DeFi
What Is Decentralized Finance (DeFi)?
Decentralized finance—often called DeFi—refers to the shift from traditional, centralized financial systems to peer-to-peer finance enabled by decentralized technologies built on the distributed ledger technology. From lending and borrowing platforms to stablecoins and wrapped coins, the DeFi ecosystem has launched an expansive network of integrated protocols and financial instruments. Now with over billions worth of value locked in various blockchain smart contracts, decentralized finance has emerged as the most active sector in the blockchain space, with a wide range of use cases for individuals, developers, and institutions.
Whereas our traditional financial system runs on centralized infrastructure that is managed by central authorities, institutions, and intermediaries, decentralized finance is powered by code that is running on the decentralized infrastructure of the blockchain. By deploying immutable smart contracts on the blockchain, DeFi developers can launch financial protocols and platforms that run exactly as programmed and that are available to anyone with an Internet connection.
The breakthrough of DeFi is that crypto assets can now be put to use in ways not possible with fiat or “real world” assets. Decentralized exchanges, synthetic assets, and flash loans are completely novel applications that can only exist on blockchains. This paradigm shift in financial infrastructure presents a number of advantages with regard to risk, trust, and opportunity.
What Are the Benefits of Decentralized Finance?
Decentralized finance leverages key principles of the Ethereum blockchain to increase financial security and transparency, unlock liquidity and growth opportunities, and support an integrated and standardized economic system.
- Programmability. Highly programmable smart contracts automate execution and enable the creation of new financial instruments and digital assets.
- Immutability. Tamper-proof data coordination across a blockchain’s decentralized architecture increases security and auditability.
- Interoperability. Ethereum’s composable software stack ensures that DeFi protocols and applications are built to integrate and complement one another. With DeFi, developers and product teams have the flexibility to build on top of existing protocols, customize interfaces, and integrate third-party applications. For this reason, people often call DeFi protocols “money legos.”
- Transparency. On the public blockchain, every transaction is broadcast to and verified by other users on the network.This level of transparency around transaction data not only allows for rich data analysis but also ensures that network activity is available to any user. Blockchains and the DeFi protocols running on them are also built with open source code that is available for anyone to view, audit, and build upon.
- Permissionless. Unlike traditional finance, DeFi is defined by its open, permissionless access: anyone with a crypto wallet and an Internet connection, regardless of their geography and often without any minimum amount of funds required, can access DeFi applications built on a blockchain.
- Self-Custody. By using Web3 wallets like MetaMask to interact with permissionless financial applications and protocols, DeFi market participants always keep custody of their assets and control of their personal data.
What Are the Use Cases for Decentralized Finance?
From DAOs to synthetic assets, decentralized finance protocols have unlocked a world of new economic activity and opportunity for users across the globe. The comprehensive list of use cases below is proof that DeFi is much more than an emerging ecosystem of projects. Rather, it’s a wholesale and integrated effort to build a parallel financial system on Ethereum that rivals centralized services because it is profoundly more accessible, resilient, and transparent.
Asset management
With DeFi protocols, you are the custodian of your own crypto funds. Crypto wallets help you easily and securely interact with decentralized applications to do everything from buying, selling, and transferring crypto to earning interest on your digital assets. In the DeFi space, you own your data: MetaMask, for example, stores your seed phrase, passwords, and private keys in an encrypted format locally on your device so that only you have access to your accounts and data.
The game changes for organizations that have heightened institutional-grade requirements for allocation capital into DeFi. For these organizations, wallets like MetaMask Institutional facilitate cryptoeconomic research, pre- and post-trade compliance, best trade execution, reporting, and of course, crypto custody.
Compliance and KYC
In traditional finance, compliance around anti-money laundering (AML) and countering-the-financing-of-terrorism (CFT) relies on know-your-customer (KYC) guidelines. In the DeFi space, decentralized blockchain infrastructure enables next-generation compliance analysis around the behavior of participating addresses rather than participant identity. These know-your-transaction, such as those provided by MetaMask Institutional, help assess risk in real-time and protect against fraud and financial crimes.
DAOs
A DAO is a decentralized autonomous organization that cooperates according to transparent rules encoded on the blockchain, eliminating the need for a centralized, administrative entity. Several popular protocols in the DeFi space, such Maker and Compound, have launched DAOs to fundraise, manage financial operations, and decentralize governance to the community.
Data and analytics
Because of their unprecedented transparency around transaction data and network activity, DeFi protocols offer unique advantages for data discovery, analysis, and decision-making around financial opportunities and risk management. The explosive growth of new DeFi applications has spurred the development of numerous tools and dashboards, such as DeFi Pulse, that help users track the value locked in DeFi protocols, assess platform risk, and compare yield and liquidity.
Derivatives
Blockchain-based smart contracts enable the creation of tokenized derivatives whose value is derived from the performance of an underlying asset and in which counterparty agreements are hardwired in code. DeFi derivatives can represent real-world assets such as fiat currencies, bonds, and commodities, as well as cryptocurrencies.
Developer and infrastructure tooling
One of the core design principles of DeFi protocols is composability, meaning different components of a system can easily connect and interoperate. As seen from the wide variety of integrated DeFi applications, composable code has created a powerful network effect in which the community continues to build upon what others have built. Many liken the process of DeFi development to building with legos—hence the increasingly popular nickname “money legos.”
DEXs
Decentralized exchanges (DEXs) are cryptocurrency exchanges that operate without a central authority, allowing users to transact peer-to-peer and maintain control of their funds. DEXs reduce the risk of price manipulation, as well as hacking and theft, because crypto assets are never in the custody of the exchange itself.
DEXs also give token projects access to liquidity that often rivals centralized exchanges and without any listing fees. Just a few years ago, projects would pay millions of dollars to get a token listed on a centralized exchange.
Some exchanges implement degrees of decentralization, in which centralized servers might host order books and other features but do not hold users’ private keys. Popular DEXs in the DeFi space currently include AirSwap, Liquality, Mesa, Oasis, and Uniswap. Aggregators of DeFi liquidity data, such as MetaMask Swaps, optimize trading experiences by providing DeFi users with unparalleled insight, enabling them to identify the best price quote, coupled with optimal gas prices for the given quote, the lowest failure rates.
Gaming
The composability of DeFi has unlocked opportunities for product developers to build DeFi protocols directly into platforms across a variety of verticals. Blockchain-based games have become a popular use case for decentralized finance because of their built-in economies and innovative incentive models.
Identity
Decentralized finance protocols paired with blockchain-based identity systems are an opportunity to help previously locked-out users access a truly global economic system. DeFi solutions can reduce the collateralization requirements for people who do not have extra funds and help assess users’ creditworthiness via attributes around reputation and financial activity, instead of traditional data points such as home ownership and income. The DeFi space prizes data privacy around personal identifying information, as well as open access. Anyone with an Internet connection can access DeFi applications while maintaining control of their data and assets.
Insurance
DeFi is still an emerging space with attendant risks around smart contract bugs and breaches. A number of innovative insurance alternatives have come to market to help users buy coverage and protect their holdings. Solutions like Nexus Mutual, for example, provide a Smart Contract Cover that protects against unintended uses of smart contract code.
Lending and borrowing
Peer-to-peer lending and borrowing protocols are some of the most widely used applications in the DeFi ecosystem. Compound, for example, is an algorithmic, autonomous interest rate protocol that integrates with and underlies a long list of DeFi platforms, including PoolTogether, Argent, and Dharma. By providing interest rate markets on Ethereum, Compound allows users to earn interest on crypto that they’ve supplied to the lending pool. The Compound smart contract automatically matches borrowers and lenders and calculates interest rate based on the ratio of borrowed to supplied assets. Compound is a compelling example of the exponential opportunity of the DeFi space: as more products integrate the Compound protocol, more and more crypto assets will be able to earn interest, even when idle.
Margin trading
Whereas margin traders in traditional finance can leverage their trades by borrowing funds from a broker (which then forms the collateral for a loan), DeFi margin trading is powered by decentralized, non-custodial lending protocols, such as Compound and dYdX. Because smart contracts automate traditional brokerage activity, some have begun referring to the rise of “autonomous money markets” in the DeFi ecosystem.
Marketplaces
DeFi protocols are supporting an array of online marketplaces that allow users to exchange products and services globally and peer-to-peer—everything from freelance coding gigs to digital collectibles to real-world jewelry and apparel.
Payments
Peer-to-peer payment is arguably the foundational use case of the DeFi space and of the blockchain ecosystem at large. Blockchain technology is architected so that users can exchange cryptocurrency securely and directly with one another, without middlemen. DeFi payment solutions are creating a more open economic system for underbanked and unbanked populations and also helping large financial institutions streamline market infrastructure and better serve wholesale and retail customers.
Prediction markets
Blockchain-based prediction markets harness the wisdom of the crowd and enable users to vote and trade value on the outcome of events. Market prices then become crowdsourced indicators of the likelihood of an event. Augur, a popular DeFi betting platform, features prediction markets around election results, sports games, economic events, and more.
Savings
By plugging into lending pool protocols like Compound, many DeFi apps offer interest-bearing accounts that can earn exponentially more than traditional savings accounts, depending on a dynamic interest rate tied to supply and demand. One DeFi activity that has exploded around these innovative savings mechanisms is “yield farming.” Yield farming refers to users moving their idle crypto assets around in different liquidity protocols to maximize returns. The frenzy of excitement around DeFi yield farming has inspired no shortage of memes.
Stablecoins
A stablecoin is any cryptocurrency that is pegged to a stable asset or basket of assets, such as fiat, gold, or other cryptocurrencies. Stablecoins were originally developed to reduce the volatile prices of cryptocurrency and make blockchains a viable payment solution. They are now implemented across the DeFi space for remittance payments, lending and borrowing platforms, and even institutional use cases like central bank digital currency (CBDC).
Synthetic assets
Related to stablecoins, synthetic assets are crypto assets that provide exposure to other assets such as gold, fiat currencies, and cryptocurrencies. They are collateralized by tokens locked into Ethereum-based smart contracts, with built-in agreements and incentive mechanisms. The Synthetix protocol, for example, implements a 750% collateralization ratio, which helps the network absorb price shocks.
Tokenization
Tokenization is one of the cornerstones of decentralized finance and a native functionality of the Defi blockchain. Tokens not only fuel the network but also unlock a variety of economic possibilities. Simply speaking, a token is a digital asset that is created, issued, and managed on a blockchain. Tokens are designed to be secure and instantly transferable, and they can be programmed with a range of built-in functionalities. From real estate security tokens that represent fractionalized properties to platform-specific tokens that incentivize the use of a particular application. Tokens have emerged as a secure and digital alternative for users across the world to access, trade, and store value.
Trading
Trading in the DeFi space encompasses a range of activities, from derivatives trading to margin trading to token swaps, and happens across an ever-growing and integrated network of exchanges, liquidity pools, and marketplaces. Crypto traders on decentralized exchanges benefit from lower exchange fees, faster transaction settlement, and full custody of their assets.
DApps
Decentralised Applications (DApps) are blockchain-based applications that allow users to interact with smart contracts deployed on the blockchain. dApps provide features similar to those provided by traditional consumer apps, but they utilize blockchain technology to give consumers greater power over their data by removing the need for centralized data management, thereby rendering the service “decentralized.” Thanks to decentralized apps, or DApps, you no longer have to go through a company or single authority to connect to people or the goods and services you need. Unlike conventional apps, DApps aren’t owned by a single entity, they never have downtime, and they cannot be shut off. This novel breed of application is quickly changing the app game and the world.
What Are Decentralized Apps (DApps)?
Decentralized Apps (DApps) are open-source software applications designed to run on peer-to-peer (P2P) blockchain networks rather than centralized servers. DApps are similar to web apps, but they’re P2P-supported.
Due to the efforts of various smart contracts development platforms, Decentralized finance (DeFi) and DApps are becoming more and more popular. Essentially, DApps are applications just like any other, but instead of running on a single server, they run on decentralized P2P networks. This means there is no single central authority.
Since they’re built on decentralized networks supported by distributed blockchain ledgers, DApps can be continually improved and built upon by others once the codebase has been released. This makes their control by a single authority virtually impossible. The use of blockchain allows DApps to process data and execute transactions through distributed networks.DApps have been created for a variety of applications, ranging from gaming and social media to web browsing and DeFi. Unlike web-based apps, DApps are always accessible and are not exposed to any single point of failure.
Criteria of DApps
In 2014, a report was released defining DApps. In it, DApps were defined as entities meeting the following four criteria:
Open Source
The first and most crucial criterion for a DApp is that its core source code must be available to everyone. It must be user-controlled and work without any third-party intervention, and no entity can own more than 50 percent of the tokens or coins issued. While it was created several years prior to Ethereum, which is the blockchain network most DApps are built on, Bitcoin is an excellent example of a DApp, as its code is open-source, it has no majority owner, and it’s governed by a proof of work consensus mechanism.
Decentralized Blockchain
As their name suggests, DApps use decentralized blockchains. In fact, to be considered a DApp, all information must be stored in an openly accessible blockchain to keep the app free of centralized authority and invulnerable to any central point of attack.
Incentivization
Since DApps are based on decentralized blockchain networks, everyone who validates their records must be incentivized or rewarded with digital assets, such as cryptographic tokens. These tokens serve as payment to miners and stakers, who are necessary for the DApp’s continued operation and growth.
Protocol
A DApp must run according to a protocol, and the development community must agree on a consensus cryptographic algorithm as a means of showing proof of value.
History of DApps
DApps have been around since the thought of blockchain technology was, well, just a thought.If you were born post-1995, you may not have heard of some of the earliest decentralized applications. The most famous were Tor, BitTorrent (which was influential in the naming of Bitcoin), LimeWire, and the infamous Napster. However, back then, the term “DApp” didn’t exist. If it did, no one knew it, and it certainly wasn’t a part of everyday nomenclature like it is today.It wasn’t until P2P file sharing, which preceded blockchain, that DApp usage really started taking off. Websites leveraging BitTorrent protocol, for example, are still widely used around the world today.
The Present DApps
Today, however, DApps are mostly talked about in relation to blockchain, as many decentralized software startups utilize the technology’s native properties as foundations for their apps. By leveraging existing networks, there’s less need for development costs. Their key characteristics:
- Works on the underlying technology, Blockchain.
- dApps are open-source, which means code is public, and hence anyone can copy and audit it.
- They are decentralized, meaning they are not governed by any central authorities like Facebook, Airbnb, etc. Thus, no central authority can stop users from using the app or doing what they want.
- Such applications use smart contracts, which automatically execute when the desired conditions are met.
- Most importantly, these apps are global, meaning anyone around the globe can publish or use these dapps.
That said, as mentioned, decentralized applications have continued to evolve with blockchain technology, and presence of a developer-friendly framework and ecosystem. These contracts are immutable and have rules and limitations built right into their code. This allows any party to transact without the need for an intermediary or centralized platform.
How Do DApps Work?
A DApp is executed and stored on a blockchain network utilizing various tokens native to other networks as well. Cryptographic tokens are used to validate the app and are required to access the application.In many ways, DApps are quite similar to conventional apps, as they both render web pages using the same front-end code. If you’re still wondering what DApps are, it’s the back-end code that makes them different, since they run on decentralized P2P networks.While traditional applications are supported by centralized servers, DApps are supported by smart contracts stored on a blockchain. A smart contract mediates transactions and enforces rules written into the code. While important, they only exist on the back end and make up just part of the complete DApp. Creating a DApp based on the use of a smart contract system requires combining a number of smart contracts for the back end. For the front end, third-party systems are used.Smart contracts run on a ledger of data stored in blocks. Rather than being stored on a server in a central location, the blocks are dispersed across distributed locations. Each of the data blocks are linked and governed by cryptographic validation.Using this decentralized blockchain as well as smart contract technology, DApps can be created and used for almost anything, including:
- Web browsing
- Social media
- Gaming
- Crypto wallets
- And much more!
Pros and Cons of DApps
DApps run on distributed systems and aren’t owned by a company or individual, giving them their own unique advantages. Of course, because technology is always changing, DApps are works in progress. Let’s go over their pros and cons.
Pros of DApps
More Secure Than Regular Web Apps As you now know, DApps don’t rely on a central server. Because of this, they’re often regarded as being more secure than traditional centralized applications. Given the rampant security breaches taking place these days, anything you can do to secure your data should definitely be a priority.
Never Lose Data
Since DApps are hosted across expansive decentralized networks, there’s virtually no need to worry about data loss. If one of the blockchain’s nodes goes down, all of the other nodes pick up the slack to ensure your data remains in sync — and that you don’t miss a beat.
Data Is Cryptographically Encrypted
Each node of a blockchain syncs with the others to accurately track every action taking place within the network. This is how new transactions are verified. Would-be attackers must control a majority of the network’s computers for a successful intrusion, but even then, they must bypass cryptographic encryption.While this alone isn’t impossible, it’s extremely difficult within a distributed, decentralized system. That being said, there’s no absolute guarantee of data safety these days, regardless of which type of app you’re using.
No Content Guidelines
Not only must conventional, centralized apps act according to their country’s laws and regulations, but they must also follow the Terms & Conditions they themselves arbitrarily set when deciding which content they should and shouldn’t publish.DApps, on the other hand, have no central authority telling community developers and users what they can and cannot say, which transactions they can or cannot make, or even what blockchain data they can read.
Cost Efficiency
Centralized apps often have higher costs. For instance, applications like YouTube profit by taking a percentage of what their users earn from their video postings. Apps that are decentralized allow users to transact directly through the use of cryptocurrency. They are thus more financially efficient, and have no middlemen to cut into profits.
Less Downtime
With greater flexibility and more robust than centralized apps, due to their lack of connectivity to a single central server, DApps can run with minimal downtime and fewer interruptions for maximum resilience and continuity.
Faster Transactions
Executing global transactions takes place very quickly, as no third parties exist to approve each one. Since transaction approval is based on consensus algorithms within the network, expensive third parties can be eliminated and transactions can be executed much faster.
Cons of DApps
Difficult to Maintain Having no central authority also means slower updates. Even fixing a minor bug requires majority consensus among every peer in the network. With this governance structure, it can take weeks and sometimes months before a problem can be fixed and an update made.
Network Effect
DApps also require a sizable user base in order to operate properly. The more users an app has, the more effective it will be in delivering its services. This is known as the network effect. DApps suffering from low user numbers, make them less interactive and diminishing the overall user experience.
Difficult KYC Process
Since DApp users aren’t required to provide their real identities when interacting with the apps, verifying the identities of customers can be challenging.
Possibility of Data Breaches
For starters, while these apps do away with the possibility of data breaches on centralized servers and data systems, their open-source nature does leave them vulnerable to hacks and scams. Since they’re open-source, hackers have opportunities to probe blockchains and their networks in search of weaknesses. Fortunately, as decentralized app technology continues to expand and user bases grow, the industry is acting to make hacking blockchain networks increasingly difficult. Some of the strategies currently being worked on include smart contract debugging, eliminating copy-and-paste errors, fixing faulty app logic and implementing regular audits. While DApp creators are taking steps to fix these issues, as more and more DeFi projects hastily launch without proper funding and auditing protocols, the hacking problem persists.
Web Apps vs. DApps
The majority of apps today operate on centralized networks owned and maintained by a controlling authority. Streaming services, social media networks and financial institutions all hold your data on servers. When accessing these apps, their servers receive a request and they send the result back to you after validating your credentials. This generates enormous amounts of user data, which results in exposure to hacks, as well as big tech companies profiting from it.
DApps
These shortcomings have led to greater data security awareness and increased interest in blockchain technology. Decentralized by nature, blockchains eliminate the need for third-party intermediaries. Thanks to automated smart contract usage and shared consensus, Ethereum-based blockchains and apps can be completely decentralized, and function without Big Tech getting in the way. For example, if you want to send some crypto to a friend using a DApp, all you have to do is log in to your personal crypto wallet, choose the amount to send, and then confirm the transaction. A smart contract then does the rest and completes the exchange. A permanent record of the transaction is created after being verified by blockchain validators.
Web Apps
Centralized web apps don’t work this way. When sending U.S. dollars to a friend using Venmo or another centralized web app, the process takes place on a centralized network, with a bank or other company handling every component of the transaction. Not only do they decide on the validity of the transaction, but they also own the data. Everyone from Twitter to Trello uses web apps, but every single one consists of both a front end and a back end. For example, when you open up the Twitter app or access it on your web browser, the Twitter web server (back end) goes to work supplying data to the display feed (front end).
Web Apps vs. DApps: Further Considerations
While huge amounts of data are channeled through the internet via centralized servers, blockchains share the transactional burden with scores of machines over a distributed network. Both websites and DApps work similarly on the front end to render available pages viewable on the internet. On the back end, however, a DApp communicates with a large blockchain network via a wallet. Your wallet is responsible for managing your blockchain address, as well as the cryptographic keys needed to verify your identity. If a DApp is Ethereum-based, a smart contract is used (rather than HTTP protocol) to communicate back and forth with the blockchain and carry out transactions.
The Future of DApps
Despite still being in its early stages, DApp technology is really taking off. Already, there are thousands of DApp solutions offering a vast array of services. From playing games to trading NFTs and investing in DeFi, you name it — and there’s a DApp for it.