What is DeFi?
Decentralized Finance (DeFi) is the collection of infrastructure, processes, and technologies that allow multiple parties to enter binding financial agreements transparently and without the need for intermediaries or third parties.
Smart contracts are published on distributed ledgers (blockchains) similar to those used by cryptocurrencies. This allows the general public to review these contracts to identify vulnerabilities. As smart contracts gain broader adoption, they become open infrastructure that can be used by anyone to perform specific transactions and financial services like lending, borrowing, trading, derivatives, and more.
What are smart contracts?
Smart contracts are blockchain-stored programs that run when predetermined conditions are met. Smart contracts are typically used to automate the execution of an agreement so that all participants can be certain of the outcome, without any intermediary's involvement or time loss.
Smart contracts are the main building blocks of DeFi. A smart contract is a piece of code that can be executed automatically and in a deterministic way. The smart contract code is usually stored and executed on the blockchain to make it trustless and secure. Smart contracts also have capabilities of receiving, storing, and sending funds and even calling other smart contracts. They follow if-then semantics which makes them fairly easy to program.
Smart contracts aim at removing the human factor from decision-making. The human factor is often proven to be the most error-prone and unreliable element of the standard, traditional contracts.
What is a Protocol?
A DeFi Protocol is a set of smart contracts that are routinely used to perform certain types of transactions.
Compound, for example, is a Protocol for secured lending and borrowing. It works like this:
Compound holds collateral from the Borrower
Compound transfers the Lender’s assets to the borrower after he posted the collateral
Compound calculates the yield that is paid by the borrowers to the lenders and performs the flow of these funds.
All of this happens using smart contracts whose code remains the same and whose execution is made certain by the underlying blockchain
What is the difference between DeFi and traditional Finance?
Decentralized Finance (DeFi) is generally compared to Centralized Finance (CeFi) or Traditional Finance (TradFi) as it removes the control that banks and institutions have on money, financial products, and financial services.
DeFi is a new financial technology that essentially eliminates credit risk. As seen in the Great Financial Crisis in 2008 - or more recently with the collapse of Celsius - Centralized Finance requires relying on intermediaries to perform financial transactions, which leads to the risk of default by individuals or financial institutions. Decentralized Finance offers users the ability to perform financial transactions without the need to trust an intermediary, and relies on publicly verifiable code.
What are the benefits of DeFi?
Lower fees. DeFi eliminates the fees that banks and other financial companies charge for using their services.
Bankless. Users hold their money in a secure digital wallet instead of keeping it in a bank.
Permissionless. Anyone with an internet connection can use it without needing approval.
Fast. Users can transfer funds in seconds.
Transparent. The distributed databases that collect and aggregate all user data are accessible across various locations and open for any user to view.
Reduced credit risk (Trustless). DeFi reduces credit risk as it is intended not to rely on intermediaries or financial institutions to perform transactions. As a caveat, some instruments like fiat-backed stablecoins still carry that risk, requiring trust that a central entity is actually backing up their stablecoins with real fiat.
Censorship-resistant. No nation-state, corporation, or third party has the power to control who can transact or store their wealth on the blockchain network.
What are the risks associated with DeFi?
You hold your money in a secure digital wallet instead of keeping it in a bank. So if you lose your keys, you lose your coin.
Smart contracts can be exploited, hacked, or - as any other piece of software - are subject to bugs that could result in unintended loss of funds.
Some instruments used in DeFi are not decentralized: stablecoins, wBTC, and other representations on the blockchain of real-life assets. These instruments carry those risks with them.
Is DeFi mature today?
Millions of smart contracts execute billions of transactions every day in a market worth hundreds of billions of dollars. However, DeFi is still young and it is important to understand and assess each protocol, asset, and investment opportunity to identify the Fundamental Risks.
Most of DeFi still relies on stablecoins, which are not yet decentralized, which creates credit risk similar to the ones that are prevalent in traditional finance
Regulations are still under development and debate.
Want to learn more?
Our team's recommended DeFi reading and viewing lists include:
What is DeFi (video, below)