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What is DeFi? Decentralized finance explained


The banking services that you currently use are fraught with challenges, shortcomings, and points of failure. You’re subject to low return rates, fraud, long processing times — and so much more.

Decentralized Finance (DeFi) came about a few years ago, but only in 2020 did it really take off. Unlike traditional financial services, in DeFi, everything is run through a programmable smart contract — largely on the open-source Ethereum blockchain, though several more are coming up.

Because of that, investors can participate in services such as lending without fear of losing money to borrowers or worrying about low rates. And that’s just the tip of the iceberg; the fact that financial services are underpinned by programmable contracts means that the sky’s the limit when it comes to novel applications. 

Until now, such services have been dominated by licensed financial institutions — but that’s all about to change with DeFi.

What is DeFi?

DeFi stands for “decentralized finance.” DeFi is a form of finance that uses smart contracts on decentralized blockchains, most popularly on the Ethereum network. Smart contracts are self-executed programs — essentially lines of code and data — and are utilized in DeFi to execute transactions on a blockchain. It is a type of account not controlled by a single user.

The transactions themselves are verified and maintained using a distributed network of nodes, i.e., a global connection of nodes takes the role of, let’s say, a bank, which would be responsible for ensuring transaction validity in a centralized system.

Furthermore, all transactions are transparent as they are verifiable on-chain — without involving any intermediaries. For example, it's easy to verify the financial transactions in tokenized real estate investing.

These smart contracts have led to the development of individual pieces in a much larger ecosystem — “money legos.” Essentially, developers could easily pick from thousands of services (underlying technical protocols) to build innovatively new financial toolsets.

Think of it this way, in today's financial system, any type of banking transaction requires multiple layers of approvals and processing can take days. Often, these financial services are loaded with hidden fees, terms, and abysmal yield-generating opportunities. And not everyone can access or afford these services.

With DeFi, its composability opens up endless possibilities for builders to provide valuable financial services that will allow anyone to easily participate in the ecosystem — instantly take out a loan, invest parts of it, lend out the rest, actually earn meaningful yields, make leveraged positions, and so much more. And you can comfortably finance yourself in DeFi without having to go through mountains of paperwork — for a fraction of the cost and time than in traditional finance.

The DeFi architecture consists of five layers:

  • Settlement layer: The blockchain itself, where transactions are recorded
  • Asset layer: Determines the type of token used, just like a bank would differentiate between foreign currencies for exchange 
  • Protocol layer: Contains the smart contracts that make up the DeFi protocol itself — like with any software, it consists of logic that triggers action when conditions are met
  • Application layer: The interface that allows you to interact with smart contracts
  • Aggregation layer: Similar to the application layer, but combines multiple DeFi apps within a single platform
Pros and Cons

The advantages of DeFi are clear: easier and wider access to financial services. This is particularly important for the underprivileged, who need nothing more than a phone and an internet connection to get started.

In comparison to traditional markets, users have more control over their assets and how they decide to yield on them. In the spirit of decentralization, they can also choose to be involved in a project's development as an active community member, as a contributing builder, or participate as a “vested investor” in their governance.

Dislike the return rates? Vote on it in the governance proposal. Want to have your idle assets generate passive income and invest in a new service without jumping through hoops? Participate in a liquidity mining program. The possibilities are endless.

But there are some downsides to DeFi at the moment as well. Primarily, scalability issues and the nascency of the space.

Being transaction-heavy, the network can get clogged up — leading to high transaction fees. Sometimes, this can result in transaction costs that may potentially eliminate profits earned. 

Volatility also remains a big challenge, as it does for the larger market. This leads to a particular issue in DeFi called impermanent loss. We won’t go into these details, but it’s something to factor in especially when you become a power user in DeFi.

Lastly, many protocols and services are new and are subject to technical or economical exploitation. There have been many notable cases of hacks and exploitations in the market, and while it's now a best practice for projects to ensure that their smart contracts are audited, users are often still advised to invest with precaution at their own risk. Insurance protocols are also beginning to see demand.

What does the DeFi ecosystem let you do?

In the traditional financial system, officially loaning people money entails going through dense red tape to get approved and registered. Likewise, if you are in need of a loan, a banking adviser would have to go through your finances to determine if you are eligible. Within the space of decentralized finance, all you need is access to the internet to acquire such financial services.

This is made possible thanks to smart contracts called Automated Market Makers (AMMs). As mentioned previously, in a traditional financial system, market makers — Nasdaq and NYSE — ensure the liquidity for smooth trading between market participants. DEXes (decentralized exchanges) remove such institutions by providing incentives to become a liquidity provider. This is the essence of yield farming.

In the same vein, those who would like to borrow have to collateralize their digital assets. To start participating in this DeFi ecosystem, you would first need to use fiat to buy cryptocurrency, which you can then trade on one of the programmable blockchains like Ethereum. Here are the most popular DeFi activities:

  • Lending: Lending is one of the most popular DeFi applications (via Aave and Compound) and remains a cornerstone of the space. Smart contracts ensure that both parties keep their end of the bargain — with an asset acting as collateral to remove counterparty risk. Often, it is overcollateralized. There are several advantages to borrowing, such as using the funds to strengthen a leverage position or covering unforeseen expenses.
  • Yield farming: By just having some crypto assets in your wallet, you can lock them up in liquidity pools on yield aggregators, AMMs, or lending protocols. This would then stake them. In turn, for your service as a liquidity provider, you earn yield depending on the amount of locked assets. Some examples include dApps like Curve Finance and Yearn Finance. Your interest rates, also called APY (annual percentage yield), can go as high as 20%.
  • Staking: Staking is another highly popular use case, where users stake assets on proof-of-stake protocols and earn passive income over time. For instance, Unagii Stake allows users to stake their assets for multiple chains, including Cosmos, Terra, and Kava.
  • NFTs: NFTs, which are now well into the mainstream, are unique assets — with each token having an identifier. This uniqueness can be used to mark objects of potential value, such as artwork or a collectible item in a game. It has already been used by artists, musicians, sports teams, and other prominent entities.
  • Lotteries: Yes, even lotteries can be decentralized. PoolTogether is the most popular one. It offers a variety of rewards in no-loss prize games. At the current weekly rate, it dishes out $155,000 worth in POOL tokens.
  • Trade in synthetic stocks, derivatives, commodities, and fiat currencies: DeFi is all about tokenizing different kinds of assets that are backed by blockchain’s security. Likewise, stocks and other assets can too be tokenized thanks to Synthetix and Mirror protocols. These ERC-20 smart contracts are called “Synths” that can be traded without actually holding them. Kwenta and Mirror are the go-to DEXes to trade Synths.
  • Exchange tokens: There are currently over 3,000 altcoins. On a DEX like Uniswap, you can exchange one crypto asset for another, if you think the utility of the latter will make its price spike.

Can decentralized finance replace banks?

Decentralized finance has come to be seen as a replacement for many of the services in the traditional banking sector. The capacity for anyone to join the global economy and invest in any sector is an idea whose effects will only be seen in the near future — but the signs are already there.

DeFi applications lead this charge. In just a single year, the total value locked (TVL) in this space surpassed $80 billion. TVL relates to the relationship between liquidity pools and liquidity providers.

In DeFi, this liquidity is provided by liquidity providers. When they stake their crypto assets into a liquidity pool, they lock them in so that one asset can be smoothly exchanged for another, thus ensuring low price volatility. This valuable service is called yield farming, and TVL represents the total value locked by liquidity providers into liquidity pools.

These DeFi dApps have become extremely popular. After all, they cut out central authorities while mirroring banking services. Last March, even Bank of America acknowledged that DeFi poses a greater threat to the banking sector than Bitcoin. They can do this thanks to stablecoins. These are tokens that are pegged to fiat currency (USD) in a 1:1 ratio so they eliminate inherent crypto volatility. 

Yet, DeFi is a long way from touching the market cap of even a single large bank. In the meantime, DeFi represents the free market in its true form, with all its deregulated volatility. This is not surprising considering that Bitcoin itself emerged just after the 2008 financial crisis.

Take advantage of DeFi’s early stage

DeFi represents a high-water mark in our monetary history. By combining smart contracts with blockchain immutability, DeFi creates a new level of transparency and user control over their financial affairs. With this comes great freedom and investment opportunities along with tremendous personal responsibility. 

Once more people realize they can take full control of their finances without asking for permission, the sky will be the limit. To get started, it would be wise to mitigate risk by employing a multi-asset yield farming strategy. In the stock market, it is commonplace to diversify your portfolio, so the same holds true in the DeFi ecosystem. 

One of the DeFi platforms to make this easy to do is Unagii. This DeFi protocol automates the entire process of yield farming, once you have locked your crypto assets in recommended liquidity pools. It’s as simple as connecting your MetaMask wallet to the Unagii DeFi dApp. Give it a try and before you know it, you will replace your savings account with Unagii’s yield farming as a source of passive income.

Unagii Team

We're a distributed team of dedicated strategists and engineers with a mission to redefine the digital asset yield experience.