these platforms.

Governance tokens are a type of cryptocurrency that provides holders with voting powers. 

Typically, DeFi projects distribute these tokens to democratize the management of their platforms.

This process allows DeFi projects to transition into decentralized platforms where key decisions are managed by their communities of users.

There are many ways for DeFi users to receive governance tokens.

A popular option is for projects to freely distribute governance tokens via an airdrop to anybody who has used their platform during a certain time period.

In 2020, Uniswap famously airdropped 400 UNI tokens — its native governance token — to anybody who had performed a swap, provided liquidity or owned and redeemed SOCKS tokens. 

At the time, each airdrop of 400 UNI tokens was worth $1,800.

Traders often use websites such as Airdrop.io and Coingecko in an effort to identify upcoming crypto airdrops.

Alternatively, DeFi users can purchase governance tokens that have already been dropped on centralized exchanges like Kraken as well as a variety of other decentralized exchanges.

You can learn more about governance tokens and how they allow their holders to participate in a project’s strategic decision making process with our Kraken Learn Center article, What is a governance token?

Synthetic DeFi platforms such as Synthetix (SNX) let users create tokenized versions of currencies, commodities, other cryptocurrencies and stocks.

DeFi users are required to deposit the protocol’s native SNX token as collateral to mint these synthetic tokens, known as spot Synths.

Newly-created spot Synths like sUSD (tokenized US dollars) can be deployed on other DeFi protocols, typically in liquidity pools for others to trade against.

In order to maintain their price relationship, they use blockchain oracle services. These protocols ensure spot Synth prices accurately reflect the underlying asset prices they represent.

For more information, check out the Kraken Learn Center article, What are synthetic crypto assets?

Flash loans are a type of uncollateralized DeFi loan that allows users to borrow funds without first putting up any crypto assets to secure the loan.

The flash loan amount must be paid back within the same transaction (a few seconds). Otherwise, the network rolls back the loan transaction as if it never happened. 

To efficiently use this type of loan, users create their own smart contracts that instantly deploy the capital across various DeFi platforms in the hopes of generating a profit before the loan must be repaid.

Trading platforms such as dYdX allow traders to utilize flash loans. However, it is important to recognize that flash loans are highly technical, involve risk and require a deep knowledge of smart contracts.

For more information, check out the Kraken Learn Center article, What is a flash loan?

To learn more about the DeFi tokens referred to in this article, check out our crypto guides.

Kraken also offer markets to trade these tokens, which you can then use to interact with many of the DeFi apps mentioned above.

Get started in the world of DeFi with Kraken today.