What is decentralized finance (DeFi)?
The Beginner's Guide to Decentralized Finance
Decentralized finance, or DeFi, refers to a sector of blockchain-based protocols and assets. If you've been in the cryptocurrency world for a while, you will have likely come across this term before.
DeFi is an ecosystem of decentralized applications (dApps) that offer various peer-to-peer financial services, from trading to lending and borrowing.
What sets these applications apart from centralized services is that they run almost completely autonomously and without the need for any sort of financial intermediary.
This is what ultimately allows decentralized finance to empower people to not just transact, but execute all sorts of financial services in a completely peer-to-peer manner.
What are the advantages of DeFi?
DeFi services provide several key advantages over traditional third-party applications, including the fact that they are:
Automated: Users can gain access to DeFi services 24/7 without the lengthy approval processes imposed by traditional financial entities.
Democratic: Users can participate in the governance process of these services (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.
Trustless: Users do not have to place trust in centralized institutions or any single person when using decentralized applications.
How do DeFi dApps work?
There are three key components to decentralized financial applications:
- A public blockchain
- Smart contracts
Blockchain technology provides a distributed, transparent ledger system for recording all dApp-related data. Its own community of volunteer participants, called "nodes," manage each blockchain. Nodes are distributed across the globe and can be anyone in the world.
Nodes use their computers to perform key tasks such as storing and validating new dApp transactions and smart contract data. Nodes all adhere to strict rules coded into each blockchain's protocol.
If you want to learn even more about how blockchains work, you can check out our Kraken Learn Center article What is blockchain technology?
Rather than building a blockchain from scratch for each new dApp, many developers build their applications on top of existing blockchain networks.
This move saves time and money, and allows dApps to be interoperable with other applications built on the same chain. More established blockchain networks also offer greater security and large communities of users than newly created networks.
Native crypto tokens often power these blockchain networks and incentivize users to participate in running them.
If you want to learn even more about how cryptocurrencies work, you can check out our Kraken Learn Center article What is a cryptocurrency?
Users must pay fees denominated in the underlying blockchain's native cryptocurrency to perform any dApp-related activities.
For dApps built on Ethereum, users pay fees in ether (ETH). With Cardano, fees are denominated in the platform’s native Ada (ADA) cryptocurrency, and so on.
In some instances, these tokens can have additional utilities. For example, governance tokens are a types of cryptocurrency that grant holders weighted voting powers over the protocol's management and future direction.
dApps achieve their autonomy by using smart contracts instead of human intermediaries. Smart contracts are self-executing computer programs that automatically fulfill contract obligations between two parties when predetermined factors are met.
If you want to learn even more about how smart contracts work, you can check out our Kraken Learn Center article What is a smart contract?
Smart contract programs are stored on blockchains. Smart contract platforms like Ethereum use simulated computer environments called virtual machines to read and execute these special types of programs.
Nodes run the virtual machine program when validating transactions involving smart contracts. The virtual machine makes sure smart contracts deployed on the blockchain produce valid transactions per the rules of the protocol.
A great example of a dApp in practice is the DAI DeFi application.
DAI allows users to "lock" cryptocurrency into a smart contract running on the Ethereum blockchain. Users deposit these funds as collateral to generate new DAI tokens that power its lending service. Users can take these newly minted DAI tokens and trade with them or deploy them on other DeFi platforms to earn yields. This project provides liquidity to investors without them having to directly dispose of their ETH.
When the user wishes to retrieve their locked assets, they simply return the DAI and pay a small interest fee.
What are the disadvantages of DeFi?
Decentralized Finance (DeFi) has gained significant popularity in recent years, however, it also comes with several disadvantages and risks.
Security Risks: DeFi platforms rely on smart contracts to automate financial transactions. While these smart contracts are designed to be secure, they are not immune to vulnerabilities and bugs. Security breaches, hacks, and exploits have occurred in the DeFi space, leading to significant financial losses for users.
Complexity and Technical Barriers: DeFi platforms often require users to have a certain level of technical knowledge and familiarity with blockchain technology. Setting up wallets, interacting with smart contracts, and managing private keys can be challenging for individuals who are not well-versed in these concepts.
Volatility and Price Risks: DeFi tokens and assets are often subject to extreme price volatility. Many DeFi projects issue their own tokens, which can experience rapid price fluctuations due to factors like speculative trading, liquidity imbalances, and market sentiment.
What do DeFi protocols do?
As DeFi protocols expand, understanding the different classes of problems these projects are trying to solve becomes beneficial.
Lending and Borrowing
DeFi cryptocurrencies focusing on lending allow users to take loans using computer software, removing the need for a trusted intermediary.
Powered by code instead of paper contracts, these projects automate the maintenance margins and interest rates required in lending. Among other things, this allows for automatic liquidation should balances fall below a specified collateral ratio.
While each lending protocol has different nuances, they generally act in similar ways.
For example, there are typically two types of users: those lending their tokens to the protocol/ providing liquidity to it, and those borrowing these tokens.
Someone wishing to lend cryptocurrencies would send those tokens to a smart contract address controlled by the protocol, and earn rewards based on the amount they lent.
Borrowers, on the other hand, deposit collateral in the form of a cryptocurrency. The dApp smart contract then allows them to borrow cryptocurrencies as a percentage of the posted value.
Should the protocols work as intended, users can easily borrow cryptocurrencies and lenders or liquidity providers can earn interest on their deposited assets.
Decentralized exchanges (DEXs) allow users to exchange crypto assets without the need for a third-party managed order book, allowing for true peer-to-peer trading.
A mechanism called an "automated market maker" is employed to facilitate this type of trading.
Instead of centralized matching software connecting buyers and sellers, volunteers (called liquidity providers) deposit their own assets into specific pools. These pools of assets are then available for others to trade against.
For example, someone wishing to swap their Chainlink (LINK) tokens for Ether (ETH) can do so in an ETH/LINK liquidity pool.
Transaction fees charged to traders are distributed proportionally among liquidity providers, compensating them for their service. In exchange, traders can execute trades instantly without needing to wait for a suitable counterparty.
A sophisticated balancing algorithm coupled with arbitrage traders makes sure that the prices of assets within each pool reflect the current market prices.
Another major benefit of a DEX is that no centralized party holds user funds. DEX's are completely non-custodial. Each user connects their own crypto wallet to the platform, keeping control over their own private keys.
This factor means users' funds are not at risk of theft through the same vectors used to hack centralized exchanges. However, DEX users can still lose funds through other means, it is important to take precautions to keep your crypto safe.
Derivatives markets allow buyers and sellers to exchange contracts based on the expected future value of an asset. These assets can be anything from cryptocurrencies to future event outcomes or 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, users wager on the outcome of events. With Augur, users can create and exchange "shares" representing a piece of the value of outcomes like elections or sporting results.
Lastly, protocols like dYdX offer users the possibility to trade margin tokens, allowing traders to leverage short or long positions in various markets.
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