Everything you need to know about DeFi

The term decentralized finance, or DeFi, goes back to a Telegram chat in 2018. That’s when a group of software developers and entrepreneurs were trying to decide what to call their movement of new-breed financial services that would be automated, built on a blockchain, and capable of stripping out traditional banks.

Three years later and DeFi is big business. A user with a crypto wallet can trade digital assets, get loans, or take out insurance, among many other things. Some $90 billion of collateral is locked up in these services, and more than 10 million people have downloaded MetaMask, one of the most popular digital wallets used to open up access to these networks.

The roots of decentralized finance come from the 2008 bitcoin whitepaper that set out the framework for a novel system for digital cash; those creation exploded into something bigger when Ethereum was invented a few years later. “Bitcoin wanted to be peer-to-peer money,” Camila Russo, founder of the crypto news service The Defiant, wrote in her book The Infinite Machine. “Etherum wanted to be peer-to-peer everything.”

DeFi is an amalgam of cryptography, finance, and software development, and it tends to be shrouded with its own lexicon and jargon. Let’s take it one piece at a time.

What is DeFi?

DECENTRALIZATION

One of the core tenants of decentralized finance is that it’s, well, decentralized. Take bitcoin, for example: The original crypto asset is basically a ledger (its blockchain) that is decentralized because the transactions are recorded in databases on many different computers. That single record (stored across many databases) is secured with cryptography and the computers keep tabs on each other to make sure it hasn’t been tampered with.

Decentralization is part of what makes bitcoin hard to kill. No single party is in charge, so it’s nearly impossible for someone to go rogue and change the rules that govern the virtual coin. Likewise, even if a government manages to prevent a bunch of computers from supporting bitcoin, the digital asset can continue functioning because other computers on the network retain a full record of transactions and can carry on running the show.

DeFi takes this concept a step further. Decentralized exchanges and lending systems use blockchains like the Ethereum network, which was proposed by Canadian-Russian programmer Vitalik Buterin in 2013. Whereas the bitcoin blockchain was designed to keep track of bitcoin transactions, Ethereum’s blockchain was created to host programs. Think of Ethereum as a decentralized computer that software developers can make applications (dApps) for. The computers that provide processing power for Ethereum are rewarded with ether, which is now the second-most valuable crypto asset behind bitcoin.

Like bitcoin, the Ethereum network is hard to shut down or corrupt. Anyone with an internet connection can access it.

GOVERNANCE

The decision making, or governance, at DeFi organizations—from the fees they charge users to the products they offer—is often meant to be decentralized. (If the US political system is a representative democracy, think of DeFi as direct democracy.) A single person or a small group of people might be driving a decentralized application at inception, but they often seek to step away as the project gains momentum, handing control to the community that uses it. That transition could be in the form of a decentralized autonomous organization (DAO), which has its rules and regulations embedded in programming code and may issue governance tokens, which gives holders of those coins say in decisions.

PEER-TO-PEER

One of bitcoin’s key innovations was the capacity for two users to make digital payments directly with one another. This is easy to do in the physical world using paper or metal money. But until bitcoin came along, the only way to do so electronically was through a bank or payment company like PayPal.

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Going through these third parties leaves a digital footprint that can be surveilled, and those companies could potentially be “censored” by the government—i.e. pressured to prevent transactions for political or other reasons. Bitcoin was envisioned to get around this, as a digital form of cash for peer-to-peer payments. DeFi apps can also be peer-to-peer. In a traditional stock-trading transaction, an order might be processed through a series of intermediaries—a broker and an exchange, among others—while the shares themselves are held at a custody bank, which is expected to keep the securities from getting lost or stolen.

By contrast, a DeFi exchange (DEX) doesn’t have those intermediaries. If you use Uniswap, a decentralized exchange built on the Ethereum platform, to trade crypto tokens, those assets will end up right in your crypto wallet, facilitated by Uniswap’s automated programs known as smart contracts. That means there are fewer parties taking a cut of your transaction.

ICOs and NFTs

Blockchain has enabled a series of digital gold rushes since it was invented 13 years ago. Two of them are initial coin offerings (ICOs) and nonfungible tokens (NFTs):

INITIAL COIN OFFERINGS (ICOS)

ICOs are a type of crowdfunding, and they’re often used to raise money for open-source software projects. In exchange for capital, ICO investors get a unique token that might give them access to the software’s special features… or might not give them access to much at all.

ICOs can sound a little bit like a stock offering—too much like stock offerings, in fact, for the US Securities and Exchange Commission; coin offerings may lack guardrails like disclosure and auditing that an initial public offering (IPO) would be expected to provide in the regulated stock market.

ICOs raised more than $7 billion in 2018, before plunging around 95% to $371 million in 2019, the latest year data was available, as regulators cracked down, according to CB Insights.

NONFUNGIBLE TOKENS (NFTS)

NFTs are kind of like a limited-edition trading card—only online. Just as blockchain enables users to prove ownership of their bitcoin holdings, so too does it enable people to make unique digital assets like collectibles and art. One of the best known NFT sales was a work by Beeple—the artist also known as Mike Winkelmann—who sold a collage through an auction at Christie’s for $69 million. Unlike a music MP3, which can be copy-and-pasted to infinity, NFTs are designed to be one of a kind, and to have one owner at a time.

REUTERS/TYRONE SIU

A digital art fair in Hong Kong with works by Andy Warhol and Mike Winkelmann.

These acronyms are more than just a gold rush, says Matthew Leising, author of Out of the Ether. ICOs gave startups and software developers a way to raise money without the help of an investment bank or the backing of a venture capital firm. Likewise, NFTs can give musicians and visual artists a new way to monetize their work. “NFTs are really interesting because they’ve proven that a digital item can be scarce,” Leising says.

What are the advantages and disadvantages of DeFi?

DeFi’s strength can also be its weakness:

• Decentralization makes DeFi difficult to censor or stamp out, but it requires some heavy-duty computing. Maintaining a database and records across a network of many computers slows things down and can make transactions more expensive. Ethereum is the most popular blockchain for DeFi applications, but the sheer amount of computing now taking place is driving up fees and bogging down the network. As Ethereum developers try to find ways to make it more scalable, other chains like Solana and Avalanche are picking up momentum. “It’s genuinely hard to get performance out of blockchains,” says Emin Gün Sirer, a computer scientist at Cornell University and an advisor to Avalanche.

• DeFi strips out intermediaries like custody banks, which are expected to keep assets (usually digital tokens) safe. That means you don’t have to worry about a financial institution failing and taking your holdings with it—or a government seizing your tokens and confiscating them. On the other hand, the only thing keeping your holdings safe is you and your passcode. If you lose that passcode (or someone steals it), your assets are gone for good.

• The DeFi upstarts often purport to be available to anyone. You may be able to get a loan or trade virtual coins without traditional financial credentials like identification or a credit score. That freedom promises to extend financial services to parts of the world that haven’t always had them, or where the services are expensive or prone to fraud or confiscation. But you can easily see the downside: If there’s no entity keeping track of who is using a service or where they are located, the systems could be used by criminals or run counter to sanctions. The regulatory crackdown has already begun.

• Blockchains have proven pretty tough to crack—but the smart contracts and apps that run on top of those chains are only as smart as the people who designed them. The code is typically open-source, which means it’s there for everyone to see and to innovate with, but that also makes it easier for hackers to attack. Much more programming code these days is audited for bugs and vulnerabilities, and a growing number of people understand the need for formal verification (a process that uses algorithms to analyze other algorithms for glitches), but plenty of money is still going into code that hasn’t been shored up in that way, Cornell’s Sirer said.