Decentralized finance or DeFi, has taken the cryptocurrency world by storm and might even eclipse the initial coin offering (ICO) craze of 2017.
Since the beginning of 2019, the Total Value Locked (TVL) in USD terms in various DeFi decentralized applications (Dapps) has shot up more than 10 times from ~$322 million to nearly $4 billion.
But what exactly is DeFi, what does it do, and how does it work? We’ll cover all of these in this article as well as you give you a few easy ways to get started with DeFi and join the latest crypto revolution.
What is DeFi (Explained Like I’m 5)
In a nutshell, DeFi is the creation of traditional financial services, such as lending, borrowing, trading, asset management, and more using decentralized technologies like public blockchains (e.g. Ethereum) and smart contracts (automated contracts made of computer code).
Here’s why that’s important.
What Problems DeFi Solves
If you’ve ever had to deal with account maintenance fees, minimum balances, overdraft fees, or account freezes, you know that banking could use some improvement – maybe lots of it.
DeFi eliminates all the issues mentioned above:
- You can’t incur overdraft fees since you can only use whatever crypto you have and nothing more
- There are no account maintenance fees
- There are no minimum balances
- And no one can freeze your “account” (cryptocurrency address), provided you control your funds and don’t leave them to an exchange or other third party
However, that’s not all. DeFi solves many more problems. Here are just a few of them:
Easier to Use
Every try getting a loan at a bank or elsewhere? It usually doesn’t take a few seconds.
Going back to things like overdraft fees and account maintenance fees – these don’t exist in DeFi.
Another aspect to consider is that DeFi automates most of the functions of banks and other financial institutions. This means that the overhead costs that places like banks have like physical locations, thousands of employees, and so on, are eliminated.
These savings are passed onto you in the form of lower fees, and higher interest rates!
Higher Interest Rates
It’s been years since many people in countries or regions of the world like the United States, Europe, and Japan have been able to earn respectable interest on their money, without having to resort to riskier investments like stocks, as opposed to keeping money in a savings account.
As of writing, the average savings account in the US pays 0.06% interest a year, which is basically nothing, and definitely doesn’t beat an average 2% annual inflation that eats away at your money’s purchasing power.
On the other hand, Compound Finance, a DeFi Dapp that lets users borrow and lend crypto without a middleman, pays lenders interest that comes from fees paid by borrowers. Over the past 30 days, lenders have earned an average of 3.66% yearly interest on Dai stablecoins, which mirror the value of the US dollar (1 DAI = $1).
In other words, keeping your savings in Compound can pay 61 times more interest than your average US savings account!
No Need to Trust Third Parties
It wasn’t the average citizen that caused the Great Financial Crisis but banks who engaged in risky speculative practices by issuing mortgages to people who couldn’t actually afford homes, and then taking those bad mortgages and rolling them into financial instruments, which were traded and spread throughout the global financial system.
Once homebuyers began to default on their home loans, banks started experiencing severe issues, as more and more loans they held went to zero. Some banks even collapsed completely.
Because of banks’ mismanagement, taxpayers had to foot the bill for massive amounts of spending by governments and central banks to stop the global financial system from collapsing.
Now imagine watching the Great Financial Crisis of 2008-2009 happening in real-time via open, transparent records and stopping it before things got bad.
This is possible in DeFi. You can use Etherscan to look up records of all Ethereum-related transactions (Ethereum is the premier blockchain platform used for DeFi as of writing). You can also look at the open-source code running Dapps’ smart contracts using Github to search for any security vulnerabilities.
On top of the transparency that comes with not having to trust third parties by looking at open transaction data and code is not having to entrust your valuable personal information to anyone.
A prime example is Equifax, a major US credit reporting agency, which lost information like Social Security numbers and credit card numbers to hackers in 2017.
You don’t ever have to give up personal information, create an account, etc. to use DeFi services. The only thing that’s public is your transaction information, such as amounts and where you send your money.
Therefore, you don’t have to worry about things like your Social Security number, credit card number, etc. falling into the hands of bad actors.
When you sign up for a bank account, it’s usually difficult to switch banks, especially if you sign up for various products and services the bank tries to sell you like credit cards, investment advice, etc. One thing piles on top of another and switching services becomes difficult.
This not only gives you more choice with less friction, but also forces Dapps to stay competitive, since anyone who can code can create a competing Dapp to win over users. On the other hand, starting your own bank isn’t as easy if you wanna compete with huge banks like JP Morgan.
So, as you can probably tell, DeFi isn’t just more decentralized than regular finance. It’s undoubtedly better in many ways.
But how does the magic happen behind the scenes? Here’s a basic overview of DeFi lending and borrowing, one of the most popular DeFi use cases.
How DeFi Works (Lending and Borrowing Example)
We’ll go over how DeFi works for lending and borrowing, a popular DeFi use case, with a simplified example. (To get an idea of other DeFi use cases, check DeFi Pulse for a list of the most popular DeFi Dapps).
Let’s say you want to get a loan but can’t do so the traditional way for various reasons, or choose not to due to the pitfalls of traditional finance like high fees, long wait times, etc.
Instead of heading to your bank’s loan officer for a meeting, you can deposit crypto collateral, such as ETH, into a DeFi Dapp, such as Compound Finance. The smart contract in the background automatically approves or denies your loan based on whether or not your deposit meets the contract’s requirements, which is usually sufficient levels of collateralization.
On the other hand, if you want to lend out money to earn interest, you can do that in a few clicks or taps using Compound’s web app or services that make it easy like Exodus wallet’s Compound Finance integration.
Earning high interest in a few clicks using Exodus Desktop.
How to Start Using DeFi
Does all this DeFi stuff sound too good to be true? You can try for yourself. DeFi has come a long way and is getting easier to use by the day thanks to solutions like the ones below.
Argent is a DeFi-focused crypto wallet that lets you use Ethereum-based DeFi Dapps right from your phone. The wallet makes DeFi easy to use and also includes innovative security features like not having to write down complicated seed phrases while still giving you control of your crypto.
Exodus is another Ethereum wallet that supports DeFi but also lets you use and exchange 100+ other crypto assets, including popular ones like Bitcoin. DeFi support is limited to Compound Finance for now, but they are in the process of rolling out more Dapps in their easy to use, visually appealing interface.
Coinbase Wallet is an offering from Coinbase, a popular place for many first time crypto users to buy crypto using fiat currencies, such as US dollars. You can transfer to/from your Coinbase.com account, making Coinbase Wallet a convenient way to buy some crypto on Coinbase.com and start using DeFi right away.
Technology has changed our lives radically in the past few decades. Yet much of the world’s financial system is running on technology that is built for 1920, and not 2020.
DeFi promises to change all that, and while it’s still early, DeFi shows the potential of blockchain and cryptocurrency and might be the gamechanger or “killer application” that really catapults crypto into the limelight.