What is Decentralized Finance (DeFi)?
Decentralized Finance, or DeFi, is the use of blockchain and smart contract technology to create finance applications that work without the need for middlemen or other oversight bodies.
Many new blockchain technologies are trying to disrupt the idea of control in finance — cryptocurrency proponents want to place that control in the hands of the individual, as opposed to the long-standing paradigm of institutionally-controlled wealth. But what separates centralized and decentralized finance?
- A single governing person or interest
- External bodies enforcing trust in the institution
- Requires accounts, personal information
Banks are a form of centralized finance that everyone is familiar with — they have a single governing individual or committee, third party oversight and regulations, and complete control over their customer’s information. This includes identifying personal info, like names and addresses, as well as each customer’s transaction history. Taking out a loan, paying into investment services, or withdrawing cash are all facilitated by the bank itself — you can’t buy a coffee with your credit card without the bank and the credit card company knowing when you got it, where, and what kind.
- Governance is distributed among the people that use it
- Trustless — all parties are subject to the terms of tamper-proof computer code
- Private and anonymous to use
To be considered decentralized, an application must have at least one decentralized function. Usually this includes a distributed transaction ledger — identical copies of the app’s records existing in multiple locations — or a decentralized system of governance, or both.
Things you would normally do through a bank, like taking out a loan, for example, are being written into blockchain applications that accomplish the same goal. Taking a loan through a Decentralized Finance program doesn’t need a brick-and-mortar bank, financial advisors or even third-party oversight. The agreements between lender and lendee are enforced by software and cannot be changed — this eliminates the amount of trust the system requires, since both parties know the exact outcome of their agreement.
Putting our trust in immutable code makes most of a traditional banking system obsolete, drastically reducing costs. There’s no need for staff, oversight, debt-collectors or their necessary infrastructures when the code itself can be trusted.
For those of us not up on our crypto-lingo, this section will briefly define some of the important terms in the rest of the Guide.
Short for Decentralized Application. This refers to any application that lacks a central authority determining its implementation. In the DeFi space, dApps are most often blockchain applications that use smart contracts to carry out their operations.
Smart contracts are autonomous agreements written in code between two parties that run on a blockchain. They are essentially mini-programs that define and execute transactions. Smart contracts usually perform the bulk of the operations in a decentralized application. The code in a smart contract will carry out its task without human intervention, and external factors cannot interfere with the outcome of the code.
Trust refers to the system of regulations used by financial institutions and applications used to ensure agreements between parties play out as agreed.
Governance in respect to a decentralized application refers to the method by which decisions are made governing the application itself. Holders of a governance token may have the right to participate in decisions about changes to the protocol that issued them.
Know Your Customer (KYC)
Know Your Customer procedures are the methods by which centralized financial services vet their clients. Signing up for a bank or exchange usually requires a valid ID and proof of residence documents, among other pieces of identification — these are forms of KYC.
DeFi services and income opportunities gained traction in 2019 and continue to sophisticate today. DeFi systems are sometimes called “money legos” — they can combine with other DeFi services to achieve better usability and more functions. As time goes on, the innovations that emerge from DeFi will have literally been built on top of one another.
While many of the innovations in DeFi benefit blockchain developers, a strong class of end-user services have emerged since 2019.
Taking out a cryptocurrency loan is completely anonymous, requires no account or sign up procedure, and is immediately accessible to anyone with a crypto wallet and internet connection. The way it works today is you must over-collateralize your loan — most DeFi applications require you provide at least 150% of the loan value at the outset, in order to protect the funds of those doing the lending (a pool of other cryptocurrency holders). In this way, DeFi loans are probably most useful for those looking to speculate on the price of the loaned token.
There are a couple of avenues where DeFi allows crypto investors to deposit a cryptocurrency and earn interest on the balance, oftentimes at better rates than those offered by most banks.
- Contribute cryptocurrency to a liquidity pool — Decentralized Exchanges (Dex) require a healthy reserve of funds called a “liquidity pool” to facilitate near-instant trading. The funds in a liquidity pool come from regular crypto traders looking to earn interest on in-demand tokens. A Dex pays out interest on your deposit at varying rates depending on the current demand for each token. Being a liquidity provider, however, isn’t without risk. For example, providers can experience “impermanent loss” — an effect that reduces the amount of the provider’s pooled crypto, reducing its total value compared to simply holding the original pooled amount in their wallet.
- Contribute crypto to a DeFi loans system — this is most similar to what most banks (used to) do with your savings account. The funds you deposit to a DeFi system are used to provide loans to other investors, and you are paid a portion of the interest proportionate to your contributed amount. Your cryptocurrency is deposited to a pool of funds rather than directly to the borrower, letting you withdraw your investment at any time. FYI, withdrawals do incur fees from using the Ethereum network.
- Contribute to DeFi stakings services — staking isn’t new to DeFi, but new applications exist that offer staking as a service. Staking is when you lock Proof-of-Stake tokens on a blockchain protocol, generating interest on the funds. The tokens you lock contribute to their respective blockchain’s consensus mechanism, helping verify new transactions as they occur.
For the uninitiated, “yield farming” is the strategic use of the savings applications described above (except staking) to consistently benefit from high-interest tokens. The Average Percentage Yield (APY) of a token fluctuates from service to service (because they use separate liquidity pools) and from day to day, depending on demand for the token.
Because you can withdraw deposited tokens at any time without penalty, crypto investors are able to move their funds from one high-yield token to another as often as they like. The practice has spawned DeFi apps that streamline the process by collecting the best yield rates available into one place.
Some decentralized exchanges (Dex) rely on liquidity pools to facilitate trading, just like DeFi loans & savings apps. These types of exchanges often have a simplified interface where you immediately exchange one token for another. There are Dex’s that resemble more traditional trading terminals with order books for peer-to-peer trading as well. Neither require Know Your Customer (KYC) procedures, which means no accounts or sharing of your identifying information. They also don’t require you to deposit funds to the exchange, making them a relatively safe option against hacks — note the “relatively” here, as there is always a measure of risk involved when using DeFi.
Stablecoins are tokens pegged to the price of another asset, often a form of fiat currency or a commodity. Decentralized stablecoins are made on-demand when you lock funds into a smart contract.
The funds you lock in exceed the amount of stablecoin you receive — this is called a Collateralized Debt Position (CDP). Essentially, you provide more of one token (usually Ethereum) than the amount of the stablecoin you want to generate. Your deposit and its surplus act as a reserve asset, backing the stablecoin's value.
If you’re interested in trying out a DeFi service, try defiprime.com for a list of current projects in the DeFi space.
DeFi apps do have advantages over their traditional counterparts that cryptocurrency traders consider worthwhile. Many of these advantages align with what most would consider the social goals of cryptocurrency — openness, privacy, and security.
Decentralized Finance applications:
- Remove central authority from financial services
Governance of these services is distributed amongst the user-base via governance tokens, rather than in the hands of a single interest. Holding an amount of a governance token gives you the right to participate in a dApp’s decision-making practices.
- Remove Trust from the equation
DeFi apps write the conditions of each transaction into smart contracts — pieces of code that define the transactions between the involved parties. Smart contracts can run without mediation, though in reality there is often a measure of oversight from the developers to make sure they run correctly. Because vetted code can be expected to operate in a certain way, this dramatically minimizes the amount of trust required of the transacting parties.
- Remove Permission from financial services
There are no accounts or sign-up procedures in DeFi apps. If you have a cryptocurrency wallet and an internet connection, you have access to DeFi. Whereas traditional finance favors the capitalized, most DeFi services are available to be used around the world.
- Are totally private
Without invasive Know Your Customer (KYC) procedures, crypto traders don’t have to reveal their identifying information to get access to a DeFi app. There’s no risk of your identity being revealed in a hack, or sold to any outside parties. And FYI: even though transaction ledgers are completely public, your real identity isn’t included in the ledger at all.
- Offer operational transparency
The code for these services is always available for public scrutiny. Anyone (who understands the coding language, that is) can understand how the dApp works, find bugs, and discuss the actual technology supporting each dApp publicly.
- Encourage innovation in new DeFi services
DeFi apps that perform a single function, such as a stablecoin, can be linked to other projects to build multifunctional tools. This can eventually lead to highly sophisticated applications that perform a variety of services on decentralized systems.
Decentralized Finance is still considered to be in its early adopters phase. Emerging technologies can be rife with bad actors looking to capitalize on inefficiencies and errors in the code, so don’t take the term “trustless” as a cue to be reckless. As you would with any financial practice, research the risks involved and the parties you’re dealing with.
- Smart contract vulnerabilities
This is likely the most difficult risk to predict unless you’re well-versed in the coding language that the dApp is built with. Fortunately, because the code for DeFi apps is publicly available, chances are that someone who does know how to read code has discussed potential flaws or bugs in the dApp’s official forum or elsewhere online.
Vulnerabilities also occur when a dApp has been “Forked” — that is, cloned or copied by another developer. Copies can be made so fast that bugs in the original dApp haven’t been found yet, leading to reproductions of the error.
Alternatively, the dApp may have undergone an independent security audit, which may have been made available online by the developers themselves.
- Scams in general
Investing early in any technology carries this as a risk. Among those trying to exploit a system’s code, there are those working to exploit the people using it. Just like in the first point, it’s a good idea to make sure the service you plan on using has been vetted by a third party. Likewise, check the cryptocurrencies you plan to trade, borrow, etc. to see if they are being imitated (ie. are not the official token) or are offered by non-reputable sources.
- Changing governance
The democratic nature of dApp governance has its pitfalls as well. For the casual user, changes in a dApp’s governance that change a financial opportunity to a resounding loss might go unnoticed. If you plan to use a service in the long-term, keep up with changes to its operational procedures.
- Lack of historical precedence
This is a risk born from the relative youth of decentralized finance as a whole. Savvy investors rely on historical benchmarks to decide on the validity of a course of action. DeFi has only recently risen in popularity and lacks the historical precedence to make informed, long-term investments. So even though an dApp may seem promising, there’s no telling what factors (eg. governments, new laws) will affect DeFi in the coming years.
- Personal cryptocurrency security
The onus is on you to protect your finances, especially if you decide to hold cryptocurrency. Cryptocurrency transactions are irreversible — if someone gains access to your crypto wallet or exchange accounts, it may be impossible to restore your funds. Read our Guide How to start trading cryptocurrency to learn more about protecting your wallet keys.
Be sure to check out Kraken’s Crypto Security Guides, hosted by Kraken’s Chief Security Officer, Nick Percoco. These videos cover the tools at your disposal for protecting your crypto finances.