Decentralized finance (DeFi) is a relatively new concept that eliminates financial intermediaries like banks, brokerage firms, exchanges, etc., allowing two parties to carry out transactions through blockchain-powered smart contracts. By eliminating third parties or middlemen, decentralized finance allows transacting parties to enjoy faster and low-cost transactions.
DeFi vs CeFi
As in the above illustration, conventional financial systems are fully centralized. Individuals and businesses rely on banks which in turn depend on payment processors to facilitate cross-border money transfers. This increases turnaround time and incurs an extra cost for the transacting parties.
Other factors, such as downtime, can further affect the efficiency of centralized financial systems. Decentralized finance arrests these shortcomings by allowing peer-to-peer transactions. Senders can interact directly with receivers in a secure, transparent, and permissionless manner.
DeFi-enabled transactions run on programmable smart contracts (usually on blockchains like Ethereum and, recently, Binance Smart Chain), leaving no room for manipulation or any form of external interference.
DeFi in 2021
DeFi exploded late last year and in the first half of the year, riding on the upward trend with bitcoin and altcoins. Google trends show that interest over time for the term “DeFi crypto” reached 100 in May this year, its highest ever. In the same period, the total value locked (TVL) in DeFi smart contracts also skyrocketed to an all-time high of $80 billion according to DeFi data aggregator, DataPulse.
Many have likened the frenzy surrounding DeFi to that of the ICO boom in 2017 and 2018. However, unlike the latter which was riddled with scams, DeFi has shown its capacity to revolutionize finance through its various applications.
Major DeFi Applications
Decentralized exchanges (DEX): Decentralised exchanges are one of the most popular innovations of decentralized finance. They permit the exchange of cryptocurrencies without an intermediary.
Rather than the custodial order book approach which matches sell orders with corresponding buy orders and vice versa, decentralized exchanges adopt the automated market maker (AMM) method. The AMM relies on individuals referred to as liquidity providers to contribute liquidity to a particular trading pair in exchange for rewards. Through the liquidity pool, traders can swap tokens in a trustless and permissionless manner.
Because of their low listing fees and reliability, DEXs have become the top choice for DeFi projects and traders. In fact, some of the leading decentralized exchanges like Uniswap and Pancakeswap now compete toe-to-toe with centralized exchanges in terms of the trading volume.
Yield farming: Yield farming (also referred to as liquidity mining) presents a means for cryptocurrency holders to borrow, lend or stake their idle crypto holdings and earn interests on them. As a form of lending, yield farmers usually contribute cryptocurrencies to liquidity pools on decentralized exchanges to facilitate trading. As a reward, they receive a percentage of transaction fees.
Since the stablecoin-based DeFi lending platform, MarketDAO kick-started liquidity mining by demonstrating how users can easily access loans without the hassles on centralized platforms, a slew of newer lending platforms have aped into the market share. Yield farming is regarded as one of the major drivers of DeFi growth and is widely credited for the rise in market cap from $500m to $10 billion last year.
Other notable applications are DeFi derivatives, asset management, insurance, tokenization, savings, etc.