Decentralized Finances (DeFi) Explained: Shortest Manual You Will Ever Find
23rd March 2021
Since the rise and fall of ICOs in 2017, decentralized financial protocols (DeFis) are the most overhyped sector in blockchain innovations. GetBlock releases a tutorial to cover what it’s all about - and whether DeFi is a crucial stage of the crypto revolution?
DeFi (pronounced ‘di-fai’) made headlines in 2020 due to the enormous growth of interest in this segment. DeFi tokens (see below) witnessed impressive rallies while the total amount of money ‘locked’ in DeFi protocols skyrocketed.
What is DeFi?
Decentralized finances (decentralized financial protocols, decentralized financial applications, etc.) should be referred to as a class of decentralized (blockchain-based) software programs designed for basic financial operations.
Typically, to use DeFi, crypto holders need to ‘lock’ some crypto (mostly, Ethers or DAI stablecoins) in their applications. That means that those tokens become inaccessible for a predetermined period of time.
Image by DeFi Pulse
In 2020 this metric surged 15x from $1B to $15B while in 2021, it has already tripled to reach an unbelievable $45B on peak.
What is ‘De’ in DeFi?
In that case, ‘decentralized’ means that normal DeFi protocol has no single centralization point (server, back-end, cloud storage, validators, etc.) All operations are going on-chain via the architecture of smart contracts. So, the team of this or that DeFi has no custody over the user's funds or private keys.
The business logic of DeFi is ‘hard-coded’ into its smart contracts and isn’t subject to changes proposed by its teams. Mostly, all critical adjustments to the protocol are implemented only with the approval of tokenholders. Thus, many top DeFis (Synthetix (SNX), Maker (MKR), etc.) migrated to the ‘decentralized autonomous organization’ (DAO) model of operations.
Three main types of DeFis
While there is a plethora of use-cases in the DeFi segment, the vast majority of products address the spheres of decentralized exchange of digital assets, ‘yield mining’ strategies aggregation and lending/borrowing of cryptos.
Decentralized exchanges (DEXs) are the oldest type of DeFi protocols. Actually, they had been popular well before the very name of ‘DeFi’ made the headlines in 2020. They allow users to exchange one crypto asset for another on-chain without disclosing private keys to the third party.
Majority of DEXs work on the top of Ethereum (ETH) which is the first-ever programmatic blockchain environment (it means that Ethereum supports smart contracts). The most popular Ethereum-based DEX is UniswapV2 (UNI) where anyone can list his/her asset for no fees.
Image by UniswapV2
‘Yield farming’ tools
This is the most attractive sort of DeFi for investors as it allows users to earn on their idle crypto riches. All they need is to just ‘lock’ their assets (‘provide liquidity’) and start earning a passive income (‘farm yield’) from the share of DeFi transaction fees and bonuses.
To obtain maximum income, DeFi ‘degens’ or ‘chads’ (a specific name for top-level DeFi users) develop sophisticated strategies including several protocols. And there’s a use-case for decentralized liquidity aggregators: they simplify the liquidity-providing experience.
The most popular and overhyped liquidity aggregator is Yearn.finance (YFI) by prominent Ethereum (ETH) developers, ‘Father of DeFi’ Andre Cronje. Its native token YFI surged 1000x in a week in July 2020.
Image by CoinGecko
In August 2020, its price rocketed to almost $45,000 per coin (or 4 Bitcoins) although Mr. Cronje re-iterated that YFI has no utility.
Other popular ‘yield farming’ tools include Furucombo (COMBO), Cream (CREAM), etc.
On-chain lending and borrowing was the first massively adopted use-case for DeFi. Such systems offer their users to collateralize their tokens in order to obtain a loan - or to provide liquidity for borrowing. This type of service provides plenty of methods to benefit from crypto price movements.
One of the best and most truthful lending ecosystems is Aave Protocol (AAVE). Its native core asset demonstrated triple-digit gains in July-August, 2020. Thus, AAVE was among the top beneficiaries of DeFi euphoria.
Compound Protocol (COMP) by Robert Leshner is one of the oldest DeFis and pioneered several concepts in the decentralized lending segment.
Top DeFi-focused blockchains
Because DeFis are actually the combinations of smart contracts, they need a programmatic blockchain as a technical basis. The main players on this market are Ethereum (ETH), Binance Smart Chain (BSC), Tron (TRX) while Cardano (ADA) has its smart contract release in sight.
Launched in 2015, Ethereum (ETH) is a pioneer of smart contract platforms. Thus, all early decentralized applications utilized this network for their computations.
Now it hosts 161 DeFis out of 420 registered by DappRadar explorer or more than 38,3%. Despite its supremacy, Ethereum (ETH) is often criticized for enormous fees, low speed of transactions and mediocre computational bandwidth.
Also, it is still unclear how all Ether-based DeFis would migrate to Ethereum 2.0 Proof-of-Stake sharded model once it launches.
Binance Smart Chain
Binance Smart Chain or BSC is Ethereum-compatible (it takes a few hours for dApp to migrate from Ethereum to BSC) smart contracts environment rolled out in 2020 by Binance, a world-leading crypto exchange.
Its transactions are secured by 21 validators. In 2021, the dApp owners tired of endless Ethereum congestion started to transfer their applications to Binance Smart Chain. It has low fees and reasonable bandwidth.
The main point of criticism against Binance Smart Chain is its alleged centralization. Skeptics insist that Binance subsidizes transaction fees on BSC to keep them surprisingly low. Also, Binance is accused of retaining control over all 21 validators.
Launched by Justin Sun, founder of Tron Foundation and CEO of BitTorrent, Tron blockchain also hosts many decentralized applications. 71 of them belong to the DeFi segment.
At the same time, Tron hosts many high-risk services, decentralized gambling tools and Ponzi schemes.
Cardano: Approaching DeFi segment
Cardano (ADA), a high-performance Proof-of-Stake blockchain is going to release its smart contract environment in Q1, 2021. Many developers are waiting for the roll-out of Cardano’s (ADA) Goguen era to deploy their smart contracts.
Input Output HK, a software studio behind Cardano (ADA), managed to gather a strong community around its workflow. So, this blockchain may be a top ‘black horse’ of the DeFi race.
In a nutshell, decentralized financial applications are a class of basic banking services launched on blockchains. DeFis utilize the combinations of smart contracts to perform simple operations with tokens.
People are attracted to this segment due to the brilliant performance of DeFi native assets and the opportunities to earn on passive crypto holdings.