What is Decentralized Finance (DeFi)?

Decentralized finance is a term used to describe blockchain-based protocols that give users access to financial services such as trading, borrowing and lending.

In contrast to traditional finance, where trust plays a fundamental role, decentralized finance protocols are built using smart contracts to eliminate middlemen and the requirement for the parties involved in a transaction to trust each other. 

DeFi basics

Decentralized finance protocols can be launched on practically any blockchain platform that supports general-purpose smart contracts.

In practice, the majority of decentralized finance activity is happening on Ethereum, as it’s the most popular blockchain for smart contracts and enjoys the highest levels of liquidity. However, other blockchains such as Tron, BNB Chain, Polygon, Avalanche and Solana are also seeing some DeFi adoption.

DeFi protocols are built using smart contracts, an approach that has its own upsides and downsides. 

On the positive side, DeFi users interact with protocols directly from their own cryptocurrency wallets, staying in control of their private keys at all times. DeFi protocols also operate on a 24/7 basis with no geographical restrictions, and anyone can use them so long as they have a sufficient amount of funds in their crypto wallet to pay for the transactions they want to perform.

However, DeFi projects are also vulnerable to exploits. Attackers can either find bugs in the smart contract’s code or a flaw in the protocol’s economic design to steal funds from the protocol’s users. DeFi protocols can be quite awkward to upgrade, as protocol upgrades can require users to migrate tokens or perform other tedious tasks. 

Even though all the underlying action takes place on the blockchain, most people use decentralized finance protocols through websites that provide an easy-to-use visual interface for interacting with the protocol. For example, most users who want to swap tokens on Uniswap do so through the app.uniswap.org interface.

A (very) brief history of DeFi in crypto 

The term “decentralized finance”, which is often shortened to “DeFi”, started gaining prominence in 2018. However, it took until 2020 for decentralized finance to truly take off – the period in 2020 when decentralized finance exploded in popularity is often referred to as the “DeFi Summer”.

In 2020, the TVL (total value locked) of the DeFi sector grew from under $1 billion in May to a peak of $15.5 billion in December. This phenomenon was known as “DeFi Summer”. Image source: DeFi Llama.

One of the biggest catalysts for this sudden growth of the DeFi sector was when Compound, a popular decentralized lending protocol, launched their COMP governance token and began distributing it to users of the protocol through liquidity mining. 

Thanks to the opportunity to earn tokens, users began pouring into Compound, and eventually other DeFi protocols followed suit with similar token incentives.

Today, the total value of assets in DeFi protocols is about $50 billion, but it reached as high as $177 billion during the heights of the 2021 cryptocurrency bull market. 

Types of DeFi protocols

To better understand what DeFi is, let’s look at the most popular types of decentralized finance protocols and what they offer to users.

Automated market makers (AMMs) — Decentralized token swaps

The most popular type of decentralized finance protocols is automated market makers (AMMs). These are protocols that use liquidity pools to enable users to swap between different tokens directly on the blockchain. The pioneer of the AMM design, and still the biggest AMM in terms of trading volume, is Uniswap.

Besides using the protocol to trade between different tokens, users can also choose to provide liquidity by depositing tokens in liquidity pools. Users are incentivized to do so because they collect a fee every time a token swap is facilitated by the liquidity pool they are providing liquidity to. The amount of fees a user collects is proportional to the amount of liquidity they provide to the pool.

Becoming a liquidity provider on a popular AMM such as Uniswap can be a nice way to make some additional income, although providing liquidity is not risk free — in some cases, simply holding tokens in your own wallet is more profitable than using them to provide liquidity. This is due to a concept known as impermanent loss. 

One of the biggest benefits of decentralized exchanges based on the AMM model is that anyone can list any token they wish, so long as they provide liquidity for it. This means that you can often find tokens from new cryptocurrency projects on AMMs before they are listed on major centralized cryptocurrency exchanges.

However, you also need to be on the lookout for scams, as some people will try to fool unsuspecting users by listing a fake clone of a token that’s in high demand.

Besides Uniswap, other popular examples of AMMs include PancakeSwap, SushiSwap, Balancer, QuickSwap, TraderJoe and Osmosis. 

Decentralized derivatives trading — On-chain crypto contract trading with leverage

While the design of AMMs is very clever, they ultimately perform a very simple task — swapping between different tokens. Meanwhile, decentralized derivatives exchanges allow users to speculate on the price of cryptocurrencies in a more sophisticated manner, and also give users the option to use leverage to amplify their trading results.

One of the benefits of decentralized derivatives exchanges is that they allow users to speculate even on crypto assets that aren’t on the same blockchain as the decentralized derivatives protocol itself. For example, you can use the GMX protocol, which is available on the Avalanche and Arbitrum blockchain platforms, to speculate on the price of Bitcoin. 

Today, the most relevant decentralized derivatives trading protocols are dYdX and GMX.  

Lending protocols — Borrow crypto or earn yield on your holdings

Lending is a key financial service, and there are plenty of DeFi protocols that allow users to borrow cryptocurrencies or lend out their crypto to earn interest.

In most protocols, the amount that users earn in interest fluctuates according to market demand. Lending out a crypto asset that’s in high demand might reward you with hefty interest rates, while lending out a crypto asset that’s in low demand might bring you almost no profits at all.

DeFi lending protocols are usually overcollateralized, which means that the value of the collateral you provide must be higher than the value of the assets you are looking to borrow.

A very popular lending protocol is Maker, which allows users to borrow a stablecoin called Dai by providing cryptocurrency as collateral. Another very important lending protocol for the DeFi ecosystem is Aave.

Liquid staking — Retain liquidity while earning staking rewards

Liquid staking protocols allow users to earn staking rewards while maintaining access to liquidity. 

For example, if you use the Lido protocol to stake your ETH coins, you would receive an equivalent amount of stETH tokens, which closely track the price of ETH since they can be redeemed for ETH coins staked through the Lido protocol. 

In this way, you can earn staking rewards with your ETH while trading or lending your stETH in other DeFi protocols. When you want to unstake, you can redeem your stETH to get your staked ETH back.  

Liquid staking protocols exist on most Proof-of-Stake blockchains that offer general-purpose smart contracts. On Ethereum, the most popular options are Lido and Rocket Pool. Meanwhile, if you’re a Solana user, you can access liquid staking through the Marinade protocol. 

The best DeFi wallets

If you want to use DeFi protocols, you will need a wallet that’s compatible with the blockchain network the protocol is deployed on. Here are some of the best DeFi wallets that you can use for free. All of the wallets featured below are non-custodial, which means that the user has the responsibility to keep their private keys safe.

• MetaMask – The world’s most popular wallet for Ethereum and EVM-compatible networks
• Trust Wallet – A top-tier wallet with support for a large variety of cryptocurrencies
• 1inch DeFi Wallet – A crypto wallet from one of the most prolific teams in the DeFi ecosystem
• XDEFI – A wallet specialized for DeFi users and NFT collectors
• Phantom – The best wallet for Solana DeFi enthusiasts

Be on the lookout for DeFi hacks

As we have mentioned previously, DeFi protocols are vulnerable to various types of exploits. An attacker might be able to find a bug in the DeFi protocol’s smart contracts, and use it to steal funds from users. 

Alternatively, an attacker could identify a flaw in the protocol’s economic design and use the protocol differently than intended by its developers in order to make a profit at the expense of other users. 

In total, billions of dollars have been stolen from DeFi users by savvy hackers across hundreds of DeFi exploits. Here’s just a short selection of some of the biggest DeFi hacks of all time:

• February 2022: $320 million stolen from Wormhole
• March 2022: $600 million stolen from Ronin Network
• April 2022: $182 million stolen from Beanstalk Farms
• June 2022: $100 million stolen from Horizon Bridge
• March 2023: $200 million stolen from Euler Finance
• July 2023: $126 million stolen from Multichain

The pros and cons of decentralized finance (DeFi)

Now that we have learned the basics of DeFi, let’s quickly run through the main advantages and disadvantages of decentralized finance.

The bottom line

In the cryptocurrency community, DeFi is often contrasted with TradFi, which stands for “traditional finance”. While many of the DeFi benefits espoused by crypto enthusiasts are real (such as decentralization and improved privacy), DeFi is not especially beginner-friendly and users need to be on the lookout for high transaction fees and costly exploits.

If you’re looking to learn more about how you can get involved in crypto and blockchain, make sure to check out our ultimate guide to investing in web3.