Decentralized Finance (commonly referred to as DeFi) is a blockchain-based form of finance that does not rely on central financial intermediaries such as brokerages, exchanges, or banks to offer traditional financial instruments, and instead utilizes smart contracts on blockchains, the most common being Ethereum. DeFi platforms allow people to lend or borrow funds from others, speculate on price movements on a range of assets using derivatives, trade cryptocurrencies, insure against risks, and earn interest in savings-like accounts. DeFi uses a layered architecture and highly composable building blocks. Some DeFi applications promote high interest rates but are subject to high risk. By October 2020, over $11 billion (worth in cryptocurrency) was deposited in various decentralized finance protocols, which represented more than a tenfold growth during the course of 2020. As of January 2021, approximately $20.5 billion was invested in DeFi.
The stablecoin-based lending platform, MakerDAO, is credited with being the first DeFi application to receive significant use. It allows users to borrow Dai, the platform's native token pegged to the US dollar. Through a set of smart contracts on the Ethereum blockchain, which govern the loan, repayment, and liquidation processes, MakerDAO aims to maintain the stable value of Dai in a decentralized and autonomous manner.
In June 2020, Compound Finance started rewarding lenders and borrowers of cryptocurrencies on its platform with, in addition to typical interest payments to lenders, units of a new cryptocurrency known as the COMP token, which is used for governance of Compound's platform but is also tradeable on exchanges. Other platforms followed suit, launching the phenomenon known as "yield farming" or "liquidity mining," where speculators actively shift cryptocurrency assets between different pools in a platform and between different platforms to maximize their total yield, which includes not only interest and fees but also the value of additional tokens received as rewards.
In July 2020, The Washington Post wrote a primer on decentralized finance including details on yield farming, returns on investments, and the risks involved. In September 2020, Bloomberg said that DeFi made up two-thirds of the cryptocurrency market in terms of price changes and that DeFi collateral levels had reached $9 billion. Ethereum saw a rise in developers during 2020 due to the increased interest in DeFi.
DeFi revolves around decentralized applications, also known as DApps, that perform financial functions on distributed ledgers called blockchains, a technology that was first made popular by Bitcoin and has since been adapted more broadly. Rather than transactions being made through a centralized intermediary such as a cryptocurrency exchange or a traditional securities exchange on Wall Street, transactions are directly made between participants, mediated by smart contract programs. These smart contract programs, or DeFi protocols, typically run using open-source software that is built and maintained by a community of developers.
DApps are typically accessed through a Web3 enabled browser extension or application, such as MetaMask, which allows users to directly interact with the Ethereum blockchain through a digital wallet. Many of these DApps can interoperate to create complex financial services. For example, stablecoin holders can lend assets like USD Coin or DAI to a liquidity pool in a borrow/lending protocol like Aave, and allow others to borrow those digital assets by depositing their own collateral, typically more than the amount of the loan. The protocol automatically adjusts interest rates based on the moment-to-moment demand for the asset.
Additionally, Aave introduced "flash loans," which are uncollateralized loans of an arbitrary amount that are taken out and provably paid back within a single blockchain transaction. While there can be legitimate uses for flash loans such as arbitrage, collateral swap, self-liquidation, and unwinding leveraged positions, multiple exploits of DeFi platforms have used flash loans to manipulate cryptocurrency spot prices.
Another DeFi protocol is Uniswap, which is a decentralized exchange, or DEX, that runs on the Ethereum blockchain. Uniswap allows for the trading of hundreds of different ERC20 tokens issued on the Ethereum blockchain. Rather than using a centralized exchange to fill orders, Uniswap incentivizes users to form liquidity pools in exchange for a percentage of the trading fees that are earned from traders swapping tokens in and out of the liquidity pools.
These liquidity pools allow users to switch from one token to another, in a fully decentralized manner, while maintaining control over their funds. At the same time, liquidity providers are encouraged to deposit tokens for a portion of the fees generated by the exchanges. After having pooled their tokens, liquidity providers may remain completely passive as the smart contract takes care of automatically adjusting the liquidity-providing logic depending on the current market price.
Thus, DEXs are powered by automatic market makers which are based on mathematical formulas, making it possible to estimate the exchange rate between two assets by considering the liquidity present on the protocol.
Because no centralized party runs Uniswap (the platform is ultimately governed by its users), and any development team can leverage the open-source software, there is no entity to check the identities of the people using the platform to adhere to KYC/AML regulations. It is not clear what position regulators will take on the legality of a platform like Uniswap.
Blockchain transactions are irreversible, which means that an incorrect transaction with a DeFi platform or even deployment of smart-contract code containing errors cannot always be easily corrected. Coding errors, and hacks, are common. In 2020, one platform known as Yam Finance quickly grew its deposits to $750 million before crashing days after launch due to a code error. Additionally, the code for the smart contracts that implement DeFi platforms is generally open-source software that can be easily copied to set up competing platforms, which creates instabilities as funds shift from platform to platform.
DeFi has been compared to the initial coin offering craze of 2017, part of the 2017 cryptocurrency bubble. Inexperienced investors are at particular risk of losing money using DeFi platforms due to the sophistication required to interact with such platforms and the lack of an intermediary with a customer-support department.
- "Why 'DeFi' Utopia Would Be Finance Without Financiers: QuickTake". Bloomberg. 2020-08-26. Retrieved 2020-10-06.
- Schär, Fabian (2021). "Decentralized Finance: On Blockchain- and Smart Contract-Based Financial Markets". Review. 103 (2). doi:10.20955/r.103.153-74. Retrieved 2021-04-17.
- "'DeFi' movement promises high interest but high risk". Financial Times. 2019-12-30. Retrieved 2020-10-06.
- Ehrlich, Steven. "Leading 'Privacy Coin' Zcash Poised For Growth Following Placement On Ethereum". Forbes.
- Ponciano, Jonathan. "Ether's Market Value Surges $20 Billion In One Day While Bitcoin Prices Slow–Here's Why". Forbes.
- "The Maker Protocol: MakerDAO's Multi-Collateral Dai (MCD) System". MakerDAO. Retrieved 2021-06-18.
- "Why 'DeFi' Utopia Would Be Finance Without Financiers: QuickTake". Bloomberg.com. 2020-08-26. Retrieved 2021-01-26.
- Stabile, Daniel T.; Prior, Kimberly A.; Hinkes, Andrew M. (2020-07-31). Digital Assets and Blockchain Technology: US Law and Regulation. Edward Elgar Publishing. ISBN 978-1-78990-744-5.
- "What's 'Yield Farming'? (And How Do You Grow Crypto?)". The Washington Post. 2020-07-31. Retrieved 2020-10-05.
- "Crypto Is Beating Gold as 2020's Top Asset So Far". Bloomberg. 2020-09-22. Retrieved 2020-10-05.
- "Coders Flock Back to Crypto Projects With Prices Surging Again". Bloomberg.com. 10 December 2020.
- "Novogratz Plows Ahead In DeFi Amid the 'Gamifying' of Crypto". Bloomberg. 2020-09-29. Retrieved 2020-10-06.
- Decentralized Finance (DeFi): An Emergent Alternative Financial Architecture. Regulation of Financial Institutions eJournal. Social Science Research Network (SSRN). Accessed 20 April 2021.
- "Crypto Exchange Gets Millions After Copy-Paste of a Rival's Code". Bloomberg. 2020-09-11. Retrieved 2020-10-06.
- Schroeder, Stan. "Crypto wallet MetaMask finally launches on iOS and Android, and it supports Apple Pay". Mashable.
- "MetaMask's Blockchain Mobile App Opens Doors For Next-Level Web". Bloomberg.com. 2 September 2020.
- Wilson, Tom (2020-08-26). "Boom or bust? Welcome to the freewheeling world of crypto lending". Reuters. Retrieved 2021-04-08.
- "Flash Loans Are Providing Instant Cash to Crypto Speculators". Bloomberg.com. 2021-02-07. Retrieved 2021-04-08.
- Evans, Jon (February 18, 2020). "DeFiance: billion dollar finance, million dollar hacks, and very little value". TechCrunch. Retrieved 22 November 2020.
- Kharif, Olga. "DeFi Boom Makes Uniswap Most Sought-After Crypto Exchange". Bloomberg.com. Bloomberg.
- "Boom or bust? Welcome to the freewheeling world of crypto lending". Reuters. 2020-08-26. Retrieved 2020-10-06.
- Braun, Alexander; Cohen, Lauren H.; Xu, Jiahua (May 2020). "fidentiaX: The Tradable Insurance Marketplace on Blockchain". Harvard Business School. Retrieved 2021-01-05.