Crypto values may have had wildly volatile swings over the past year, but one area of the market continues to grow. DeFi, or decentralized finance, is a catch-all term for a huge variety of products and services relying on blockchain technology.
Operating outside of the banking system, DeFi works differently than traditional finance (which people in the crypto world call “TradFi”). There is a presumption of open access, without the constraints imposed on people who use traditional financial services — such as having a particular credit history or being of a certain nationality.
In spite of this mission of openness, the DeFi market can seem dense and confusing to the uninitiated. The brand-new space is rapidly evolving and developing its own jargon, which can often only be deciphered by looking through relevant Twitter threads or Discord servers.
For all its obscure terminology, though, much of DeFi actually resembles products and services that are available in TradFi. To help bridge the gap, here’s an overview of main categories of DeFi offerings — exchanges, loans, assets, derivatives, and payments — put in the clearest and most accessible language we could manage.
Market makers (aka decentralized exchanges)
Market makers are organizations that allow buyers and sellers of shares to transact. In DeFi this usually means automated market makers or decentralized exchanges, such as Curve Finance and Uniswap.
These DeFi market makers work differently than the Nasdaq or the New York Stock Exchange, which use a “payment for order flow” model, fulfilling buyers and sellers’ orders when their price expectations and time frames overlap.
DeFi market makers instead determine token prices with a formula (called “constant product market maker”) that responds to supply and demand. They also fulfill orders instantly regardless of the trading volume thanks to a liquidity pool. In essence, liquidity providers stake tokens into smart contracts (which are lines of codes that automatically execute in certain conditions). In exchange for providing liquidity, the mechanism will charge a 1% fee on every trade and redistribute it to the liquidity providers.
All cryptocurrency traders need to do to transact with one another in decentralized exchanges like Curve and Uniswap is connect their crypto wallets.
Loan providers (and margin trading)
DeFi loan providers enable margin trading, which allows you to invest more in a certain asset than you own thanks to debt. The reason that DeFi loans tend to focus on margin trading is that the loans are overcollateralized. In that case, it makes more sense to use volatile assets as collateral than stable ones.
Here is why: When the collateral is a digital asset whose price you expect will increase over time, you can leave it as a collateral and take out more money than you originally had to bolster your position. DeFi loans have to be overcollateralized to protect lenders, sometimes at 150% the amount of the debt, because the DeFi ecosystem is pseudonymous (and therefore does not have the KYC or “know your customer” system traditional banks rely on). That means DeFi does not have a credit scoring system either, as of yet.
With loan providers such as Aave or Maker, you can borrow USDC (a stablecoin pegged to the U.S. dollar) against ETH (a volatile asset), exchange the borrowed USDC for more ETH, and recollateralize that ETH for more USDC iteratively. This allows you to put more ETH to work than you could have with your own money.
However, there is a catch. The price of ETH cannot go below a certain threshold or else your collateral will be liquidated without warning to protect lenders. That is why it makes sense to overcollateralize even more than the mechanism requests. Alternatively, you can also settle your debt and get out of your position when you think the risk of your collateral’s price dropping is too high.
The legal status of some kinds of DeFi lending is still being worked out. In September 2021, Coinbase was poised to launch its own crypto lending product, but the U.S. Securities and Exchange Commission issued a notice saying it intended to sue the exchange over the plan, effectively killing it at least for now.
Coinbase CEO Brian Armstrong maintains that his company is committed to following the law. With the agency increasingly turning its sights on the crypto world, it’s likely the regulatory battles over DeFi lending are just getting started.
Assets
The “assets” category in DeFi allows you to invest your money in automated ways, sometimes curated by experts. For example, with Badger DAO you can invest your Bitcoin in various “paths” or strategies. Other popular places to invest digital assets include Convex Finance, yearn.finance, and Rari Capital, among others.
Those strategies make investing simpler by acting as a sort of money-manager algorithm, essentially automating the work of having to find which DeFi project generates the most yield, what loan providers provide the best rates for lenders or other research. They allow you to park your digital currencies and passively earn returns from other projects in exchange for the liquidity you provide without having to monitor constant changes.
Derivatives
Derivatives are financial products that have a relationship with underlying assets, allowing traders to make money off bets on price fluctuations. In TradFi, derivatives can include options, futures and perpetual swaps. With options, you pay for the right, but not the obligation to buy or sell a certain asset at a set price within a given time frame, whereas with futures you have the obligation rather than the right to make the purchase. Perpetuals are like futures, but with no expiry date.
Derivatives in the DeFi space look much the same, but with digital assets like cryptocurrencies as the underlying assets. DeFi offerings like dYdX allow people to trade these bets on crypto price expectations as market conditions change.
The difference in decentralized derivatives exchanges then lies in what happens behind the curtain. Thanks to blockchain-based smart contracts only you can seize your funds and move them elsewhere with your “private keys,” tied to your cryptocurrency wallet. The guardians of the platform cannot hack your account any more easily than others could by finding your passwords in your emails or your drawer. It is in this sense that some qualify the technology as “censorship-resistant” and headless (“without a single point of failure”).
Proponents assert that as smart contracts automate how parties settle derivatives, legal and bank fees will go away, making DeFi more attractive and driving adoption. Critics, meanwhile, argue that without regulation such DeFi products will lead to “rug pull” scams and uninsured losses from hacks.
Payments
Many DeFi projects are aiming to address complaints about current payment systems, as well as to integrate those solutions with digital assets. These pain points include the billions of dollars in interchange fees that credit card issuers like Visa and Mastercard charge merchants for transactions, the several day lag time for international wire transfers via SWIFT, and the delays that can hit even local payments as they are not settled immediately. Another issue with current systems is vulnerability to data breaches.
Various DeFi offerings seek to enable peer-to-peer payments using cryptocurrencies to reduce fees and security risks and improve speed and privacy. Although it is not clear yet whether blockchain technologies will provide the answers, the problems provide interesting opportunities for entrepreneurs to focus on.
One startup, Flexa is working on helping retailers integrate their credit card terminals and e-commerce website rails with cryptocurrency payments. One notable aspect of the company’s solution is relying on people to stake cryptocurrency to secure payments in the event of a hack in exchange for yield.
Another, the Lightning Network, builds on the Bitcoin blockchain to make it faster and more scalable in terms of the numbers of transactions it can accommodate. While Sablier enables money streams that reflect real-time payment for contributors, with the potential side effect of making creator platforms more transparent about compensation.
What’s next?
As the DeFi world continues to expand new areas are bound to open up. For example, There is a potential for crossovers between the DeFi universe and NFTs, or non-fungible tokens. As substantial assets in their own right, NFTs also warrant their own investment strategies.
Supplemental products that support DeFi may also start growing. Because developers build new DeFi projects on top of blockchain platforms such as Ethereum or Solana there is always a risk that the smart contracts could be vulnerable to hacks. Durable projects will have their code checked by DeFi audit firms and purchase insurance within the crypto ecosystem such as with Nexus Mutual.
While the DeFi ecosystem saw great growth in 2021, it is now bracing for increased regulation. For instance, new rules on the horizon might include requiring user identity verification and approval for both taxation and user protection purposes. But even though regulation could slow growth in the near-term, it may also drive wider adoption of DeFi by reducing risks.
