Introduction to DeFi – DeFiGuide.org

You’ve heard of DeFi, but don’t really know what’s behind it and what it’s supposed to be good for? Then you are exactly right here! In this article I will give you the most important basics about DeFi. I will not only explain to you what is meant by the term DeFi, but we will also look at the problems of the traditional financial system DeFi tries to solve. Ultimately, something new and revolutionary only makes sense if it solves a relevant problem. Then we look at the individual building blocks that are used in the DeFi ecosystem to build new solutions. But don’t worry, it won’t get too technical! Then we take a look at the different DeFi services that you can already use today. And last but not least, we highlight the (currently still significant) risks of DeFi. Have fun reading!

What is DeFi?

DeFi is short for Decentralized Finance and includes financial services that work without centralized intermediaries such as banks, stock exchanges, brokers or insurance companies. Instead, DeFi services run in a decentralized environment based on public blockchains. Even more precisely: The DeFi ecosystem consists of decentralized applications (dApps), which are based on a blockchain settlement layer and offer financial services such as payments, loans, exchanges, derivatives, fund management and insurance. This blockchain settlement layer is (still) the Ethereum blockchain for the vast majority of DeFi dApps.

DeFi services that go beyond simple payment transactions have been around since 2017, but DeFi only really got going in the summer of 2020 – the so-called DeFi summer – when numerous new DeFi applications such as the loan platform Compound appeared and were used by a broader public. According to market data provider DeFi Pulse, the total value of digital assets in DeFi applications has grown from zero in 2017 to a peak of USD 112 billion in November 2021. However, DeFi is still in its infancy and new innovative services are popping up almost daily. With that in mind, this is a super exciting time to dive into the DeFi ecosystem!

Advantages of DeFi

DeFi is often praised as a revolutionary solution that will change the world. But what is the background for this enthusiasm around DeFi? Basically, the idea is that DeFi’s decentralized approach has the potential to fundamentally solve core problems of our traditional, centralized financial system. As mentioned above, DeFi is still a very young discipline and it is probably too early to be able to conclusively assess whether DeFi can meet the high expectations. Nevertheless, we want to take a look at the most important advantages that DeFi is attributed to:

More efficient – The traditional, centralized financial system involves many inefficiencies: It is run by companies with organizational overhead, and financial transactions often have to pass through several companies before they are finalized. This often results in longer waiting times (sometimes several days) and high costs for the end customer. These high costs in turn make it impossible to provide certain services such as micro payments. In contrast, DeFi introduces a whole new level of efficiency: DeFi smart contracts offer their services 24/7 and mostly at almost zero cost. (Note: If you are already a bit more familiar with blockchains, then you will probably object at this point that the proof-of-work consensus mechanism and the transaction costs on Ethereum are anything but efficient or free. This objection is for absolutely legitimate for Ethereum today. However, other blockchains have already successfully solved this problem and with Ethereum 2.0 a solution seems to be within reach for the ETH community as well… even if the June deployment has just been postponed.)
Accessible to everyone – Approximately 1.7 billion adults were unbanked in 2017, according to the World Bank Global Findex Report. This means 1.7 billion adults do not have access to savings, credit, investments and other basic financial services. The report also states that about two-thirds of these “unbanked” adults have a cell phone. With a mobile phone and an internet connection being all one needs to access DeFi, DeFi consequently holds the potential to enable more than a billion unbanked adults to access financial services.
More transparent – The transparency of today’s financial system is quite limited for most of us. This becomes obvious when you take a closer look at the events that led to the global financial crisis in 2008. For example, high-risk mortgage-backed securities were given the safest ratings by the most reputable rating agencies. We all remember what happened to these “highly secure” securities. In contrast, DeFi dApps are completely transparent, as how they work is visible to everyone in the form of open source code lines on the blockchain. So everyone knows at all times 100% what they are getting into when they use a DeFi service.
More distributed control – DeFi enthusiasts often criticize the centralization in today’s financial system, which is created by the large global financial service providers. DeFi avoids such centralization by handing over control of financial services to smart contracts on the blockchain, whose set of rules (e.g. the rules for determining the interest rates or fees offered) are either immortalized in unmodifiable code or managed by a decentralized organization (DAO = Decentralized Autonomous Organization). Of course, such DAOs entail completely new risks that are not yet known, so that it is probably still too early to draw a conclusion here.
Combinable – A fundamental problem of the traditional financial infrastructure is the often lacking compatibility. Although progress has been made in this regard in recent years under the keyword “Open API banking”, today’s financial system often still consists of silos that can only be connected to one another to a limited extent. This makes it difficult to combine multiple services from different banks to create new financial services. And this lack of compatibility hampers innovation. This is completely different in the DeFi ecosystem, where all services (i.e. all smart contracts) are completely open source by design and accessible to everyone. With this we have a kind of perfectly open API banking, in which any financial service (any smart contract) can be used by any other financial service (any other smart contract) and combined to create completely new innovative services. This peculiarity of DeFi, that any service can be combined into new services, is the reason why people are often speaking of DeFi lego.

DeFi building blocks

Now we know what DeFi is and what advantages it offers over the traditional financial system. In a next step, we want to look at the building blocks that make up DeFi applications.

Blockchains – The core of the decentralized nature of DeFi are blockchains, which serve as a settlement layer for DeFi transactions. Simply put, a blockchain is a decentralized, distributed ledger that is shared between the individual nodes of a computer network. Most DeFi applications are currently running on the Ethereum blockchain, which has extensive smart contract functionalities and a very active community.
Digital assets – Digital assets or crypto assets or simply tokens represent entities of value on the blockchain such as currencies or securities. These are cryptographically stored and transferred on the blockchain. The cryptocurrency Bitcoin was the first digital asset on a blockchain (invented in 2008, launched a year later).
Wallets – A wallet is a piece of software that enables its users to securely store and transfer their digital assets on the blockchain without having to go through a central intermediary.
Smart contracts – Smart contracts are a core component of DeFi. Smart contracts are non-modifiable programs in which the functionalities of DiFi applications are hard-coded. They are stored on the blockchain and run automatically (and unstoppably) when certain conditions are met.
Decentralized apps (dApps) – dApps are applications that DeFi users interact with directly to access smart contracts. dApps are built on top of a decentralized software stack, which usually means there is a traditional web-based or Android/iOS-based user interface built on top of smart contracts, which in turn are built on blockchains such as Ethereum. Because there is a blockchain at the core of dApps, this means that dApps can be used by anyone and nobody can stop them. (For example, a regulator can have the domain – that means the www address – of a dApp switched off, but the smart contract itself cannot be switched off on the blockchain, which means that anyone can set up a new interface to the smart contract at any time.)
Governance systems – dApp governance systems are mechanisms for managing smart contracts. They are hard-coded into software. Decentralized governance systems usually use so-called governance tokens, which give their owners the right to propose smart contract changes or to vote on such proposals.
Oracle – Oracles are information service providers that connect smart contracts on the blockchain to the world outside of the blockchain. For example, they feed stock price information from traditional exchanges into the blockchain so that smart contracts can use that information to deliver their services.

DeFi service categories

Next, let’s take a look at the different DeFi service categories. As you can see listed below, these are basically the same service categories as we know them from the traditional financial world. However, it is important to understand that DeFi has already introduced new innovative services within these categories that were not possible in the “old” financial world; for example, as an average Joe, you can easily raise a USD 10 million flash loan via Compound and use it to conduct an arbitrage trade that used to only be reserved for the big hedge funds, or you can use the Set Protocol to create your own fund and offer it to the world to invest in… or you can act as a market maker on a decentralized exchange (DEX) and earn transaction fees.

However, we do not want to go into all the concrete examples from the DeFi world in this general introduction to DeFi, but save this for dedicated blog posts. The following figures on the share of the service category in the overall DeFi market and the top three players per category are based on the Total Value Locked (TLV) figures published on DeFiPulse.com as of February 8, 2022. The TVL is the total value in US dollars, which is stored in the corresponding smart contracts of the category; i.e., a kind of balance sheet total of the respective smart contract.

Decentralized credit – Market share of 49%; top three players are Maker, Aave and Compound
Decentralized exchanges – Market share of 28%; top three players are Curve Finance, Uniswap, Balancer
Decentralized fund management – Market share of 19%; Top three players are Convex Finance, yearn.finance and Rari Capital
Decentralized derivatives – Market share of 2%; top three players are dYdX, Nexus Mutual and Synthetix
Decentralized payments – Market share of 2%; top three players are Flexa, Tornado Cash and xDai

DeFi risks

As always with young, radically new technologies, blockchain technology and thus DeFi in particular are associated with risks that users of these services must be aware of. So: Before you use a DeFi service and entrust your hard-earned tokens to a smart contract, always check carefully what risks you are taking with it. The credo “There is no such thing as a free lunch” also applies in the DeFi world. Here is an overview of the most important risks associated with DeFi:

Smart contract risk – As described above, a major strength of DeFi is the openness of the system. All functionalities of DeFi applications are encoded in smart contracts, which are completely open source, so that, unlike the traditional financial system, everyone can view and use them without restrictions. The downside of this transparency is that if a smart contract programmer makes a mistake that technically enables attackers to steal the assets held in the smart contract, then you almost certainly don’t have to wait long before this smart contract get exploited… because the code of the smart contract is visible to everyone like an open book. The best-known example of such a smart contract hack is probably the DAO hack, which shocked the Ethereum community in 2016. Back then, attackers managed to steal $70 million worth of tokens from the flawed DAO smart contract.
Governance risk – Software risks as described above are basically nothing new and have already caused damage in the traditional financial world. However, DeFi brings with it a whole new risk, the so-called governance risk. As already explained, the rules and parameters of a smart contract are often not written in code but can be changed by the holders of corresponding governance tokens, provided that the majority of governance token owners agree to the change. Behind this is the democratic idea of distributed governance. However, since these governance tokens, like all digital assets, are freely tradable, one can now imagine the case where an attacker buys the majority of the governance tokens of a dApp regularly via a marketplace (DEX) and, thanks to this majority, then changes the dApp in his favor.
Regulatory risk – And of course there are also significant regulatory risks in the DeFi space. This is the risks that regulators will completely ban certain DeFi financial services or force them into a narrow regulatory framework.
Oracle risk – As we have learned, oracles serve to bring off-blockchain data such as price information from traditional securities exchanges into the blockchain. Many smart contracts depend on such oracle data. At this point, the critical reader can of course ask what a secure blockchain is supposed to achieve if the oracle that brings the data into the blockchain is vulnerable. The oracle risk is probably one of the most active research areas around DeFi at the moment. Chainlink is one of the market leaders here and relies on an approach in which the oracle itself is based on a decentralized network in order to avoid a single point of failure.
Custody risk – Last but not least, there is the custody risk. If I, as a customer of a bank, have forgotten my e-banking PIN, then that’s not so bad. I call my bank advisor, identify myself on the phone and order new access data for my e-banking, which is physically sent to the address stored for me at the bank. With DeFi, it is not that simple. If I lose or forget my private key for my crypto wallet, then no power in the world can help me to get my digital assets back. These are lost forever without a private key. The situation is similar if someone gets hold of my private key for example through phishing. With my private key, this person can anonymously withdraw all assets from my wallet without restriction. There is no institution that could help me here to get my assets back.

Get started with DeFi

So… this has been a pretty extensive introduction to DeFi. If you still haven’t had enough and the “DeFi spark” has jumped for you, then now is the time for you to get started. One of the best ways to continue your DeFi journey is to next take our video-based DeFi course and get your DeFi certificate. In this course I will introduce to you many practical tips and tricks to navigate the DeFi space.

(Disclaimer)

Sources:
– https://www.defipulse.com
– https://globalfindex.worldbank.org
– Harvey, C., Ramachandran, A., Santoro, J., Ehrsam, F. and Buterin, V., nd DeFi and the Future of Finance.
– Fang, L., 2021.How to DeFi. United States: Coin Gecko.