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 paid back within a single block interval, a duration of minutes or even seconds. While there can be legitimate uses for flash loans such as arbitrage, collateral swap, and self-liquidation, multiple exploits of DeFi platforms have used flash loans in short-term manipulation of 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.
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.
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