What is decentralised finance (DeFi)?

What is decentralised finance (DeFi)?

Decentralised finance (DeFi) is the idea of an open, trustless ecosystem of financial applications and services built on public blockchain networks.

The term DeFi refers to the market for decentralised applications (dapps) in financial services and transactions, including lending, trading and borrowing. Such peer-to-peer systems allow anyone to access traditional financial services without gatekeepers or intermediaries, while lowering costs and barriers to entry.

DeFi applications and services can be particularly useful for residents of countries with lagging or unstable economies. They are also in demand in developed markets, notably for lending, investing and experimenting with new income models. 

What are DeFi’s key features and advantages?

DeFi is a flexible, multifaceted concept. Compared with traditional finance, its advantages are numerous. Among the most important are: 

Decentralisation and self-governance

DeFi lacks centralised management: the rules of business operations are encoded in smart contracts. Once deployed, an application can run autonomously with minimal or no human intervention.

Transparency

The source code of DeFi applications is open for audit: any user can understand a contract’s functionality or spot bugs. All transactional activity is public—transactions are pseudonymous by default.

Cross-border reach

Most DeFi applications are available to any internet user. There are exceptions: some may restrict access for certain categories of users. For example, a function discovered in the repository for the fourth version of the decentralised exchange (DEX) Uniswap allows a configurable KYC procedure.  

Inclusivity

The DeFi ecosystem is inclusive—anyone can create an application and use it. Unlike traditional finance, there are no gatekeepers or account-opening processes that require filling out complex forms. Users can interact directly with smart contracts, regardless of social group or status.

User-experience flexibility

DeFi offers a flexible user experience. If a user dislikes an application’s interface, they can use a third-party front end or build their own. Smart contracts are akin to an open API on top of which anyone can develop.

Interoperability

New applications can be created by composing other DeFi products—stablecoins, decentralised exchanges and prediction markets. This resembles a modular architecture, in which the same building blocks can be combined in different ways.

Where, and how, is DeFi used?

There are no rigid boundaries or standards for deploying decentralised financial applications. Even so, several areas have taken root and continue to develop. 

Decentralised stablecoins

Stablecoins are cryptocurrencies whose value is pegged to an underlying asset (for example, the US dollar). Collateral may consist of fiat currencies, baskets of currencies, cryptocurrencies, physical assets such as gold, or combinations thereof. 

Stablecoins backed by the US dollar are essentially claims on fiat reserves held in centralised custody. Their value depends on the issuer, and using them often entails AML/KYC procedures. There have been instances of accounts being frozen or closed. In November 2013, 225m USDT were frozen in connection with a criminal syndicate that engaged in human trafficking in South-East Asia.

An example of a decentralised stablecoin is DAI from MakerDAO. Its issuance resembles a gold-backed currency, except that Ether is used instead of the metal. A user sends some ETH or other ERC‑20 tokens (for example, BAT) to a smart contract, which mints the asset. This type of smart contract is called a “Collateralized Debt Position” (CDP). 

Non-custodial lending protocols

Another popular DeFi use case is obtaining loans without a trusted intermediary such as a bank or corporation. Non-custodial lending protocols use smart contracts to reduce counterparty risk and transaction costs.

MakerDAO was among the first applications of this type. It was followed by protocols such as Compound, Fulcrum and Aave. Compound and Fulcrum create pools of capital, allowing users to lend or borrow cryptoassets, including DAI, USDC, ETH and others.

Decentralised exchanges 

A DEX is an exchange that operates on a blockchain. It does not store users’ funds or personal data on its servers and serves solely to match orders to buy or sell assets.

Decentralised exchanges offer a new model for trading and exchanging assets that dispenses with KYC procedures, dependence on a single intermediary and oligopoly.

One of the most successful and fast-developing decentralised exchanges is Uniswap, which combines trading with lending and borrowing. Other popular DEXs and protocols include Bancor, Kyber, PancakeSwap, Loopring, SushiSwap, Jupiter and dYdX. 

Peer-to-peer prediction markets

Prediction markets are platforms that allow users to bet on the outcomes of sporting events, court cases, elections and more. 

To determine probabilities, prediction-market applications rely on the “wisdom of crowds”. According to this theory, a large number of people (“the crowd”) predicts outcomes more accurately than individual experts.

Augur is a platform for creating peer-to-peer prediction markets on which anyone can place bets. The protocol lets users buy and sell shares in potential outcomes. Also in this category is the decentralised prediction platform Polymarket, which allows users to bet on world events.

Numerai is a hedge fund that uses AI to search for the most effective ways to trade securities. Its contributors—data specialists—build algorithms to forecast trades and stake their predictions using NMR tokens. The size of the reward depends on forecast accuracy and the amount staked.

Synthetic assets

Protocols are being developed to issue synthetic assets and derivatives via smart contracts. One of the largest in this area is Synthetix.

Liquid-staking services also fall under synthetic markets: Lido, Jito, Mantle.

Platforms for issuing tokenised securities (security token offerings, STOs)

These platforms decentralise the issuance or creation of securities, a process that in traditional finance requires intermediaries such as investment banks.
DeFi’s equivalent of the securities market is the segment of security tokens. STOs involve issuing digital assets in full compliance with regulation, which provides stronger investor protection and reduces regulatory risk for issuers.