What Is DeFi And How Does It Work?

Since Bitcoin (BTC) broke onto the scene in 2009, the growth of blockchain technology has been exponential. From facilitating the trade of traditional cryptocurrency products, to NFTs and ICOs, the blockchain has gone mainstream. As a result, the term decentralised finance (DeFi) has become a buzzword not only in the crypto space, but within the broader commercial landscape.

What Is Decentralised Finance (DeFi)?

Decentralised finance, commonly referred to as "DeFi," refers to a direct mode of exchange where computing software is used to eliminate intermediaries. The exact definition of the term varies from agency to agency, with advocates and detractors frequently debating exactly what decentralised finance is.

According to U.S. Securities and Exchange Commission (SEC) Commissioner Caroline Crenshaw, DeFi is as follows:

"An effort to replicate functions of our traditional finance systems through the use of blockchain-based smart contracts that are composable, interoperable and open-source."[1]

The World Economic Forum (WEF), in collaboration with the Wharton Blockchain and Digital Asset Project, goes into a bit more detail on the subject:

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"It [decentralised finance] is a category of blockchain-based decentralised applications (DApps) for financial services. DeFi encompasses a variety of technologies, business models and organisational structures, generally replacing traditional forms of intermediation."[2]

Essentially, decentralised finance is the framework by which individuals can conduct business using blockchain technology. Supported activities are trading crypto, selling third-party apps, or really any type of commerce conducted on a blockchain. The DeFi revolution flies in the face of traditional finance as conventional monetary institutions are not needed to facilitate transactions.

Beginning in 2018, the DeFi sector exploded in popularity. In fact, from June 2018 to June 2021, the aggregate value of DeFi assets increased from US$4 billion to US$93 billion.[3] The swift appreciation drew attention from both the conventional financial and business worlds alike. In early 2021, Tesla CEO Elon Musk summed up the situation on Twitter with this tweet: "Don't defy DeFi."[4]

How Does DeFi Work?

The nuts and bolts behind decentralised finance is rooted in blockchain technology. To thoroughly understand how DeFi works, it is necessary to first understand what the blockchain actually is.

According to digital asset exchange Coinbase, "a blockchain is a list of transactions that anyone can view and verify."[5] Further, it is decentralised in nature and consists of confirmed transactions known as blocks. The functionality of the blockchain allows for the trade of crypto assets such as BTC or Ethereum (ETH), as well as more exotic products such as NFTs. Proponents of the blockchain claim that it will replace traditional banks because of the following advantages:[5]

  • Blockchains are global, meaning crypto products can be sent around the world quickly, in a cost-effective fashion.
  • Cryptocurrency payments conducted on the blockchain are anonymous, thus boosting user privacy.
  • Transactions and programming codes are transparent, so anyone is free to scrutinise them.

Essentially, decentralised finance uses the functionality of the blockchain to execute commercial endeavours. The speed by which transactions may be completed, anonymity, and the lower cost make DeFi an attractive avenue for many businesses and individuals.

What Are Smart Contracts?

Although the topic is technologically complex, smart contracts are simply programs local to the blockchain. According to the experts at IBM, smart contracts "are digital contracts stored on a blockchain that are automatically executed when predetermined terms and conditions are met."[6]

How Do Smart Contracts Work?

The automated nature of a smart contract is conducive to its functionality on a blockchain. Below is a quick look at how a smart contract actually works:[6]

  1. Smart contracts follow basic "if/when…then" logical statements that are coded on a blockchain.
  2. When the predetermined conditions are met and verified, computers on a blockchain execute the outlined actions.
  3. The resulting actions may come in a variety of forms, including financial services such as the transfer of digital assets.
  4. When a transaction completes, the blockchain is then updated. Once updated, the transaction is irreversible and only reviewable by parties who have been granted permission.

Benefits Of Smart Contracts

One of the most beneficial aspects of smart contracts is their ease of application. Once the "if/when…then" rules are finalised, they may be directly put onto the blockchain by a programmer. Below are several other key benefits:[6]

  • Speed: Upon a condition being met, contracts are then executed immediately in an automated fashion. Due to the automation, smart contracts aren't subject to manual errors that sometimes plague conventional financial institutions.
  • Transparency: Transactions are encrypted and direct from party-to-party. Accordingly, all information is standardised and unaltered.
  • Security: All transactions are conducted on the blockchain and are very difficult to hack. In fact, to change a single record, nefarious parties would have to hack an entire chain, not a single block.
  • Cost-effective: Without any intermediaries such as traditional banks, smart contracts are cost-effective.

The cost and speed of smart contracts make them especially attractive to the DeFi applications (DApps) and DeFi protocols local to DeFi lending practices. Although the space is still in its infancy, many financial experts believe that crypto and smart contracts will eventually rival currencies and the world's conventional financial system.

Applications

From a practical standpoint, the applications of smart contracts on the blockchain remain largely unexplored. The technology is relatively new, so unique uses are being developed all the time. However, smart contracts are typically utilised in two primary ways:[7]

  1. To hold funds and data on the blockchain under the contract's address.
  2. Run code that performs actions in concert with the contract's directives.

One example of how smart contracts are used is on the Ethereum blockchain. In fact, the Ethereum blockchain is one of the leading DeFi platforms. On the ETH network, contracts are used to perform computations, create cryptocurrency, in data storage, build NFTs and send communications.[8]

More specifically, contracts on ETH are used to develop stablecoins, in decentralised gaming, decentralised exchanges and in annuity insurance payments. Chances are, if you have a crypto wallet or crypto exchange account, then you are at least indirectly utilising smart contract technology.

The Role Of DeFi

Per definition, DeFi is the execution of financial enterprise on the blockchain. This can mean many things to the world of finance, from managing liquidity pools to facilitating algorithm crypto trading.

Although the infrastructure and technology behind the DeFi space continues to evolve, the ultimate goal is to remove intermediaries from financial transactions. This is especially true in the provision of DeFi platforms, DeFi lending and the introduction/trade of non-fungible tokens (NFTs).

DeFi Platforms

A DeFi platform is an actual protocol that operates on a blockchain network. From a functionality perspective, the DeFi platform allows people to execute smart contracts and conduct various enterprises. A few included functions are the trade of cryptocurrency, person-to-person monetary transfers and crypto-lending practices.

On the blockchain, DeFi platforms furnish customers with an abundance of services. And, the sector has exhibited substantial growth, posting a total value locked (TVL) of US$105 billion as of December 2021. Below are a few high profile DeFi platforms and their TVL or "invested worth":[9]

  • Maker (US$19.03 billion) is one of the oldest DeFi projects and accounts for 18% of the aggregate value in the DeFi space. Maker is a DeFi lending platform that mints DAI stablecoins in return for pledged collateral.
  • SushiSwap (US$3.73 billion) is a decentralised exchange (DEX) that allows for the trade of crypto products. SushiSwap is an automated market maker (AMM), meaning that it establishes cryptocurrency exchange rates and furnishes traders with liquidity.
  • Curve Finance (US$15.36 billion) is a DEX that facilitates the exclusive trade of stablecoins via deep liquidity pools. Curve Finance effectively eliminates the role of counterparties and injects liquidity into the trade of stablecoins.
  • Compound (US$11.38 billion) is a lending platform built on the Ethereum blockchain. Compound gives individuals the ability to earn revenue by contributing crypto to liquidity pools. Investor revenues are derived from a variable interest rate that is based on relative levels of crypto supply and demand.

Since 2014, the role of DeFi platforms has expanded greatly to service a growing number of crypto aficionados. Given the integration of blockchain technology into the financial mainstream, the sector's expansion is likely as demand for DeFi services continues to increase.

DeFi Lending

DeFi lending is a rapidly growing space that offers loans to individuals that pledge their digital assets for lending purposes. In this way, DeFi lenders can issue crypto-based loans without intermediaries on a person to person basis.[10] Under this scenario, lenders are able to earn interest rates on their pledged crypto, thereby generating passive income.

Although similar to traditional banks issuing loans to individuals, DeFi lending deals in cryptocurrencies not conventional moneys such as the US dollar (USD). Due to the fact that business is conducted person-to-person on a blockchain, there is no centralised exchange. Among all of the DApps (decentralised applications), DeFi lenders have the highest growth rate and are the premier way of "locking up" cryptocurrency assets.[10]

Risks Of DeFi Lending

Unfortunately, like in all things in finance, DeFi lending does pose risks to the user. Here are a look at three of the largest risks:[11]

Impermanent Loss

Impermanent loss occurs when the value of crypto assets pledged to a liquidity pool falls, resulting in an unrealised fiat currency loss. As a result, the automated market maker system rebalances the assets of the liquidity pool to regain the notional value. In the process, an investor's holdings can change resulting in an impermanent loss. One way savvy cryptocurrency investors mitigate this risk is by pledging only stablecoins to liquidity pools.

Flash Loan Attacks

A flash loan is an unsecured loan that is afforded to crypto holders. Flash loan attacks occur when cyber criminals gain access to large amounts of flash loans and manipulate DeFi protocols for their own gain. In turn, token and liquidity pool values can be negatively impacted.

DeFi Rug Pulls

A "rug pull" occurs when DeFi developers build a new token and pair it to a primary crypto product within a liquidity pool. Then, using built in "back doors," the same DeFi developers use the associated smart contracts to mint millions of new coins and trade them for the popular crypto. Subsequently, the liquidity pool becomes worthless, burning investors.

Ultimately, DeFi lending is not a risk-free way of generating passive income. It's up to each investor to understand the potential pitfalls of the industry before pledging crypto to a liquidity pool.

Summary

DeFi is a catch-all term for financial business that is conducted on the blockchain. It's a quickly evolving environment that relies on smart contracts and DeFi platforms to facilitate services and transactions. Users are afforded a collection of unique benefits, including low costs, security and fast transactions.

Among the most popular products available in the space is DeFi lending. Although many investors favour the interest rates paid by liquidity pools, they do come with several prominent risks. As with the digital asset class in general, it's important for each participant to perform the necessary due diligence to ensure their own safety and prosperity in the environment.

References

1

Retrieved 21 Dec 2021 https://www.sec.gov/news/statement/crenshaw-defi-20211109

2

Retrieved 21 Dec 2021 https://wifpr.wharton.upenn.edu/wp-content/uploads/2021/06/DeFi-Policy-Maker-Toolkit-Final.pdf

3

Retrieved 21 Dec 2021 https://www.cnbc.com/2021/09/17/how-decentralized-finance-works-and-why-its-taking-on-wall-street.html

4

Retrieved 21 Dec 2021 https://twitter.com/elonmusk/status/1375031060753346564

5

Retrieved 21 Dec 2021 https://www.coinbase.com/learn/crypto-basics/what-is-a-blockchain#introduction

6

Retrieved 21 Dec 2021 https://www.ibm.com/sa-en/topics/smart-contracts

7

Retrieved 21 Dec 2021 https://auth0.com/blog/101-smart-contracts-and-decentralized-apps-in-ethereum/#Smart-Contracts

8

Retrieved 21 Dec 2021 https://ethereum.org/en/smart-contracts/

9

Retrieved 21 Dec 2021 https://www.pymnts.com/blockchain/2021/what-are-the-top-defi-platforms/

10

Retrieved 21 Dec 2021 https://www.leewayhertz.com/how-defi-lending-works/

11

Retrieved 21 Dec 2021 https://www.coindesk.com/learn/2021/07/13/defi-lending-3-major-risks-to-know/

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