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What Is Decentralized Finance?: A Deep Dive by The Defiant

Published on:
September 1, 2020

The term DeFi was born in an August 2018 Telegram chat of ETH developers and entrepreneurs.

Table of Contents

Definition 

Decentralized finance, or DeFi, is the ecosystem of financial applications being built with blockchain technology.

The Term

The term DeFi, short for decentralized finance, was born in an August 2018 Telegram chat between Ethereum developers and entrepreneurs including Inje Yeo of Set Protocol, Blake Henderson of 0x and Brendan Forster of Dharma. They were discussing what to call the movement of open financial applications being built on Ethereum. Other options considered were Open Horizon, Lattice Network and Open Financial Protocols. Henderson said DeFi worked well, as it “comes out as DEFY.”

DeFi admins talking about naming protocols


Characteristics

  1. Non-Custodial

These distributed networks allow people to have control over their own assets and data and for value to be transferred from one person to another, without the need to use intermediaries like banks and other financial institutions. Users are the only ones who hold the keys to their wallets and control their funds. The term used to describe this feature is that DeFi apps are “non-custodial,” as they don’t have custody of your assets — you do.


  1. Open 

These networks are also global, which means there are no borders in this parallel financial system, and everyone can access it. It's like the internet, but instead of information being transferred globally, seamlessly and creatively, the same is happening with money. It’s an internet of value. 


  1. Transparent 

The code for these financial applications is open for anyone to see and inspect. This is important because anyone is able to verify how the applications and protocols work, and track exactly where their money is. 


  1. Composable

Open-source code also enables developers to build on top of others’ applications, accelerating innovation and allowing these applications to become like lego pieces, leveraging each others’ value  –– hence the term, “money legos.” And if users don’t like how one application is being built, they can copy the code and build a new app. 


  1. Decentralized 

DeFi protocols are built on public blockchains like Ethereum. These blockchains, the rails to this new financial system, are run by thousands of nodes ––computers running the blockchain’s software–– spread out across the globe, so that it’s almost impossible to censor or stop them.  


On top of this base layer of decentralization, DeFi platforms are built to be managed by a community of users, and not centrally controlled. Users become owners of their financial applications; they’re able to participate in major decisions, including by proposing changes themselves, and benefit from their growth and success. No centralized party can unilaterally take control of funds or change the rules of the game. 


Open Finance 


Most DeFi applications don’t meet all of the characteristics listed above. Ironically, considering the name DeFi, the decentralized aspect is the hardest to meet. Completely relinquishing control of an application makes it harder for developers to quickly react if there’s a problem, since they can’t unilaterally make changes to it without going through community consensus. This is hard for applications which are still at very early stages of development, so teams will often maintain some degree of control over their protocols. 


Decentralization is a spectrum, and while not all DeFi apps are at the most decentralized end, they are working to get there with teams gradually relinquishing control over their protocols. 


Rather than decentralization, the main characteristic which most DeFi protocols meet and has come to define the ecosystem is that these applications are open for anyone to access. All users need is an internet connection and a blockchain address. That’s why the term “Open Finance” is often used instead of DeFi. 


DeFi: A Brief History


One could argue that DeFi started with Bitcoin in 2009. BTC was the first-ever peer-to-peer digital money; the first financial applications built on blockchain technology.


But the turning point for financial applications allowing users to do more with their money than send it from point A to point B happened in December 2017, when MarkerDAO launched. 


MakerDAO is an Ethereum-based protocol that allows users to issue a cryptocurrency that’s pegged at 1-to-1 to the value of the U.S. dollar by using digital assets as collateral. This mechanism effectively allowed anyone to borrow the Dai stablecoin against Ether (Ethereum’s native cryptocurrency). It created a way for anyone to take out a loan without relying on a centralized entity. It also created a dollar-pegged digital asset, which didn’t rely on holding dollars in a bank, like USDC, USDT and other stablecoins. 


The MakerDAO lending protocol and its Dai stablecoin provided the first building blocks for a new, open, permissionless financial system. From there, other financial protocols launched, creating an increasingly vibrant and interconnected ecosystem. Compound Finance, released in September 2018, created a market for borrowers taking out collateralized loans, and lenders to  rake in interest rates paid by those borrowers. Uniswap, launched in November 2018, allowed users to seamlessly and permissionlessly swap any token on Ethereum.


Less than three years after MakerDAO placed the first money lego, there are now dozens of DeFi applications, from basic use-cases like enabling lending, borrowing, trading, to crazier ones like creating synthetic assets, streaming payments and playing in a lottery where you can always get your money back. 


Assets held in these platforms’ smart contracts climbed to surpass $1 billion, then quickly $2, $3 and $4 billion just this year. It’s clear we’re just getting started.

Not a Buzzword: DeFi Is an Ecosystem of Financial Applications


As the term decentralized finance starts popping up with increasing frequency in headlines and conversations, its short-hand, DeFi ,may start to sound like an empty term. But it’s far from just a buzzword. 


DeFi is a growing ecosystem of actual, working protocols and applications, which are delivering value to several thousands of users, and transacting the equivalent of hundreds of millions of dollars in digital assets, every day. 


The very foundations of a new financial system are being laid, with applications that enable everything from simply making transfers and payments, to lending, borrowing, trading, portfolio management and insurance.


Here’s an overview of some of the most popular applications in decentralized finance.


MakerDAO


MakerDAO is the protocol that issues the stablecoin Dai. Co-founded by Rune Christensen in 2015, it was one of the very first projects to be built on the Ethereum network, and can be considered the foundation for DeFi.


Dai is pegged at 1-to-1 to the value of the U.S. dollar. Unlike other stablecoins, which are backed by dollars in a bank, Dai is backed by digital assets held in MakerDAO’s smart contracts. This makes Dai one of the few stablecoins that reduces the risk of censorship from regulators and financial institutions, providing a more decentralized alternative.


Dai is issued against digital assets that anyone can deposit into Maker’s smart contracts, which are called “Vaults.” These assets, or collateral, need to be around 150% the value of Dai borrowed. Borrowers pay a stability fee, which works similarly to a borrowing interest rate, when the loan is closed. If their collateral drops below the 150% ratio, the loan is liquidated, which means assets locked up are sold at a discount, and borrowers pay a penalty fee.


Once Dai is issued, borrowers are free to sell it in exchange for goods, services or more crypto: that’s how a secondary market for Dai is created. Anyone can also buy Dai in an exchange; it’s not necessary to take out a collateralized loan. 


Dai can also be deposited in Maker and in other lending protocols to earn a variable savings rate, allowing anyone in the world to open a dollar-based savings account. 


The other piece of MakerDAO is the MKR token. Unlike Dai, MKR is volatile and not pegged to anything. Holders of MKR can vote in Maker’s governance system, where everything from borrowing and lending rates to the types of collateral accepted is decided. MKR holders benefit when the token increases, but they also take the biggest hit when the system fails; when collateral falls too sharply, MKR is minted and sold to make up for it.


Compound Finance


Compound Finance is a lending protocol built on Ethereum. Anyone can lend out their assets to gain interest or borrow assets against collateral. Compound was co-founded by Robert Leshner and launched on the mainnet in September 2018.


The platform is open for anyone, anywhere in the word to use and financial contracts are executed automatically by computer code. Securing loans doesn’t depend on credit score or the person’s income and liabilities, but on the assets they deposit in the system to cover for the value of the loan; in short, loans in Compound as in most of DeFi, are over-collateralized. It’s not the most capital efficient system, but it allows loans to be permissionless and automatic. 


If the collateral drops below the required ratio, the funds get sold in the open market at a discount (ie. liquidated).


Interest rates paid out by borrowers of tokens including BAT, DAI, SAI, ETH, REP, USDC, WBTC and ZRX, is earned by lenders of those assets. Lenders earn interest continuously and funds can be removed at any time — so no waiting until the end of a fixed period in a time deposit. 


The biggest difference between Compound Finance and a savings account in a bank is that lenders get tokens representing their deposits and the interest earned ––like a derivative of their assets. These instruments are called cTokens –– cDai is for Dai deposits, etc. These tokens can in turn be used as collateral to borrow against or sold for other cryptocurrencies. Savers can get cTokens by depositing assets in Compound or by simply buying them in the secondary open market, on a DEX. 


Compound launched its own native COMP governance token in May 2020. COMP was distributed to users of the platform in proportion to the funds they have lent or borrowed. Token holders are able to participate in Compound’s governance system, proposing and voting on changes. It’s the way for the Compound team to cede control to its community as management of the project starts to become closer to an open protocol than a company. 


Uniswap


Uniswap is one of the largest decentralized exchanges by trading volume on Ethereum. It was founded by Hayden Adams in November 2018. Uniswap is one of the first DEXs to pioneer the automated market maker system, which allows traders to swap tokens without relying on an order book. This is important in crypto where, after BTC and ETH, there is a long tail of less liquid tokens which are hard to trade if you need to wait to be matched by a counterpart. 


The automated market maker (AMM) model relies on liquidity pools, in which each token is paired with ETH, ensuring there’s always enough liquidity between any two tokens.


The price is set by a simple equation: x * y = k, proposed by Vitalik Buterin in a 2018 research paper. In the so- called “constant product market maker” formula, x and y represent the quantity of ETH and ERC20 tokens in a liquidity pool and k is the product of the two. K must be kept constant and for that to happen, x and y must move inverse to each other. 


Thanks to liquidity pools and the price being defined by a formula, a trade can always take place –– though spreads may still be wide on illiquid pairs. 


Unlike centralized exchanges, which have been reported to charge exorbitant amounts to list tokens, anyone can list any token on Uniswap. All they have to do is create a liquidity pool by supplying the ERC20 token and ETH.


Also unlike centralized exchanges, which verify users’ identities and have the power to restrict traders from some locations, Uniswap is an open protocol open for anyone to use. All traders need to start swapping tokens is an Ethereum address.


Anyone is also free to provide liquidity to these pools of tokens in exchange for trading fees in proportion to their share of the pool’s liquidity. Liquidity providers can add to or withdraw their funds at any time. Uniswap doesn’t have a native token, but liquidity providers get tokens which represent their share of the pool. 


Balancer


Balancer is both an asset manager and a decentralized exchange built on the Ethereum network. It was founded by Fernando Martinelli and Mike Ray McDonald in March 2020. Similar to Uniswap, Balancer enables anyone to create pools of tokens, which rebalance to keep the same ratio among those tokens, regardless of their price change. The difference is that more than one token can be added, and ETH isn’t required. Effectively, it allows anyone to create something like an ETF ––an index fund made up of crypto assets.  


There are private pools, where only the creator of the pool can add liquidity and has full control over the pool’s parameters. There are also shared pools and smart pools, open for anyone to invest in and gain exposure to how the portfolio moves. Investors can supply any of the tokens in the portfolio and they get BPT, or Balancer Pool Token in exchange, which represents their ownership of the pool. The difference between shared and smart pools is that in shared pools, the parameters are set, while in smart pools, they can be changed. 


The other side of the protocol is the DEX. Traders can swap tokens in the liquidity pools and take advantage of arbitrage opportunities when they become imbalanced. The trading fees they pay to exchange tokens go to the token pools’ liquidity providers. 


This is what allows Balancer to be an inverse ETF; instead of paying portfolio management fees to hold an index fund, investors collect fees from traders. 


In June 2020, Balancer distributed its governance token BAL among liquidity providers. BAL tokens allow holders to participate in the protocol’s governance system. 


Synthetix


Synthetix is a protocol for minting and trading synthetic assets on Ethereum. It was founded by Kain Warwick in 2017 as stablecoin project Havven, and launched as Synthetix on the mainnet in February 2019. 


On-chain synthetic assets, or Synths, are minted on the platform. Synths are designed to track the value of crypto to and non-crypto assets, including forex, commodities and indexes. There are now almost 40 different trading pairs on Synthetix, including for gold, silver, the Japanese yen and UK’s FTSE stock index. 


Like all of DeFi, Synthetix is open and permissionless, which means anyone in the world can have access to trading securities, which has been restricted to the very few in the past.


Users can deposit Synthetix’s native token SNX in a smart contract to issue new Synths. 

This pooled collateral enables traders to swap Synths directly with the smart contract, avoiding the need for counterparties. SNX holders who stake their tokens are paid a pro-rata portion of the fees generated through activity on Synthetix’s exchange. Still, trading on Synthetix.Exchange does not require the trader to hold SNX.


In July 2020, the project started to wind down the Synthetix Foundation, which had largely guided the direction of the platform, so that three decentralized autonomous organizations, or DAOs, would take control of the protocol. DAOs are on-chain organizations led by the wider community and token holders. Synthetix’s move is part of a wider trend in DeFi to become increasingly more decentralized and community-owned.


Curve Finance 


Curve Finance is a decentralized exchange focusing on stablecoins. It was co-founded by Michael Egorov and launched in January 2020. Curve uses liquidity pools like Uniswap, but because pools are between stablecoins, which have roughly the same value, it is able to minimize slippage for traders and reduce or eliminate impermanent loss for liquidity providers. Impermanent loss is a common problem on other DEXs as volatility of token pairs against ETH reduces returns for liquidity providers.


The other difference with other AMMs like Uniswap and Balancer is that tokens in Curve’s liquidity pools are lent out on DeFi money markets like Compound and yEarn Finance. This allows liquidity providers to earn trading fees and also returns from those lending pools. 


Curve launched its own native token CRV in August 2020, and uses it to reward users for providing liquidity and as a way for the community to take control over the protocol’s governance. 


Yearn.finance 


Yearn Finance is a lending aggregator, known as a yield bouncer, which optimizes users’ deposits by routing them to lending and liquidity pools offering the most yield. It uses protocols including Compound, Dydx and Curve Finance. It was founded by Andre Cronje in February 2020.


Users who deposit tokens into Yearn, get yTokens representing those deposits, in return ––Dai depositors get yDai, USDC depositors get yUSDC and so forth. 


Curve Finance created a liquidity pool of yTokens, using yDAI, yUSDC, yUSDT, yTUSD, which allows savers to earn trading fees on Curve on top of lending fees for their deposits.


Yearn issued its native governance token YFI in July 2020. YFI was distributed only to users who stake yTokens to pre-specified liquidity pools. In a first for an Ethereum token, there was no pre-sale to investors, there was no allocation for the Yearn team, and it wasn’t sold through an exchange –– only Yearn users could earn YFI in its primary listing. 


Control of YFI was transferred from Andre Cronje to a multi-signature wallet, which requires six out of nine participants to agree on changes. YFi token holders have full control over Yearn Finance’s governance system, and can propose and vote on changes to the protocol via on-chain votes. 


Yam Finance


Yam Finance is a project designed to reward users with YAM tokens in exchange for their deposits of cryptocurrency into different liquidity pools. It was founded in August of 2020 by a group of cryptocurrency developers, investors and entrepreneurs including Dan Elitzer of IDEO and Will Price of Flipside Crypto.


It was one of the first projects built specifically around the trend of yield farming –– depositing cryptocurrency tokens in DeFi platforms to earn the platform’s native tokens on top of lending interest rates. The launch was controversial as it was built seemingly overnight by copying the code of different DeFi protocols, and released on mainnet without a formal audit. Following the footsteps of YFI, only Yam Finance users were able to earn YAM in its primary listing. 


YAM is pegged to 1 USD and controls its peg by contracting or expanding its supply.


The platform drew hundreds of millions of dollars in a day and its success spurred a flurry of copycats, and also an explosion of so-called meme coins, or tokens linked to an emoji and funny name, many of which were also linked to food (CREAM, SHRIMP, TACO, PASTA).


Two days after its launch, the team found a bug in its code which would make governance impossible and raised funds from the community to audit the code of a new version of YAM. Token holders were still in the process of mIgrating to YAM v2 and awaiting the final version of YAM v3 at the time of writing.




Author(s)

Camila Russo

I’ve extensively covered crypto and finance, and now I’m diving into DeFi, the intersection of the two.

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