How does DeFi work?
Decentralized finance (DeFi) has emerged as one of the crypto economy's most important and active sectors.
Combining smart contracts and a range of decentralized applications, DeFi has paved the way for entirely new types of financial service that operate autonomously, without the need for trusted intermediaries.
Just a few years after the Bitcoin white paper showed the viability of blockchain technology, protocols have already had a profound impact on the financial services industry.
Crypto holders are now using DeFi protocols to generate additional yields on their assets. Unbanked citizens in developing countries are using DeFi to access important services such as loans and insurance.
Even if you understand the importance of cryptocurrency, you may still be wondering how these DeFi protocols work. So let's dive in.
The main components of DeFi
DeFi consists of the following components:
- Blockchain technology
- Smart contracts
- Decentralized applications (dApps)
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Key components of DeFi
DeFi relies heavily on blockchain technology, which is essentially a decentralized and immutable digital ledger that records all transactions and smart contract data across a network. Ethereum and Solana, two of the most popular blockchains for DeFi, play a crucial role in these financial services thanks to their ability to support smart contracts.
Want to learn more about blockchains? You can check out our article What is blockchain technology?
Smart contracts are the backbone of DeFi. These self-executing programs allow for automated and transparent execution of agreements without intermediaries.
Developers can write and deploy these programs on a smart contract-supported blockchain such as Solana or Polkadot. Once added, the parameters of the smart contracts become unchangeable and perform strictly based on their preset rules.
Want to learn more about smart contracts? You can check out our article What are smart contracts?
Decentralized applications (dApps)
Developers implement DeFi projects through decentralized applications or dApps. These applications interact with the underlying blockchain to provide various financial services such as lending, borrowing, trading, and more. DApps enable users to access all types of services (including DeFi) from anywhere in the world with an internet connection, without needing to hand over personal information or place trust in a centralized entity.
Want to learn more about decentralized applications? You can check out our article What is a decentralized application (dApp)?
Types of DeFi platforms
Decentralized lending and borrowing
DeFi platforms allow users to lend their digital assets and earn interest while enabling others to borrow these assets. Smart contracts, which automatically determine interest rates and handle collateralization, facilitate the lending and borrowing processes. Borrowers pledge collateral, and the smart contract holds it until the loan is repaid.
Examples of lending and borrowing platforms include:
Decentralized exchanges (DEXs)
Many of the most popular cryptocurrency exchanges are centralized exchanges. While centralized exchanges are often the most efficient way to trade crypto, many feel this is contrary to the basic crypto idea of "decentralization."
DeFi addresses these issues through decentralized exchanges or DEXs. These exchanges allow users to trade digital currencies directly from their crypto wallets without the need for a centralized party to connect buyers and sellers. Instead, DEXs use smart contracts to execute trades, provide transparency and ensure security.
Examples of DEX platforms include:
Stablecoins are cryptocurrencies designed to maintain price stability with a stable asset, such as the US dollar. DeFi platforms leverage stablecoins to provide more stability in transactions and lending/borrowing activities. Collateral or algorithmic mechanisms often back these stablecoins to maintain the value of the asset they are meant to track.
Examples of decentralized stablecoin projects include:
Yield farming and liquidity mining
Yield farming and liquidity mining are popular DeFi practices that incentivize users to provide liquidity to decentralized exchanges or lending platforms.
Users contribute their digital assets to liquidity pools and earn rewards in the form of additional tokens or fees for participating in the pool.
By leveraging multiple yield-generating protocols simultaneously, it can enable crypto holders to maximize their yield potential from a single pair of assets.
Examples of yield farming platforms include:
At its core, DeFi refers to a set of financial services that are provided by applications built upon blockchain technology. These services are self-operated and do not rely on intermediaries like banks or traditional financial institutions.
Think of any financial service that currently exists in the traditional financial market; be it loans, mortgages, or insurance products. Now imagine if, instead of insurance brokers and traditional banks acting as the gatekeepers to these services, everything was automated based on a transparent set of rules laid out by a computer program.
Instead of waiting days for bankers to approve a loan, or insurance providers to pay out a claim, developers could write a computer program that would instantly provide these services as soon as certain predefined conditions are met.
Developers can build these programs to follow a conditional logic, such as “if a valid certificate is provided, the smart contract will automatically process a life insurance pay out — based on the terms that have already been set.”
DeFi leverages the decentralized nature of blockchain networks to provide these types of financial services in a transparent and autonomous manner. Unlike traditional finance, where centralized institutions control and oversee all transactions, DeFi relies on smart contracts to automate processes and enforce agreements.
Removing middlemen from these services not only saves time and money, but also makes them more accessible for people around the world. As long as people meet the predefined conditions established in the smart contract, there's no need for intermediaries to be involved in intrusive processes like credit checks and storing personal identifying information.
Using these decentralized platforms, anyone — not just those who have been granted exclusive access — can lend or borrow funds.
For example, a person in the United States could lend funds to a person in India using DeFi services. To secure the loan, the smart contract may first require the borrower to deposit an amount of collateral. If a borrower defaults, the smart contract itself can automatically liquidate the collateral and fully reimburse the lender. No intermediary needs to be involved in any step of this process.
Since the agreement is based on a series of clearly defined terms, there is less potential for unexpected outcomes or manipulation. These terms can be defined and mutually agreed upon ahead of time between the individuals entering into the agreement. Facilitating truly peer-to-peer financial services is the true innovation of DeFi.
Pros and cons of DeFi
- Financial inclusion: DeFi opens up financial services to individuals who do not have access to traditional banking systems. Anyone with an internet connection and a digital wallet can participate in DeFi, democratizing access to financial products and services globally.
- Enhanced transparency: Nodes record all DeFi transactions and activities on the blockchain, providing transparent and immutable records that anyone can audit.
- Permissionless: Traditional financial services often require extensive documentation and approval processes. DeFi removes these barriers by allowing anyone to participate without needing permission or facing discrimination.
- 24/7 accessibility: DeFi platforms operate 24/7 without any downtime, enabling users from different time zones to access financial services at their convenience.
- Smart contract exploits: Smart contract exploits in the realm of decentralized finance (DeFi) can lead to significant financial losses and disruptions within the ecosystem. Developers deploy DeFi platforms on blockchains and often use smart contracts to automate and execute various financial operations. While smart contracts offer efficiency and transparency, they can also be vulnerable to a variety of exploits due to their code-driven nature
- Impermanent loss: Impermanent loss is a concept in decentralized finance (DeFi) that is similar to the concept of opportunity cost in Economics. Impermanent loss specifically relates to providing liquidity in automated market maker (AMM) protocols, such as those found in decentralized exchanges (DEXs). When you provide liquidity to a pool on these platforms, you contribute both crypto assets (usually in a 50/50 ratio) to facilitate trading between them. In return, you earn a share of the cryptocurrency trading fees generated by the protocol. Impermanent loss occurs when the prices of the two tokens in the liquidity pool diverge significantly over time. This divergence can happen when the market price of one token changes relative to the other token, causing the value of the tokens you provided to the pool to become imbalanced.
- Rug pulls: A "rug pull" is a term used in the context of decentralized finance (DeFi) to describe a type of scam or fraudulent activity where the creators of a DeFi project intentionally deceive investors or users by abruptly pulling out liquidity or funds from a project, leaving participants with worthless or significantly devalued tokens.
Why DeFi is important
DeFi is revolutionizing the financial sector by leveraging the power of blockchain ledger technology to create an open, transparent, and inclusive financial ecosystem.
With its core principles of decentralization, smart contracts, and dApps, DeFi is set to provide a more accessible, efficient, and secure way for people to manage their finances and access a wide range of financial products and services.
As DeFi continues to evolve and mature, it could likely play a crucial role in shaping the future of finance on a global scale.
Get started in DeFi with Kraken
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