A Beginner’s Guide to Decentralized Finance (DeFi)

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By Sid Coelho-Prabhu

Cryptocurrency’s promise is to make money and payments universally accessible– to anyone, no matter where they are in the world.

The Decentralized Finance (DeFi) or Open Finance movement takes that promise a step further. Imagine a global, open alternative to every financial service you use today — savings, loans, trading, insurance and more — accessible to anyone in the world with a smartphone and internet connection.

This is now possible on smart contract blockchains, like Ethereum. “Smart contracts” are programs running on the blockchain that can execute automatically when certain conditions are met. These smart contracts enable developers to build far more sophisticated functionality than simply sending and receiving cryptocurrency. These programs are what we now call decentralized apps, or dapps.

You can think of a dapp as an app that is built on decentralized technology, rather than being built and controlled by a single, centralized entity or company. (Get used to this word, dapp, you’ll be seeing it a lot from here on out.)

While some of these concepts might sound futuristic–automated loans negotiated directly between two strangers in different parts of the world, without a bank in the middle– many of these dapps are already live today. There are DeFi dapps that allow you to create stablecoins (cryptocurrency whose value is pegged to the US dollar), lend out money and earn interest on your crypto, take out a loan, exchange one asset for another, go long or short assets, and implement automated, advanced investment strategies.

What differentiates these DeFi dapps from their traditional bank or Wall Street counterparts?

  • At their core, the operations of these businesses are not managed by an institution and its employees — instead the rules are written in code (or smart contract, as mentioned above). Once the smart contract is deployed to the blockchain, DeFi dapps can run themselves with little to no human intervention (although in practice developers often do maintain the dapps with upgrades or bug fixes).
  • The code is transparent on the blockchain for anyone to audit. This builds a different kind of trust with users, because anyone has the opportunity to understand the contract’s functionality or find bugs. All transaction activity is also public for anyone to view. While this may raise privacy questions, transactions are pseudonymous by default, i.e. not tied directly to your real-life identity.
  • Dapps are designed to be global from day one — Whether you’re in Texas or Tanzania, you have access to the same DeFi services and networks. Of course, local regulations may apply but, technically speaking, most DeFi apps are available to anyone with an internet connection.
  • “Permissionless” to create, “permissionless” to participate — anyone can create DeFi apps, and anyone can use them. Unlike finance today, there are no gatekeepers or accounts with lengthy forms. Users interact directly with the smart contracts from their crypto wallets.
  • Flexible user experience — don’t like the interface to a certain dapp? No problem — you can use a third party interface, or build your own. Smart contracts are like an open API that anyone can build an app for.
  • Interoperable — new DeFi applications can be built or composed by combining other DeFi products like Lego pieces — e.g. stablecoins, decentralized exchanges, and prediction markets can be combined to form entirely new products.

DeFi is now one of the fastest growing sectors in crypto. Industry observers measure traction with a unique new metric — “ETH locked in DeFi”. At the time of writing, users have deposited over $600 million worth of crypto into these smart contracts.

Intrigued? Let’s take a closer look at just a few of the popular DeFi dapps out there that you can try today. You’ll need a cryptocurrency wallet with a built-in dapp browser (like Coinbase Wallet) to connect to these dapps. You can also use most of these dapps on desktop by selecting the Coinbase Wallet option and scanning a QR code.

It’s still early days for dapps, so DeFi users should do their research on new products and services. Like any computer code, smart contracts can be vulnerable to both unintended programming mistakes and malicious hacks.

Stablecoin and Decentralized Reserve Bank: MakerDAO

Maker is a stablecoin project where each stablecoin (called DAI) is pegged to the US Dollar and is backed by collateral in the form of crypto. Stablecoins offer the programmability of crypto without the downside of volatility that you see with “traditional” cryptocurrencies like Bitcoin or Ethereum.

You can try creating your own DAI stablecoin on the Maker Oasis dapp. Maker is more than just a stablecoin project, though–it aspires to be a decentralized reserve bank. People who hold a separate but related token, MKR, can vote on important decisions like the Stability Fee (similar to how the Federal Reserve’s Federal Open Market Committee votes on the Fed Funds rate).

Another stablecoin with a different architecture is USD Coin (USDC), where every USDC token is backed by one US dollar held in an audited bank account.

Borrow and Lend: Compound

Compound is a blockchain-based borrowing and lending dapp — you can lend your crypto out and earn interest on it. Or maybe you need some money to pay the rent or buy groceries, but your funds are tied up in your crypto investments? You can deposit your crypto to the Compound smart contract as collateral, and borrow against it. The Compound contract automatically matches borrowers and lenders, and adjusts interest rates dynamically based on supply and demand.

Other popular borrow/lend dapps are Dharma and dYdX. Aggregators like LoanScan track borrow/lend interest rates across the various dapps, so you can shop around for the best rates.

Automated Token Exchange: Uniswap

Uniswap is a cryptocurrency exchange run entirely on smart contracts, letting you trade popular tokens directly from your wallet. This is different from an exchange like Coinbase, which stores your crypto for you and holds your private keys for safekeeping. Uniswap uses an innovative mechanism known as Automated Market Making to automatically settle trades near the market price. In addition to trading, any user can become a liquidity provider, by supplying crypto to the Uniswap contract and earning a share of the exchange fees. This is called “pooling”.

Other popular Decentralized Exchange platforms (DEXes) include 0x, AirSwap, Bancor, Kyber, IDEX, Paradex and Radar Relay. All have slightly different architectures.

Prediction Markets: Augur

Augur is a decentralized prediction market protocol. With Augur, you can vote on the outcome of events, except you put ‘skin in the game’ by attaching a value to your vote. Prediction market platforms like Augur and Guesser are nascent, but offer a view into a future where users can make better predictions by tapping into the wisdom of the crowd.

Synthetic Assets: Synthetix

Synthetix is a platform that lets users create and exchange synthetic versions of assets like gold, silver, cryptocurrencies and traditional currencies like the Euro. The synthetic assets are backed by excess collateral locked into the Synthetix contracts.

No-loss savings games: PoolTogether

The composability of DeFi lends itself to infinite new possibilities. PoolTogether is a no-loss game where participants deposit the DAI stablecoin into a common pot. At the end of each month, one lucky participant wins all the interest earned, and everyone gets their initial deposits back.

So what’s next for DeFi?

Money and finance have been around in one form or the other since the dawn of human civilization. Crypto is just the latest digital avatar. In upcoming years, we might see every financial service that we use in today’s fiat system being rebuilt for the crypto ecosystem. We’ve already seen asset issuance and exchange, borrowing, lending, custody, and derivatives built for crypto. What’s next?

The first generation of DeFi dapps rely heavily on collateral as a safeguard. That is, you need to already own crypto and provide it as collateral in order to borrow more crypto. More traditional unsecured borrowing and lending will need to rely on an identity system, so that borrowers can build up credit and increase their borrowing power, much like today’s SSN and FICO scores. Unlike today’s identity and credit systems however, a decentralized identity will have to be both universal and privacy-preserving.

We’re also seeing innovation in the insurance space. Many of today’s DeFi loans are overcollateralized (meaning that loans seem inherently safe because of the generous cushion of assets held in reserve). But the black swan for DeFi is smart contract vulnerabilities. If a hacker finds and exploits a bug in the open source code for a dapp, millions of dollars could be drained in an instant. Teams like Nexus Mutual are building decentralized insurance that would make users whole in the event of smart contract hacks.

Another trend we’re seeing is better user experience. The first generation of dapps was built by blockchain enthusiasts for blockchain enthusiasts. These dapps did a great job of demonstrating exciting new DeFi possibilities, but the usability left something to be desired. The latest iterations of DeFi apps are prioritizing design and ease of use in order to take open finance to a wider audience.

In the future, we expect that crypto wallets will be the portal to all your digital asset activity, just like an internet browser today is your portal to the world’s news and information. Imagine a dashboard that shows you not just what assets you own, but how much you have locked up in different open finance protocols–loans, pools, and insurance contracts.

Across the DeFi ecosystem, we’re also seeing a move towards decentralizing governance and decision-making. Despite the word “decentralized” in DeFi, many projects today have master keys for the developers to shut down or disable dapps. This was done to allow for easy upgrades and provide an emergency shutoff valve in case of buggy code. However, as the code becomes more battle-tested, we expect developers will give up these backdoor switches. The DeFi community is experimenting with ways to allow stakeholders to vote on decisions, including through the use of blockchain-based Decentralized Autonomous Organizations (DAOs).

Something magical is happening in the open financial system — crypto is bringing money online, and we’re seeing a quantum leap in what’s possible when it comes to the functionality of money. It’s a rare opportunity to see an entirely new industry blossom from scratch. The DeFi space will at first play catch up with today’s financial services industry. But over time, it’s hard to even fathom what innovations will come about when the power to build financial services is democratized to anyone who can write code.

More resources

If you’d like to dive deeper into the DeFi rabbithole, here’s a list of resources you might find helpful

  • DeFi Pulse
  • DeFi Prime
  • Introducing USDC
  • Stablecoin Stats
  • Decentralized Lending

Help us build an open financial system

If you’re inspired by the potential of a new financial system that serves everyone, everywhere, get in touch. We’re hiring!

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A Beginner’s Guide to Decentralized Finance (DeFi) was originally published in The Coinbase Blog on Medium, where people are continuing the conversation by highlighting and responding to this story.