At the heart of the cryptocurrency's rise over the past year has been the growth of decentralized finance - or DeFi for short - which has helped propel the popularity of the cryptocurrency Ethereum-network while introducing a multitude of new innovations in the financial sector.
The money flowing across DeFi platforms is already up from billion in June 2020 to almost billion in May 2021 has risen, indicating a meteoric rise and adoption that could further transform the way financial transactions take place.
Here's a closer look at what DeFi is, how it works, and what it could mean for the future of finance.
What is DeFi?
Technically, all forms of cryptocurrency could be termed decentralized finance, as all cryptos are decentralized in nature - which has long served as one of their main advantages. But the term DeFi is a bit more specific.
DeFi specifically refers to a variety of blockchain-based financial applications aimed at disrupting the traditional financial system, which many see as too outdated and overly controlled to serve an optimally effective purpose on the modern global scale.
The current financial system is largely defined by intermediaries - centralized third-party intermediaries who can limit the efficiency and sophistication of transactions by offering users less direct control over their money.
DeFi aims to defy this age-old system by applying the concept of blockchain to more complex financial problems, giving users more control and transparency over their money in a more secure way and based on code that anyone can control.
Removing the middleman
A core aspect of digital assets is the lack of an intermediary. Even on the Bitcoin platform, institutions like banks are removed from the transaction equation to allow two parties to trade directly with each other.
DeFi goes one step further, removing centralized middlemen from more complex transactions like loans, insurance, crowdfunding, and more. DeFi markets are always open, and there are no centralized authorities able to block payments or deny access.
Open to essentially anyone with an internet connection, DeFi eliminates the need to hold your funds from another entity that can take days to process transactions and that has access to your identity and other personal information.
DeFi Applications
The building blocks of the DeFi space are its applications, most of which are built on the Ethereum platform - the second largest blockchain network in the world behind Bitcoin. Ethereum differs from Bitcoin in that, in addition to conducting simple peer-to-peer transactions, it can also be used to create decentralized applications.
Smart contracts are the primary basis of many DeFi apps, allowing transactions to be executed automatically once certain conditions are met (eg. (e.g. your portfolio's asset allocation adjusts when a certain metric crosses or falls below a certain threshold).
Popular examples of DeFi applications and practices include:
- Decentralized Exchanges (DEXes), which are automated no-custodial exchange platforms that allow users to exchange currencies for other currencies. DEXes connect users directly, allowing them to trade without an intermediary.
- Uniswap (UNI) is an example that you can use to trade or make money on any Ethereum-based token by adding liquidity to its market.
- Stablecoins, which are forms of cryptocurrency that are pegged to a non-cryptocurrency asset such as gold or the U.S. dollar. Tying crypto to a fiat asset helps stabilize the price over time.
- Tether (USDT) is the first stablecoin to hit the market and is also the most widely used and adopted stablecoin with the largest market capitalization. Tether is smeared one-to-one on the US dollar.
- Lending platforms that use smart contracts to replace intermediaries who manage lending in the middle. Many of the largest DeFi apps are lending platforms.
- Maker (MKR) is one of the most popular DeFi lending platforms based on the Ethereum network with the goal of minimizing the price volatility of its own stablecoin, Dai, against the US dollar.
- Yield farming, a term for users who browse DeFi tokens to look for opportunities for greater returns.
What's next for DeFi?
Similar to crypto, the specifics of DeFi's future remain largely unknown, but a few different opportunities for investors and developers to anticipate have been identified, including:
- Cross-blockchain compatibility, which would make it possible to use more and more crypto on other networks and not just on their own.
- Expansion beyond Ethereum to platforms like Binance and Huobi.
- Integration with centralized finance to enable compatibilities such as linking credit scores to DeFi lending protocols, pocketing real estate as collateral for a crypto loan, and more.