DeFi: The Basics

Articles From: Global X ETFs
Website: Global X ETFs

By: Christian Hazim & Rohan Reddy

Editor’s Note: Please see the glossary at the end for all terms highlighted in sea green found in the order that they appear.

Technological innovation has a habit of kick-starting disruptive movements across the global economy. And one of the reasons why we believe that decentralized finance, or DeFi, has such vast disruptive potential is that it offers inclusion and innovation.

Participants in economies where the financial system promotes regulated inclusion are fortunate to have relatively easy access to capital markets, savings, borrowing, lending, and other financial functions. However, financial access is a relative luxury and not equal to all, especially in developing economies. Traditional finance, being tied to centralized entities and intermediaries, offer permissioned entryways to financial inclusion. The merger of finance and technology into fintech has opened doors to new participants by simplifying front-end applications. But fintech’s underlying infrastructure still relies on the existing centralized models and functions.

Enter DeFi, which is designed to solve those problems. With the rise of smart contract blockchains that host programmable applications, developers built DeFi decentralized applications (dapps) to provide a permissionless, global financial platform for users, by users. DeFi eliminates the need for intermediaries like financial institutions while transferring the power, cost savings, and operational effectiveness to users. It offers financial inclusion in a transparent, secure, and efficient ecosystem.

What to Know About DeFi and How It Works

  • How was DeFi born? Smart contract innovation allowed developers to bring financial utility to dapps within smart contract blockchains.
  • What is DeFi? DeFi is a decentralized, open-source, and user-owned financial umbrella. DeFi is an ecosystem of composable applications, free of traditional financial intermediaries, for money markets, loans, asset management, digital liquidity channels, and digital ownership.
  • Who can participate in DeFi? DeFi is open to all. A non-Know Your Customer (KYC) cryptographically-derived public key allows users around the world to permissionlessly engage within DeFi dapps. The peer-to-peer nature of distributed ledger technology facilitates global value exchange.
  • Where is DeFi today? DeFi user adoption continues to grow as its utility expands, helped by rising developer activity intent on innovating new ways to engage with financial infrastructure.

The Rise of DeFi

The Bitcoin network offered the first glimpse of what decentralized finance could be. Bitcoin allowed users to control and exchange value via a peer-to-peer network rather than by relying on financial intermediaries, which set the initial blueprint for a decentralized financial movement.

In 2013, at just 19, programmer Vitalik Buterin published the Ethereum whitepaper in which he introduced a novel, general-purpose, Turing-complete blockchain network that allows developers to build programable conditions and applications. In essence, Buterin created a programmable system that revolutionized how people think about, create, and deploy utility through blockchain technology. These programable conditions are known as smart contracts, as we discussed in Exploring the Disruptive Potential of Smart Contracts.

The ability to compose smart contract-powered dapps launched a utility and innovation movement. Applications that leveraged dapp technology with money programmability moved the needle for DeFi adoption. These applications were built to improve the financial system by creating a user-owned model that is censorship-resistant and open to all, and because of dapp composability traits, these applications could interact with each other. This created a world of possibilities and a new financial paradigm.

Smart contracts help DeFi eliminate the middlemen

One of the first DeFi dapps was MakerDao, a collateralized debt position (CDP) project. Created around 2015, the project allowed users to over-collateralize their ether (ETH) positions in exchange for DAI, a stablecoin pegged to the U.S. dollar. This development was significant because it foreshadowed DeFi’s development. Other dapps such as Compound and Aave introduced decentralized money market platforms for lending and borrowing against cryptocurrencies, and Uniswap introduced the first successful decentralized asset exchange which relies on liquidity pools of token pairs to determine price rather than on market makers as in a traditional order book.

June 2020, popularly referred to as the start of “DeFi Summer”, was another inflection point for DeFi. Kickstarted by Compound, many projects launched community governance tokens, liquidity mining programs, and yield farming opportunities. The tokenization of projects incentivized and attracted users seeking yield in the form of borrower interest and/or token rewards for providing liquidity, triggering waves of new applications and users. Between June and August 2020, DeFi’s market share within the cryptocurrency landscape, as measured by the total cryptocurrency market cap, jumped from roughly 0.9% to 4.6%.1

DeFi Is a Novel Approach to a New Financial System

DeFi applications are where cryptocurrencies and smart contract programmability intersect. DeFi provides an application layer that replaces traditional human-controlled financial infrastructure with disintermediated, trustless, and permissionless proxies governed by immutable code.

Smart contract dapp programmability powered by the security, scalability, and transparency of a blockchain as the base layer allows DeFi to exist. Ultimately, DeFi seeks to democratize traditional finance (TradFi), as the table below shows.

Key differences between TradFi and DeFi

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Originally Posted September 13, 2022 – DeFi: The Basics

FOOTNOTES

1. Fang, L., Hor, B., Azmi, E., & Win, K. W. (2021, May). How to DeFi: Advanced (1st Edition). CoinGecko.
2. Kunt, A. D., Klapper, L., Singer, D., & Ansar, S. (2021). The Global Findex database 2021: Financial inclusion, digital payments, and resilience in the age of COVID-19. The World Bank. https://www.worldbank.org/en/publication/globalfindex
3. World Development Indicators. (2022, July 20). Data: Population ages 15-64, total. The World Bank. https://data.worldbank.org/indicator/SP.POP.1564.TO
4. Chainalysis. (2021, October). The 2021 geography of cryptocurrency report: Analysis of geographic trends in cryptocurrency adoption and usage.
5. CryptoStats. (2022, July 14). Crypto fees: There’s tons of crypto projects. Which ones are people actually paying to use? Cryptofees.info. https://cryptofees.info/history/2022-07-14
6. Sanbase. (n.d.). Explorer. Accessed on August 9, 2022 from https://app.santiment.net/
7. Defi Llama. (n.d.). Defi yields: Overview. Accessed on August 9, 2022 from https://defillama.com/
8. Aavewatch. (n.d.). V2: USD. Accessed on August 9, 2022 from https://v2.aavewatch.com/

GLOSSARY

Decentralized finance (DeFi): Decentralized applications (see below) that offer financial instruments without the need for intermediaries. DeFi dapps are powered by smart contracts. DeFi allows users to participate in money market activities such as lending and borrowing via decentralized avenues.

Smart contract blockchains: Smart contract (see below) compatible distributed ledger networks, such as Ethereum, Solana, and Avalanche.

Decentralized applications (dapps): Decentralized applications built on top of smart contract platforms. Dapps use the infrastructure of distributed ledger networks and are composable with each other.

Smart contract: Smart contracts are programs that automate the execution of an agreement so that all participants can be immediately sure of the outcome without any intermediary’s involvement or time delay. Smart contracts remove trust concerns in transactions, without the need for third parties. Data feeds, conditions, and rules embedded in the contract trigger a pre-defined outcome executing the agreed-upon terms.

Composability: Refers to the ability to interact, build on, and improve on open-source applications and layers, including like-kind assets.

Cryptographically-derived public key: Also known as asymmetric cryptography, it utilizes two distinct but mathematically connected keys, one for encryption and one for decryption where the public key is used to receive assets, and the private key is used to sign transactions to spend assets,

Turing-complete: Programing language that can perform any computational operation.

Stablecoins: Crypto tokens designed to be pegged to a currency, like the U.S. dollar, on a 1:1 ratio. Their aim is to stabilize the market by adding liquidity and trading avenues. There is no guarantee the peg will be maintained.

Governance tokens: A utility token that allows for decentralized governance voting on-chain.

Yield farming: The act of lending or staking cryptocurrencies in exchange for borrower interest and other rewards such as protocol tokens.

Liquidity mining: The act of providing liquidity to DeFi protocols in exchange for trading fees.

On-chain: Refers to transactions that occur on the actual blockchain.

Flash loans: Funds borrowed and returned within the same block confirmation; are generally used for arbitrage purposes.

Maximal extractable value (MEV): Refers to the maximum value that can be extracted from block production in excess of the standard block reward and transaction (gas) fees by including, excluding, and changing the order of transactions in a block.

GitHub events: Defines certain developer actions in GitHub, an open-source code repository, software development, and version control site.

Total value locked (TVL): The overall value of cryptocurrencies in their platforms. The term refers to the monetary value deposited in applications and serves as a reliable gauge of sentiment and growth. Locking assets within protocols indicate growth, utility, and user conviction.

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