DeFi is short for “decentralized finance,” an umbrella term for Ethereum and blockchain applications geared toward disrupting financial intermediaries.
Using blockchain, the technology behind the digital currency bitcoin, DeFi came up with a way to make it easier for people to keep a record of their transactions. This way, it’s not controlled by a single, central source. That’s important because centralized systems and human gatekeepers can limit the speed and sophistication of transactions while offering users less direct control over their money. DeFi is unique because it moves the use of blockchain from simple value transfer to more complex financial use cases. This makes it stand out.
When you use Bitcoin and other digital-native assets, there are no middlemen in the transactions. This is a big difference from legacy digital payment methods like Visa and PayPal, which have middlemen in the transactions. There is a financial institution between you and the business when you pay for your coffee with a credit card. It has the power to stop or pause the transaction, record it in its own private ledger, and write it down. With bitcoin, those institutions aren’t in the picture at all.
Direct purchases aren’t the only type of transaction or contract that big companies are in charge of. Financial applications like loans, insurance, crowdfunding, derivatives, betting, and more are also in their hands. One of the main benefits of decentralized finance is that middlemen don’t have to be involved in any kind of deal.
Before it was known as “decentralized finance,” the idea of “open finance” was used a lot more often.
Most decentralized finance applications are built on top of Ethereum, the world’s second-largest cryptocurrency platform, which sets itself apart from the Bitcoin platform in that it’s easier to use to build other types of decentralized applications beyond simple transactions. These more complex financial use cases were even highlighted by Ethereum creator Vitalik Buterin back in 2013 in the original Ethereum white paper.
That’s because Ethereum’s platform for smart contracts, which automatically do things if certain conditions are met, is much more flexible. Programming languages for Ethereum, like Solidity, are designed to make and run smart contracts.
For example, say a user wants his or her money to be sent to a friend next Tuesday, but only if the temperature climbs above 90 degrees Fahrenheit according to weather.com. Such rules can be written in a smart contract.
With smart contracts at the core, dozens of DeFi applications are operating on Ethereum, some of which are explored below. Ethereum 2.0, an upcoming upgrade to the network that runs Ethereum, could help these apps because it could help solve some of Ethereum’s scalability problems. These apps could get a boost from the upgrade.
There are a lot of different types of DeFi applications:
- Decentralized exchanges (DEXs): Online exchanges help users exchange currencies for other currencies, whether U.S. dollars for bitcoin or ether for DAI. Some people are excited about DEXs, which let people trade cryptocurrencies directly with each other without having to put their money in the hands of someone else.
- Stablecoins: A cryptocurrency that’s tied to an asset outside of cryptocurrency (the dollar or euro, for example) to stabilize the price.
- Lending platforms: These platforms use smart contracts to do away with middlemen like banks that handle lending in the middle.
- “Wrapped” bitcoins (WBTC): A way to send bitcoin to the Ethereum network so that the bitcoin can be used right away in the DeFi system of the Ethereum network. It’s possible to earn interest on the bitcoin you lend out through the decentralized lending platforms we talked about above. WBTCs let people do this.
- Prediction markets: Markets where people can bet on what will happen in the future, like elections. In DeFi prediction markets, the goal is to have the same functionality but without any middlemen.
Read also: What is Bitcoin Lightning Network?
These apps aren’t the only DeFi ideas out there: There are also new ideas around them.
- Yield farming: For knowledgeable traders who are willing to take on risk, there’s yield farming, where users scan through various DeFi tokens in search of opportunities for larger returns.
- Liquidity mining: When DeFi applications give tokens to people who sign up for their platform in order to get them to sign up. This is the most talked about type of yield farming yet.
- Composability: DeFi apps are open source, meaning the code behind them is public for anyone to view. In this way, these apps can be used to build new apps with the code as building blocks.
- Money legos: Putting the concept “composability” another way, DeFi apps are like Legos, the toy blocks children click together to construct buildings, vehicles and so on. DeFi apps can be put together in the same way as “money legos” to make new financial products, like a Lego set.
A popular type of DeFi is called a “lending market,” which connects people who want to borrow money with people who want to lend them money in the form of a cryptocurrency. The Compound platform is one of the most well-known. It lets people borrow cryptocurrencies or lend their own money. If you loan out some of your cash, you can make money by getting paid interest. So if there’s a lot of demand to borrow a cryptocurrency, the interest rates will go up. This is how Compound sets the interest rates.
DeFi loans are collateral-based, which means that in order to get a loan, a person has to put up something as collateral, like ether, the token that runs Ethereum. That means users don’t have to give out their name or credit score to get a loan, which is how normal loans work.
Stablecoin is another type of DeFi, and it’s one of them. Cryptocurrencies often experience sharper price fluctuations than fiat, which isn’t a good quality for people who want to know how much their money will be worth a week from now. They do this to keep the price of a cryptocurrency, like the US dollar, from going up or down. Stablecoins do this by pinning cryptocurrencies to non-cryptocurrencies, like the US dollar. As the name implies, stablecoins are meant to keep the price stable.
Users bet on what will happen, like “Will Donald Trump win the 2020 presidential election?” This is one of the oldest DeFi apps on Ethereum.
Participants, of course, want to make money. Prediction markets, on the other hand, can sometimes be better at predicting things than other methods, like polling. Intrade and PredictIt are two central prediction markets that have good records in this area. There is a good chance that DeFi will make people more interested in prediction markets, because governments don’t like them and often shut them down when they’re run in a centralized way.