DeFi is an open global financial system designed for the Internet age. It is an alternative to an opaque system with strict controls based on decades-old processes and infrastructure. It gives you control and visibility of your money. DeFi opens global markets to the user, creates alternatives to national currencies and standard banking products. DeFi products open up financial services to anyone with access to the Internet. They are largely owned and operated by the users themselves. To date, tens of billions of dollars worth of cryptocurrency transactions have already passed through DeFi, and the volume is growing every day.
What is DeFi?
DeFi is a generalized term for financial products and services available to anyone who can use Ethereum, which is basically anyone with Internet access. With DeFi, markets are always open and there is no centralized regulator that will stop payments or close access to anything. Services that used to be time-consuming and at risk of human error are now automated and safer because they are managed by code that is open for anyone to learn and analyze.
The crypto-economy is booming today, with credit and borrowing, long and short positions, interest-bearing investments, and much more becoming available. Argentines advanced in cryptocurrencies have used DeFi to offset the effects of inflation. Companies started paying their employees real-time salaries. Some even took out and paid back millions of dollars in loans without the need for personal identification.
DeFi and traditional finance
To better understand DeFi’s potential, let’s take a look at the current problems.
- Not all people have the opportunity to open a bank account and take advantage of financial services.
- Inaccessibility of financial services is one of the causes of unemployment.
- Financial institutions can block the flow of funds.
- There is a hidden fee for financial services – the provision of personal data.
- Governments and centralized institutions can shut down markets whenever they want.
- Trading hours are often limited to the business hours of a particular time zone.
- Money transfers can take several days due to internal processes involving a person.
- Financial services are provided with a markup because intermediary institutions need their own profits.
|You hold your assets.||Your assets are held by companies.|
|You control where your money goes and how it is spent.||You have to trust companies not to abuse your money by lending it to risky borrowers.|
|The transfer of assets takes place in a matter of minutes.||Payments can take several days due to additional checks.|
|Transactional activity is pseudonymous in nature.||Transactional activity is personal in nature.|
|The DeFi system is open to everyone.||You must apply to use financial services.|
|The markets are always open.||Markets close because employees need breaks.|
|Everything is built on transparency: anyone can view transaction data and check how the system works.||The activity of financial institutions is hidden: you cannot see their credit history, information about their assets and so on.|
It all started with Bitcoin
Bitcoin was in many ways the first DeFi app. Bitcoin allows you to actually own the currency, control it, and send it anywhere in the world. It does this by enabling a large number of people who don’t trust each other to reconcile the ledger without the need for a trusted intermediary. Bitcoin is open to all, and no one has the power to change its rules. Bitcoin’s rules, such as its scarcity and openness, are spelled out in the technology. It is not like traditional finance, where governments can print money that devalues your savings and companies can shut down markets.
Ethereum is built on this. Like Bitcoin, the rules can’t change, everyone has access. But here digital money is programmable with smart contracts, so you can go beyond storing and sending currency.
It sounds strange… “Why would I program my money?” However, this is more of a default feature for tokens on Ethereum. Anyone can code logic into payments. So you can get the control and security of Bitcoin combined with the services provided by financial institutions. This will allow you to do cryptocurrency transactions that you cannot do with Bitcoin, such as lending and borrowing, payment planning, investing in index funds, and more.
Explore our DeFi app suggestions if you’re just getting familiar with Ethereum.
What can I do with DeFi?
There is a decentralized alternative to most financial services. But Ethereum also creates opportunities to create financial products that are completely new. This list is constantly growing.
- Sending money around the world
- Streaming money around the world
- Access to stable currencies
- Loan of funds with collateral
- Loan of funds without collateral
- Cryptocurrency savings
- Token trading
- Increasing your portfolio
- Funding your ideas
- Buying insurance
- Managing your portfolio
Quickly send money all over the world
As a blockchain, Ethereum is designed to send transactions in a secure and global way. Like Bitcoin, Ethereum makes transferring money around the world as easy as sending email. Just enter your recipient’s ENS name (e.g. bob.eth) or their account address in your wallet, and your payment will arrive directly to them within (usually) a few minutes. To send or receive payments, you’ll need a wallet.
Send money around the world
You can also transfer money through Ethereum. This allows you to pay someone’s salary in a second, giving them access to money when they need it. Or rent something in a second, like a warehouse or an electric scooter.
If you don’t want to send or transfer ETH because of how much its price can change, there are alternative currencies to Ethereum: Stablecoins.
Get access to stable currencies
Cryptocurrency volatility is a problem for many financial products and general spending. The DeFi community has solved this with Stablecoins. Their value is tied to another asset, usually a popular currency such as the dollar.
Coins like the Dai or USDC have a value that stays within a few cents of the dollar. This makes them ideal for earning or retailing. Many Latin Americans have used Stablecoins as a means of protecting their savings at a time of considerable uncertainty over currencies issued by governments.
Borrowing money from decentralized suppliers comes in two main ways.
- Peer-to-peer format (Peer-to-peer): the borrower will borrow directly from a particular lender.
- Pool-based: Lenders provide funds (liquidity) from which borrowers borrow.
There are many advantages to using decentralized credit…
Borrowing with privacy
Today, lending and borrowing money revolves around the individuals involved. Banks need to know if you can repay a loan before they issue it.
Decentralized lending works without the need for either party to be identified. Instead, the borrower must provide collateral, which the lender will automatically receive if their loan is not repaid. Some lenders even accept NFTs as collateral. An NFT is a unique asset, such as a painting.
This allows you to borrow money without checking your credit or giving out personal information.
Access to global funds
When you use a decentralized lender, you have access to funds from all over the world, not just those held at the bank or institution of your choice. This makes loans more affordable and improves interest rates.
A loan can give you access to the funds you are interested in without requiring you to sell ETH (a taxable action). Instead, you can use ETH as collateral for a Stablecoin loan. This gives you the influx of money you need and allows you to save ETH. Stablecoins are tokens that are much better for those in need of cash because they do not change in value, unlike ETH.
Instant loans are a more experimental form of decentralized lending that allows you to borrow without collateral or providing any personal information.
They are not as widely available to non-technical people now, but hint at something that may become available to everyone in the future.
They work on the basis that the loan is taken and paid in a single transaction. If it cannot be repaid, the transaction is cancelled as if nothing had happened.
Often used funds are held in liquidity pools (large pools of funds used for borrowing). If they are not being used at the moment, it creates an opportunity for someone to borrow those funds, do business with them, and repay them in full literally at the same time as the loan is being made.
In order for transactions to be successful, serious effort must be put into programming the logic. A simple example: someone uses instant credit to buy the maximum possible amount of an asset at one price and sell it on another exchange with higher prices.
So, in one transaction, the following happens:
- You borrow X asset $asset for $1.00 from exchange A
- You sell X asset $asset on exchange B for $1.10
- You are repaying the loan on exchange A
- You keep your profits minus the transaction fee
If the supply of exchange B suddenly drops and the user cannot buy enough to cover the initial loan, the transaction simply will not work.
To perform the above example in the world of traditional finance, you would need a huge amount of money. These money making strategies are only available to those who already have a large amount of wealth. Term loans are an example of a future where having money is not a prerequisite for making money.
Start saving in cryptocurrency
You can earn interest on your cryptocurrency by lending it and see your funds grow in real time. Right now, the interest rates are much higher than what you would probably get from your local bank (if you are lucky enough to have access to one). Here’s an example.
- You lend your 100 Dai (that’s Stablecoin) to a platform like Aave.
- You receive 100 Aave Dai (aDai), which is a token representing your borrowed Dai.
- Your aDai will increase based on the interest rate, and you will be able to see the balance in your wallet grow. Depending on the annual interest rate, in a few days or even hours your wallet balance will look like about 100,1234!
- You can withdraw an amount of regular Dai equal to your aDai balance at any time.
Win-win lotteries (like PoolTogether) are an exciting and innovative new way to save money.
- You buy 100 tickets using 100 Dai tokens.
- You get 100 plDai representing your 100 tickets.
- If one of your tickets is selected as a winner, your plDai balance will increase by the prize pool amount.
- If you don’t win, your 100 plDai goes into next week’s drawing.
- You can withdraw an amount of regular Dai equal to your plDai balance at any time.
The prize fund is made up of all the interest earned from providing deposits for tickets, as in the lending example above.
There are thousands of tokens on Ethereum. Decentralized Exchanges (DEX) allow you to trade different tokens at any time. You are always in control of your assets. It’s like using a currency exchange when visiting another country. But the DeFi version never closes. The markets are open 24/7, 365 days a year, and the technology ensures that there is always someone who will agree to a trade.
For example, if you want to use the PoolTogether win-win lottery (described above), you need a token such as Dai or USDC. DEX allows you to exchange your ETH for these tokens and back when you’re done.
There are more advanced options for traders who like a little more control. Limit orders, open-ended contracts, margin trading and more are possible. With decentralized trading, you have access to global liquidity and a market that never closes, and you are always in control of your assets.
When you use a centralized exchange, you must deposit your assets before trading and trust the exchange to take care of them. As long as your assets are deposited, they are at risk because centralized exchanges are attractive targets for hackers.
Increasing your portfolio
Ethereum has fund management products that will try to develop your portfolio based on the strategy you choose. This happens automatically, is open to everyone, and does not require a manager to take a cut of your profits.
A good example is the DeFi Pulse Index (DPI) fund. This is a fund that automatically rebalances to ensure that your portfolio always includes the best DeFi tokens in terms of market capitalization. You don’t have to manage the change, and you can get out of the fund whenever you want.
Funding your ideas
Ethereum is an ideal platform for crowdfunding:
- Potential sponsors can be from anywhere: Ethereum and its tokens are open to anyone, anywhere in the world.
- Everything is transparent because fundraisers can confirm how much money has been raised. You can even keep track of how the money is spent later.
- Fundraisers can set up automatic refunds if, for example, there is a certain deadline and minimum amount that have not been met.
Ethereum is open source software, and much of the work is still funded by the community. This has led to the development of an interesting new fundraising model: quadratic funding. This could improve the way we fund all kinds of public goods in the future.
Quadratic funding ensures that the projects that receive the most funding are the ones that are most in demand. In other words, projects that improve the lives of most people. It works like this:
- There is an appropriate pool of donated funds.
- The public financing round begins.
- People can state their need for the project by donating some money.
- At the end of the round, the corresponding pool is distributed to projects. Projects with the largest number of unique requests receive the largest amount from the corresponding pool.
This means that Project A with its 100 $1 donations may receive more funding than Project B with one $10,000 donation (depending on the size of the respective pool).
Decentralized insurance aims to make insurance cheaper, speed up payouts and increase transparency. With more automation, insurance becomes more affordable and payouts are much faster. The data used to decide your claim is completely transparent.
Ethereum products, like any software, can suffer from bugs and exploits. So right now many insurance products are focused on protecting their users from losing money. However, there are already projects that are starting to insure everything we might encounter in real life. A good example of this is Etherisc Crop Insurance, which aims to protect small farmers in Kenya from droughts and floods. Decentralized insurance can provide cheaper insurance for farmers, prices that are often out of line in traditional insurance.
Aggregators and portfolio managers
Among other things, you will need a way to keep track of all your investments, loans and transactions. There are many products that allow you to manage all your DeFi activity from one program. That’s the beauty of DeFi’s open architecture. Teams can create interfaces where you can not only view asset balances, but also use their functions. This can be useful while learning DeFi.
How do DeFi work?
DeFi uses cryptocurrencies and smart contracts to provide services that do not require intermediaries. In today’s financial world, financial institutions act as guarantors of transactions. This gives these institutions enormous power because your money flows through them. In addition, billions of people around the world may not even have access to a bank account.
In DeFi, a smart contract replaces a financial institution in a transaction. A smart contract is a type of Ethereum account that can store funds and can send and return them under certain conditions. No one can change this smart contract once it is launched: it will always work the way it was programmed.
A contract designed to pay benefits or pocket money can be programmed to send money from account A to account B every Friday. And it will do so as long as account A has the necessary funds. No one can change the contract and add account C as the recipient to steal the funds.
Contracts are also open to any inspection and audit. This means that bad contracts often come to the attention of the community fairly quickly.
Currently, there is a need to trust more technically literate members of the Ethereum community who can read the code. The open source community helps verify developers, but over time this need will diminish as smart contracts become easier to read and other ways of proving code reliability will be developed.
Ethereum and DeFi
Ethereum is an ideal foundation for DeFi for a number of reasons:
- No one owns Ethereum or the smart contracts that are used on it, which gives everyone the ability to use DeFi. It also means that no one can change the rules against you.
- All of DeFi’s products speak the same language behind the scenes: Ethereum. This means that many products work together without any problems. You can borrow tokens on one platform and exchange tokens at interest on a different market and in a completely different app. It’s like being able to cash out loyalty points at your bank.
- Tokens and cryptocurrencies built on Ethereum, a common registry tracking transactions and ownership rights are what Ethereum is all about.
- Ethereum provides complete financial freedom: most products will never intercept your funds, control remains with you.
You can divide DeFi into layers:
- Blockchain: Ethereum contains transaction history and account status.
- Assets: ETH and other tokens (currencies).
- Protocols: smart contracts
- which provide functionality, such as a service that allows decentralized asset lending.
- Applications: the products we use to manage and access the protocols.
DeFi is an open source movement. All DeFi protocols and applications are open to your research, branching and innovation. With this layered stack (they all use the same blockchain and assets), protocols can be mixed and matched to unlock unique combinatorial possibilities.