What's DeFi?
DeFi is a collective term for financial products and services that are accessible to anyone who can use Ethereum – anyone with an internet connection. With DeFi, the markets are always open and there are no centralized authorities who can block payments or deny you access to anything. Services that were previously slow and at risk of human error are automatic and safer now that they're handled by code that anyone can inspect and scrutinize.
There's a booming crypto economy out there, where you can lend, borrow, long/short, earn interest, and more. Crypto-savvy Argentinians have used DeFi to escape crippling inflation. Companies have started streaming their employees their wages in real time. Some folks have even taken out and paid off loans worth millions of dollars without the need for any personal identification.
DeFi vs traditional finance
One of the best ways to see the potential of DeFi is to understand the problems that exist today.
- Some people aren't granted access to set up a bank account or use financial services.
- Lack of access to financial services can prevent people from being employable.
- Financial services can block you from getting paid.
- A hidden charge of financial services is your personal data.
- Governments and centralized institutions can close down markets at will.
- Trading hours often limited to business hours of specific time zone.
- Money transfers can take days due to internal human processes.
- There's a premium to financial services because intermediary institutions need their cut.
It started with Bitcoin...
Bitcoin in many ways was the first DeFi application. Bitcoin lets you really own and control value and send it anywhere around the world. It does this by providing a way for a large number of people, who don't trust each other, to agree on a ledger of accounts without the need for a trusted intermediary. Bitcoin is open to anyone and no one has the authority to change its rules. Bitcoin's rules, like its scarcity and its openness, are written into the technology. It's not like traditional finance where governments can print money which devalues your savings and companies can shut down markets.
Ethereum builds on this. Like Bitcoin, the rules can't change on you and everyone has access. But it also makes this digital money programmable, using smart contracts, so you can go beyond storing and sending value.
Programmable money
This sounds odd... "why would I want to program my money"? However, this is more just a default feature of tokens on Ethereum. Anyone can program logic into payments. So you can get the control and security of Bitcoin mixed with the services provided by financial institutions. This lets you do things with cryptocurrencies that you can't do with Bitcoin like lending and borrowing, scheduling payments, investing in index funds and more.
Send money around the globe quickly
As a blockchain, Ethereum is designed for sending transactions in a secure and global way. Like Bitcoin, Ethereum makes sending money around the world as easy as sending an email. Just enter your recipient's ENS name (like bob.eth) or their account address from your wallet and your payment will go directly to them in minutes (usually). To send or receive payments, you will need a wallet.
Stream money around the globe...
You can also stream money over Ethereum. This lets you pay someone their salary by the second, giving them access to their money whenever they need it. Or rent something by the second like a storage locker or electric scooter.
And if you don't want to send or stream ETH because of how much its value can change, there are alternative currencies on Ethereum: stablecoins.
Access stable currencies
Cryptocurrency volatility is a problem for lots of financial products and general spending. The DeFi community has solved this with stablecoins. Their value stays pegged to an another asset, usually a popular currency like dollars.
Coins like Dai or USDC have a value that stays within a few cents of a dollar. This makes them perfect for earning or retail. Many people in Latin America have used stablecoins as a way of protecting their savings in a time of great uncertainty with their government-issued currencies.
Borrowing
Borrowing money from decentralized providers comes in two main varieties.
- Peer-to-peer, meaning a borrower will borrow directly from a specific lender.
- Pool-based where lenders provide funds (liquidity) to a pool that borrowers can borrow from.
There are many advantages to using a decentralized lender...
Borrowing with privacy
Today, lending and borrowing money all revolves around the individuals involved. Banks need to know whether you're likely to repay a loan before lending.
Decentralized lending works without either party having to identify themselves. Instead the borrower must put up collateral that the lender will automatically receive if their loan is not repaid. Some lenders even accept NFTs as collateral. NFTs are a deed to a unique asset, like a painting.
This allows you to borrow money without credit checks or handing over private information.
Tax-efficiencies
Borrowing can give you access to the funds you need without needing to sell your ETH (a taxable event). Instead you can use ETH as collateral for a stablecoin loan. This gives you the cash-flow you need and lets you keep your ETH. Stablecoins are tokens that are much better for when you need cash as they don't fluctuate in value like ETH.
Exchange tokens
There are thousands of tokens on Ethereum. Decentralized exchanges (DEXs) let you trade different tokens whenever you want. You never give up control of your assets. This is like using a currency exchange when visiting a different country. But the DeFi version never closes. The markets are 24/7, 365 days a year and the technology guarantees there will always be someone to accept a trade.
For example, if you want to use the no-loss lottery PoolTogether (described above), you'll need a token like Dai or USDC. These DEXs allow you to swap your ETH for those tokens and back again when you're finished.
Advanced trading
There are more advanced options for traders who like a little more control. Limit orders, perpetuals, margin trading and more are all possible. With Decentralized trading you get access to global liquidity, the market never closes, and you're always in control of your assets.
When you use a centralized exchange you have to deposit your assets before the trade and trust them to look after them. While your assets are deposited, they're at risk as centralized exchanges are attractive targets for hackers.
Fund your ideas
Ethereum is an ideal platform for crowdfunding:
- Potential funders can come from anywhere – Ethereum and its tokens are open to anybody, anywhere in the world.
- It's transparent so fundraisers can prove how much money has been raised. You can even trace how funds are being spent later down the line.
- Fundraisers can set up automatic refunds if, for example, there is a specific deadline and minimum amount that isn't met.
Quadratic funding
Ethereum is open source software and a lot of the work so far has been funded by the community. This has led to the growth of an interesting new fundraising model: quadratic funding. This has the potential to improve the way we fund all types of public goods in the future.
Quadratic funding makes sure that the projects that receive the most funding are those with the most unique demand. In other words, projects that stand to improve the lives of the most people. Here's how it works:
- There is a matching pool of funds donated.
- A round of public funding starts.
- People can signal their demand for a project by donating some money.
- Once the round is over, the matching pool is distributed to projects. Those with the most unique demand get the highest amount from the matching pool.
This means Project A with its 100 donations of 1 dollar could end up with more funding than Project B with a single donation of 10,000 dollars (dependent on the size of the matching pool).
How does DeFi work?
DeFi uses cryptocurrencies and smart contracts to provide services that don't need intermediaries. In today's financial world, financial institutions act as guarantors of transactions. This gives these institutions immense power because your money flows through them. Plus billions of people around the world can't even access a bank account.
In DeFi, a smart contract replaces the financial institution in the transaction. A smart contract is a type of Ethereum account that can hold funds and can send/refund them based on certain conditions. No one can alter that smart contract when it's live – it will always run as programmed.
A contract that's designed to hand out an allowance or pocket money could be programmed to send money from Account A to Account B every Friday. And it will only ever do that as long as Account A has the required funds. No one can change the contract and add Account C as a recipient to steal funds.
Contracts are also public for anyone to inspect and audit. This means bad contracts will often come under community scrutiny pretty quickly.
This does mean there's currently a need to trust the more technical members of the Ethereum community who can read code. The open-source based community helps keep developers in check, but this need will diminish over time as smart contracts become easier to read and other ways to prove trustworthiness of code are developed.
Ethereum and DeFi
Ethereum is the perfect foundation for DeFi for a number of reasons:
- No one owns Ethereum or the smart contracts that live on it – this gives everyone an opportunity to use DeFi. This also means no one can change the rules on you.
- DeFi products all speak the same language behind the scenes: Ethereum. This means many of the products work together seamlessly. You can lend tokens on one platform and exchange the interest-bearing token in a different market on an entirely different application. This is like being able to cash loyalty points in at your bank.
- Tokens and cryptocurrency are built into Ethereum, a shared ledger – keeping track of transactions and ownership is kinda Ethereum's thing.
- Ethereum allows complete financial freedom – most products will never take custody of your funds, leaving you in control.
You can think of DeFi in layers:
- The blockchain – Ethereum contains the transaction history and state of accounts.
- The assets – ETH and the other tokens (currencies).
- The protocols – smart contracts that provide the functionality, for example a service that allows for decentralized lending of assets.
- The applications – the products we use to manage and access the protocols.