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What is DeFi?

Updated on
Jul 3, 2023

4 min read

Overview

DeFi, a concept originally introduced in 2017, has led to the growth of over 500 cryptocurrency protocols and a combined asset value of over 50 billion dollars (source). In this guide, you will learn more about the history of DeFi, current use cases, risks, and how to get started in DeFi.

What is DeFi?

DeFi, also known as Decentralized Finance, is used to categorize finance-related cryptocurrency projects powered by smart contracts on blockchains. DeFi aims to provide an alternative option compared to traditional financial services systems. Here are the key takeaways you should understand about DeFi:

  • DeFi is Programmable: DeFi runs on smart contracts and distributed computing infrastructure, thus removing the need for unnecessary intermediaries, administration, and overhead in financial processes.
  • DeFi is Permissionless: DeFi is meant to be open to anyone with a wallet and internet connection, regardless of who you are and your geographical location.
  • DeFi is Transparent: Since DeFi runs on public blockchains, anyone can access historical and real-time transaction history. This level of transparency isn't easily accessible in traditional financial markets.
  • DeFi is Interoperable: Since much of DeFi is open-source, it is common for DeFi protocols to interact with one another.

Current Use Cases

To understand which DeFi protocols are the most used today, we can look at ratios that can apply across the industry of DeFi protocols. For example, the total-value-locked (TVL) ratio measures the total amount of underlying supply that is secured by a specific protocol.

Here are the categories within DeFi today that currently attract the most attention:

  • Decentralized Exchanges (DEXs): Protocols that help you buy/sell/swap/trade digital assets (e.g., Uniswap, Serum)
  • Bridges: Protocols that help users move digital assets across different blockchains (e.g., MultiChain, Wormhole)
  • Stablecoins: Protocols that mint their own stablecoin (i.e., there are various sub-types of stablecoins such as CDP-based stablecoins (e.g., DAI), algorithmic-based stablecoins (e.g., FRAX), and custodial-based stablecoins (e.g., USDC)
  • Lending Protocols: Protocols that let users borrow and lend their digital assets (e.g., MakerDAO, Aave)
  • Asset management (a.k.a yield aggregators): Protocols that pay you a reward for depositing your digital assets on their platform (e.g., Yearn.Finance)
  • Liquid Staking: Rewards/Liquidity for staked assets (e.g., Lido Finance, Rocket Pool)
  • Derivatives: Smart contracts that get their value, risk, and structure from an underlying asset (e.g., UMA, Synthetix)
  • Payments: Protocols that give the ability to pay in the form of digital assets (e.g., Flexa)

This is not an exhaustive list of all the DeFi protocols available today, but it covers most of them. For a full list, check out DeFi Llama's dashboard.

DeFi Risks

There are two main types of risk when it comes to participating in DeFi. Protocol risk and blockchain risk:

Protocol Risk: This is the risk you inherit when participating with a specific DeFi protocol. Note that you can have many layers of protocol risk. For example, if you are lending your assets (e.g., DAI) on Aave (a lending protocol), one layer of risk is if the protocol itself experiences an exploit or has faulty smart contract logic, causing unintended losses. The next layer of risk is the risk of the digital asset you're holding. For example, in the case of DAI (an over-collateralized stablecoin), there is a chance (albeit low chance) that the stablecoin could de-peg from its intended value. There are additional layers of risks a DeFi user may take on, but we will discuss them in the next guide.

Blockchain Risk: DeFi protocols rely on the underlying blockchain technology to facilitate their activities. Blockchains must be secure and bug-free for DeFi to work. A typical risk that most blockchains run into is if their consensus mechanisms get exploited (e.g., a 51% attack).

You should also be aware of ways to keep your digital assets secure. For this information, reference our An Introduction to Crypto Wallets and How to Keep Them Secure guide.

How to Get into DeFi

Luckily, there are tons of resources for learning about DeFi protocols. Commonly, cryptocurrency projects have a web page dedicated to additional resources and documentation; this should be the first place you look.

Additionally, each DeFi protocol generally has a discord or telegram you can join to interact with the community or ask additional questions.

Final Thoughts

Kudos! You now have a better understanding of what DeFi is and what it aims to achieve. If you have any feedback or questions on this guide, let us know, we'd love to hear from you!

Feel free to reach out to us via Twitter or our Discord community server.

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