What Is DeFi?
Find out what DeFi means, how it was invented, and what bottlenecks it aims to remove.
DeFi stands for Decentralized Finance. In a nutshell, DeFi means a collection of money-making techniques that involve swapping digital tokens sitting on distributed ledgers, also known as blockchains. There are several techniques—trading, lending, borrowing, yield farming, leveraged yield farming, and staking.
Some, namely lending and borrowing, were available to people all over the world for centuries before digitalization and on-chainization began. Trading with leverage is also something that’s been around for quite some time now, but only in traditional finance. Others, like (leveraged) yield farming and staking, are unique to the decentralized world.
As a term, “DeFi” was coined (no pun intended!) back in August 2018 in a Telegram chat whose members were entrepreneurs and developers building on Ethereum. So it’s only logical that the first DeFi project ever, Maker, was based on the Ethereum network. It had been formulated as a concept in 2014—long before the term “DeFi” was even invented—and managed to attract investment from a large venture capital fund.
Once Maker went live in late 2017, others followed, leading their own ICOs (initial coin offerings) to crowdfund the development and marketing efforts. With time, Ethereum stopped being the only platform for decentralized finance, and projects started choosing the likes of NEAR, which offered faster confirmation times and lower fees, which is critical for such quick-paced activities.
But the real boom happened during the great DeFi Summer of 2020 when Compound launched an incentivization program for those who borrowed and lent $COMP—the platform’s native digital currency. The move gave birth to yield farming as such since users were encouraged to hunt for pairs that would rake in the largest amount of $COMP rewards.
This was also when Uniswap, one of the largest and most popular DeFi projects on Ethereum, launched its own utility token $UNI and airdropped ~US$1,400 worth of it to all of its early adopters. This earned Uniswap a lot of credibility and caused an influx of new liquidity providers to the platform.
While many DeFi projects, such as Uniswap, are decentralized exchanges meant to challenge the conventional trading system, some—like Synthetix, which provides exposure to digitized derivatives—are more niche. That being said, the total value locked (“TVL”) on all DeFi platforms stands at a staggering US$94.6 billion as of Wednesday, November 2, 2022. Seeing that level of trust, you should be asking, But what pain points does DeFi heal, exactly?
To cut a long story short, DeFi was designed to respond to four critical challenges.
Traditional financial markets have a high entry threshold, meaning that users need to undergo some sort of identity verification before proceeding to trading (by the way, the same rule applies to centralized crypto exchanges). Then again, the first barrier that everybody faces is the availability of a given trading services provider in one’s country of residence. The regulatory landscape is harsh and ever-changing, so obtaining required licenses usually takes too much time and effort.
With DeFi, things get much easier as all you really need to have is a wallet with digital assets you want to trade in and Internet access, of course.
In the fiat world, markets open and close at a specified time. This gives you less flexibility in terms of moving your capital in time in order to make the most of it. DeFi, on the other hand, is accessible 24/7/365, and all earning options are interconnected within a single ecosystem, which means you can take advantage of them simultaneously.
One of the most pressing issues with centralized venues is the low returns they offer. In DeFi, literally anyone can start their own token, which may later skyrocket and bring its holders hundreds and even thousands of percent in revenues. Remember, however, that cryptos are subject to high volatility, exit scams, rug pulls, and hacks, which means there’s always a fair chance you can end up losing all of your hard-earned money. Stay aware, diversify, and always do your own research rather than jump straight into the “next big thing.”
You can track the total value locked across all DeFi projects out there in real-time. Moreover, you can also see all the transactions in a given pool, all the shares its participants have, and all the operations made by any address. If that’s not complete transparency, then what is? With regards to shares, they also contribute to making decentralized finance protocols as equal as possible because everyone gets rewarded in accordance with the size of their contribution.
DeFi enables anyone to become a liquidity provider and earn % of the fees paid by those who make swaps (even if they’re short of capital). This means that in the DeFi space, you can not only buy crypto and hold it but also invest in a certain trading pair to boost its liquidity and, therefore, support the entire crypto market while getting richer yourself.
There are two major cornerstones behind DeFi’s delivery on the decentralized promise.
In general, blockchains are distributed and decentralized. It is this technology that fuels all of DeFi. The operation of a certain chain is maintained by nodes, who ensure that all data is valid and there’s no malicious behavior. There are numerous nodes (e.g., over 400,000 on Ethereum), and they are usually situated in different data centers scattered across the globe.
Decentralized autonomous organizations (DAOs) are another integral part of the DeFi multiverse. Through them, participants of a protocol can express their opinion on matters related to its further progress. For example, at PembRock, we have a DAO of our own, which directly impacts how much both lenders and farmers make every month, on top of 100% protocol profit distribution.
To sum up, although DeFi is still in its infancy, it’s already managed to make a substantial impact. There are surely many more interesting players to enter the market yet—think of traditional finance giants who’d like to turn on-chain, at least partially.