DeFi is a shortened version of the term ‘decentralized finance’. In essence, it refers to financial tools whose foundation is on a (decentralized) public blockchain. DeFi applications may also be referred to as part of the “open finance” movement, which takes advantage of the transparency, security and peer-to-peer features of public blockchains.
There is a growing number of sectors within the DeFi universe, but the following represent some of the most commonly seen protocols in today’s markets:
- Lending and borrowing
- Digital asset exchanges & liquidity pooling
- Issuance platforms and investing
DeFi protocols at a glance
1-DeFi Lending and Borrowing
DeFi Lending & Borrowing platforms allow a global community of anonymous participants to pool their resources and lend it out to other users, who generally secure the loan with crypto assets. Instead of interest fees going to the bank, the fee revenue is often distributed through a smart contract to all the lenders within the protocol. Example of DeFi lending protocols include Aave, Maker, and Compound.
Some of the unique features of DeFi lending protocols include:
- The collateralization of digital assets
- Instant and automatic interest payments
- Instantaneous transaction settlement and novel secured lending techniques
- No credit checks, which means there is extensive access to people that cannot access traditional services
- Uniformity and interoperability; both of which can also cut down on costs with automation
Exchanges in DeFi refer to decentralized exchange (DEX) protocols where users worldwide may exchange digital assets in a peer-to-peer fashion, without a 3rd party intermediary. Examples of these 3rd parties include centralized exchanges such as Coinbase, banks, and payment processors like Visa or Paypal.
The emergence of liquidity pools and DEX aggregators have helped to solve the liquidity limitations on DEXes (not enough people were trading on them) so that now users of DEXes such as Uniswap and 1Inch Exchange are incentivized with crypto tokens to provide liquidity (by making transactions and staking coin), and traders can choose from many DEXes at once to make a potentially favorable exchange.
Issuance platforms enable other teams to build decentralized applications and launch crypto tokens on top of their platform. Solana and Polkadot are prime examples of issuance platforms, where teams and startups can build DeFi applications that are interoperable with other applications and blockchains.
Decentralized Stablecoins such as DAI and Ambpleforth have become a prominent entity in the cryptocurrency markets in recent years. Along with them are new models for token issuance, reserve auditing, and price peg management. Stablecoins are really just blockchain-issued tokens whose design helps preserve a stable peg with an outside asset. In most cases, it is the USD, however, there are other instances where it is gold or a combination of traditional and digital assets.
Stablecoins are often used as gateways from decentralized exchanges to centralized platforms, which can be connected to a traditional bank account. They lack the usual volatility of crypto assets because their price stays pegged to another “stable” asset.
When you read about stablecoins, you may hear a lot about Tether or USDC, as well as many different stablecoins that are native to crypto exchanges, such as Gemini’s GUSD. While these stablecoins may not be issued from decentralized exchanges, they are still an integral part of the overall DeFi ecosystem.
Centralization of finances vs DeFi
Financial markets have the capability of driving the welfare and success of a society by making interesting ideas a reality. However, the overall power in finance is generally centralized. A good chunk of people experience exclusion from certain decisions about who should receive funding, and in many instances, who can open a bank account. Moreover, the users of centralized financial systems are often at risk to date breaches, surveillance, and platform-centric companies that prioritize their own profits.
Decentralized finance (DeFI) applications enable a community of users to pool their resources, have a say in the direction of the protocol (through token-enabled voting) and share in the revenue of the platform. All this without giving over their personal data to a centralized database.