What is Decentralized Finance?

The Beginner’s Guide

If you’re diving deep into the world of cryptocurrency, you have probably heard the term “DeFi” used to describe a variety of new protocols and assets.

First, it’s important to acknowledge DeFi is a newer term just now coming into wider use. This means that DeFi, short for decentralized finance, doesn’t have a strict definition. Rather, it is attempting to describe what a certain class of cryptocurrencies is now striving to achieve.

That said, DeFi cryptocurrencies can be said to have emerging commonalities.

Most DeFi projects are software protocols that run on top of another cryptocurrency – commonly Ethereum or Cosmos – and that use a combination of that protocol’s crypto asset (as well as their own and maybe others) as a means to automate a financial service.

A great example of this in practice is the cryptocurrency DAI.

Put simply, DAI allows users to “lock” cryptocurrency in a smart contract running on the Ethereum blockchain, where the funds are used as collateral to generate new assets that power its lending service.

DeFi projects like DAI can also incorporate what’s called a “governance token,” a crypto asset that may allow users to influence project direction or generate earnings from the service.

Proponents of DeFi cryptocurrencies argue that this means they serve as “capital assets” similar to stocks and bonds. So, whereas Bitcoin may serve as a pure money or store of value, these new crypto assets aim to provide exposure to the value of the service provided.

Note: The above represents our best effort to summarize the state of the industry’s cutting-edge.

As always, you should exercise scrutiny when analyzing projects and protocols, and this may count doubly so for projects operating at the emerging edges of the technology.

what is decentralized finance defi

How does DeFi work?

As explained above, DeFi protocols use a combination of crypto assets to offer a service.

In doing so, proponents argue these services may offer benefits over the offerings of banks and other centralized financial institutions.

Such services may be described as:

Automated: Users may be able to gain access to DeFi services 24/7 and without the lengthy approval processes imposed by traditional financial entities.

Open: Users may be able to participate in decisions essential to the service. (This may include the ability to vote on changes to rates, for instance.)

Permissionless: Users cannot be denied access to DeFi services arbitrarily or due to unjust regulation, or they may be able to fork a project if needed or desired.

Trustless: Users may not have to rely on a central institution for access to the service, only trusting that the software will work as the code describes.

Note: You should always check the code of such protocols to ensure it works as advertised.

What do DeFi protocols do?

As DeFi protocols become more numerous, it’s beneficial to understand the different classes of problems these projects are attempting to solve.

The purpose of this section is to classify the various categories that popular projects fall under, which might be helpful when building and diversifying your crypto portfolio.

Lending and Borrowing

DeFi cryptocurrencies focusing on lending may allow users to take out a loan with software, removing the need for a trusted third party.

Powered by code instead of paper contracts, these projects might automate the maintenance margins and interest rates required in lending. Among other things, this allows for automatic liquidation should balances fall below specified collateral ratio.

While each lending protocol has different nuances, they all act in similar ways. For example, there are typically two types of users: those lending their tokens to the protocol and providing liquidity to it, and those borrowing it.

Someone wishing to lend cryptocurrencies would send those tokens to an address controlled by the protocol, earning interest based on the amount lent.

Borrowers, on the other hand, post collateral in the form of a cryptocurrency. They are then allowed to borrow cryptocurrencies as a percentage of the posted value.

Should the protocols work as intended, users can easily borrow cryptocurrencies, and holders can earn a return on their assets.

Examples of lending protocols are Aave, Compound, yEarn.

Decentralized Exchanges

Decentralized exchanges (DEXs) may allow users to exchange crypto assets without the need for a mediator, allowing for the true peer-to-peer trading of cryptocurrencies.

The protocol's users are typically able to instantly convert cryptocurrencies without needing to access an order book. Instead, the conversion rate might be built into the network.

The idea is that DEXs can provide access to trading pairs, even when the volume of the underlying asset may be too small for larger exchanges.

Another major benefit of a DEX is that user funds are not held by centralized parties. Instead, they are held in personal wallets, increasing the privacy of those using DEXs.

Examples of decentralized exchanges are Uniswap, 0x and Kyber Network.

Derivatives

Derivatives markets are where buyers and sellers exchange contracts based on the expected future value of an asset. These assets can be anything from cryptocurrencies to future event outcomes to real-world stocks and bonds.

In protocols like Synthetix, users can trade real world assets such as stocks, currencies and precious metals in the form of tokens on Ethereum.

On other protocols, such as Augur or Gnosis, users wager on the outcome of events. With Augur, users can create and exchange “shares” representing a portion of the value of outcomes like election results or sports results.

Lastly, protocols like dYdX offer users the possibility to trade margin tokens, allowing traders exposure to leverage short or long positions in various markets.

Evaluating DeFi Protocols?

Lastly, the rise of DeFi has also given rise to new metrics that purport to offer insight into their performance. Note: These metrics are as new as the crypto assets themselves.

An emerging standard in DeFi is the “Total Value Locked” metric put forward by data aggregator DeFi Pulse. As of August 2020, more than $4.5 billion were locked into DeFi protocols.

The metric attempts to show how much value in cryptocurrency is locked in the contracts of a protocol. However, this metric may rise and fall based on the fiat value of the stored assets, so it is possible for it to rise substantially without any change in the underlying protocol use.

Another emerging metric is “on-chain cash flow,” which aims to show the daily amount of money that is awarded to the users who own tokens powering DeFi protocols.

Useful Resources

Looking to learn what makes Ethereum the top option for DeFi protocols? Head on over to the “What is Ethereum?” page located in Kraken’s Learn Center for a deeper dive.

If you are interested in learning more about the consensus mechanisms that power most blockchains today, you can visit Kraken’s “Proof of Work vs Proof of Stake” page.

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