Analyses
03
May
crypto market overview

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DeFi (Decentralized Finance) explained

Decentralized Finance, or DeFi, is a term used to describe a new financial system that operates on decentralized blockchain technology. The roots of DeFi can be traced back to the launch of Ethereum in 2015, which introduced smart contract functionality to the blockchain world.

DeFi is built on a foundation of core infrastructure that includes building blocks such as smart contracts, stablecoins, and oracles. DeFi applications can be grouped into several categories, including decentralized exchanges, lending and borrowing platforms, stablecoins, liquid staking, and bridges.

While DeFi has experienced remarkable growth and success, it also faces several challenges that need to be addressed. DeFi has already made significant strides in revolutionizing the financial markets, but the future holds even greater potential for its growth and impact.

What is DeFi?

Decentralized Finance, or DeFi, is a term used to describe a new financial system that operates on decentralized blockchain technology. DeFi represents a paradigm shift in how financial systems are structured and operated. DeFi eliminates the need for centralized intermediaries and promotes greater accessibility and transparency for all participants.

DeFi is built upon the principles of decentralization, transparency, and inclusivity. By eliminating the need for intermediaries like banks, DeFi empowers individuals, especially those in underdeveloped regions, to access financial services.

Leveraging the transparency and decentralization of blockchain technology, DeFi applications are open to anyone with an internet connection and a Web 3 wallet, such as MetaMask. These applications are transparent, meaning that they are open for anyone to audit, and decentralized, meaning that they operate on a peer-to-peer basis without any central authority.

defi metamask

Smart contracts are the foundation of DeFi applications. These programs are stored on the blockchain and are publicly accessible for anyone to review. Smart contracts eliminate the need for human intervention, reducing errors and ensuring that every command is executed as intended.

With DeFi, individuals can participate in a wide range of financial activities, including lending, borrowing, trading, and earning interest, all while retaining full control over their assets. Transactions on DeFi platforms are conducted on the blockchain, ensuring that they are secure and transparent.

In recent years, the DeFi space has seen explosive growth, with new projects and applications emerging on a regular basis. The Most popular DeFi apps are built on Ethereum, but other smart contract platforms, such as BNB Chain, Cardano, Tron, and Solana, are also gaining traction.  As the DeFi ecosystem continues to evolve, it has the potential to revolutionize the financial industry and provide individuals with greater control over their financial lives.

The history of DeFi

The roots of DeFi can be traced back to the launch of Ethereum in 2015, which introduced smart contract functionality to the blockchain world. Smart contracts are self-executing programs that enable fully automated, decentralized, applications.

Many would argue that the first DeFi application was MakerDAO, which launched in 2017. It introduced the concept of a decentralized stablecoin, Dai, which is pegged to the US dollar.

maker dai

Other notable DeFi projects that emerged in the following year (2018) include Compound and Uniswap. Compound introduced the concept of algorithmic interest rates, while Uniswap built the first automated market making (AMM). This made new decentralized exchanges possible.

Despite the early developments, DeFi largely went unnoticed until the first DeFi boom in the spring of 2020. This is when a surge of interest and investment flowed into the ecosystem, leading to explosive growth and the birth of new projects. The total value locked (TVL) in DeFi protocols grew from just over $1 billion in May 2020 to $180 billion in November 2021.

The graph below shows the development of TVL in the DeFi sector. View up-to-date data at defillama.com.

defi tvl

In 2020-2021, DeFi tokens also hit the market and became popular investments. These include tokens such as Aave, Uniswap, and MakerDAO. DeFi coins are mostly governance tokens giving the investor a vote in the decision-making of the project’s future development. DeFi tokens are not needed for using the app or paying transaction fees.

The DeFi boom of 2020-2021 also highlighted some challenges, including scalability issues, high transaction fees, and security vulnerabilities. There have been tens of hacks too in the DeFi apps and infrastructure over the past years that have cost investors billions of dollars.

The DeFi ecosystem has continued to evolve rapidly even if most of the investors (and liquidity) left the industry in the bear market of 2022. New projects have emerged, focusing on areas such as decentralized derivatives, yield farming, decentralized insurance, and more.

Additionally, layer 2 solutions and cross-chain interoperability protocols have been developed to address scalability concerns and enable greater adoption. This is especially a topic related to Ethereum. You can read more about it from our Arbitrum & Layer 2 overview.

The core infrastructure of DeFi

DeFi is built on a foundation of core infrastructure that includes building blocks such as smart contracts, stablecoins, and oracles.

Smart contracts are self-executing computer programs that run on a blockchain. They are the foundation of DeFi, as smart contracts enable the creation of fully automated DeFi applications. Smart contracts make it possible to build apps that don’t require centralized intermediaries or any human interaction.

Stablecoins are cryptocurrencies that are designed to maintain a stable value. They are typically pegged to a fiat currency such as the US dollar. Stablecoins are an important building block of DeFi, as they provide liquidity to all apps.

Since DeFi apps are built on blockchain they don’t have access to traditional banking. This means there are no bank transfers either. Lending, borrowing, and trading wouldn’t be possible without stable fiat currencies. Stablecoins bring US dollars to the world of DeFi. The table below shows the market caps of the five largest stablecoins.

StablecoinTickerMarket cap
Tether USDT $110 billion
USD Coin USDC $34 billion
Dai DAI $5,5 billion
First Digital USD FDUSD $3.6 billion
Ethena USD USDe $2.3 billion

Oracles are third-party services that provide external data to smart contracts, enabling them to interact with the real world. Oracles play a critical role in DeFi, as they provide price feeds and other data necessary for DeFi applications to function effectively.

Chainlink is the leader in the oracle category. It has created decentralized oracle networks, which remove the need to trust a centralized data feed. You can read more about Chainlink from our in-depth beginner’s guide.

These three core infrastructure elements work together to create a robust and decentralized financial system.  The importance of these building blocks cannot be overstated. As DeFi continues to grow and evolve, these core infrastructure elements will remain essential to the industry.

Different types of DeFi applications

DeFi applications can be grouped into several categories, including decentralized exchanges, lending and borrowing platforms, stablecoins, liquid staking, and bridges. Below is a list of the top 5 categories in terms of TVL (total value locked). TVL means the combined liquidity of all the DeFi apps in that category.

CategoryTVL
Liquid staking $17.8 billion
Dexes $17.5 billion
Lending $14.3 billion
Bridge $12.4 billion
CDP $10.1 billion

Liquid staking apps allow users to earn staking rewards without having to lock up their tokens for a specific period, which is typically required in traditional staking mechanisms. Instead, users can deposit their staked tokens into a liquidity pool on a DeFi platform and receive a tokenized version of their stake in return, called a liquidity token.

The liquidity token can be traded or used in other DeFi applications, providing users with more flexibility and liquidity compared to traditional staking mechanisms. The biggest (in TVL) liquid staking DeFi app is Lido. It is also the biggest app in the entire DeFi market.

lido finance

Decentralized exchanges (DEXes) enable peer-to-peer trading of cryptocurrencies without relying on intermediaries. They utilize smart contracts to facilitate transparent and secure transactions. Notable examples include Uniswap, Sushiswap, and PancakeSwap.

Lending and borrowing platforms allow users to lend their digital assets and earn interest or borrow assets by collateralizing their own holdings. Platforms like Aave, Compound, and MakerDAO offer decentralized lending and borrowing services.

DeFi bridges are protocols that enable the seamless transfer of assets between different blockchain networks. These protocols typically use a variety of techniques, such as atomic swaps, cross-chain bridges, and wrapped tokens, to enable the transfer of tokens from one network to another. Wrapped BTC (WBTC) is the most popular example.

Wrapped tokens, such as Wrapped Bitcoin (WBTC), are a popular mechanism used in DeFi bridges to represent a token from one blockchain network on another network. For example, WBTC is a token that represents Bitcoin on the Ethereum blockchain, allowing users to leverage the advantages of both networks.

wrapped btc

Stablecoins in DeFi are often referred to as CDP (collateralized debt position). CDPs are a key component of the MakerDAO protocol, which is one of the most popular DeFi protocols in the ecosystem. The MakerDAO protocol uses a system of CDPs to create Dai, a stablecoin that is pegged to the US dollar, using collateralized debt positions.

Most popular stablecoins (USDT and USDC) are centralized meaning there is a company issuing them and managing the collateral. They are still used a lot on DeFi. Investors prefer so far, a centralized stablecoin over Dai, but this might change in the future.

These are just a few examples of the diverse range of DeFi applications available. You can browse through all DeFi categories at defillama.com.

The challenges of DeFi

While DeFi has experienced remarkable growth and success, it also faces several challenges that need to be addressed. In this chapter, we will explore these challenges. These are the biggest challenges for the DeFi space at the moment:

  • Scalability
  • Regulatory uncertainty
  • Security vulnerabilities
  • User experience

As more users and transactions enter the DeFi ecosystem, blockchain networks, particularly Ethereum, have struggled to handle the demand. This has resulted in congestion and high transaction fees.

Ethereum is tackling this issue with layer 2 solutions, such as Arbitrum and Optimism. They help to move the transaction load from the main chain to layer 2, where transactions are many times cheaper. There is also the ongoing development of the Ethereum main chain as the ecosystem moves toward the Ethereum 2.0 version.

ethereum roadmap

DeFi operates in a relatively unregulated space, and regulatory frameworks are still being developed worldwide. The lack of clear regulations can create uncertainty for DeFi projects and users, potentially hindering adoption. The coming years will reveal whether the governments will attack DeFi or accept it as part of the financial system.

DeFi protocols are built on smart contracts, which can be vulnerable to hacks and exploits. Several high-profile incidents have exposed vulnerabilities within DeFi projects, resulting in significant financial losses. Many would argue that these are the natural growing pains of the industry.

Auditing and security best practices are crucial to mitigating risks, and the development of decentralized insurance platforms provides potential solutions to safeguard against unforeseen events.

DeFi applications can be complex and daunting for newcomers, presenting a barrier to wider adoption. Improving user interfaces and creating more intuitive experiences are vital to making DeFi accessible to a broader audience. User-friendly wallets, simplified onboarding processes, and educational resources are some of the steps being taken to enhance the user experience.

The Future of DeFi

DeFi has already made significant strides in revolutionizing the financial markets, but the future holds even greater potential for its growth and impact. In this chapter, we will explore some potential developments and trends that may shape the future of DeFi.

The most promising trends are:

  • Increased integration with traditional finance
  • Financial inclusion
  • Disrupting traditional financial systems

Institutional investors have begun to take notice of the opportunities presented by DeFi. As regulatory frameworks become more established and DeFi platforms mature, we can expect to see increased participation from institutional players, bringing additional liquidity and credibility to the ecosystem. This could involve collaborations between traditional financial institutions and DeFi projects, as well as the adoption of DeFi principles and technologies within traditional financial systems.

DeFi has also the potential to foster greater financial inclusion by providing access to financial services for individuals who are unbanked or underserved by traditional financial systems. Through decentralized lending, borrowing, and investment platforms, DeFi can empower individuals worldwide to participate in the global economy.

defi inclusion

There are billions of people in third-world countries without access to financial services or even a bank account. DeFi can give these people a chance to grow their wealth and access financial opportunities. Financial inclusion is one of the key advantages of DeFi.

DeFi has the power to disrupt traditional financial systems by removing intermediaries, reducing costs, and increasing transparency. Smart contracts enable the automation of financial agreements, reducing the need for trust in counterparties. This disruption has already started. The question is if the development is allowed to continue by the regulators. Regulatory clarity must be addressed before DeFi can realize its full potential.

Antti Hyppänen

Antti Hyppänen is the founder and editor-in-chief of AboutBitcoin.io. Antti has written articles about cryptos since 2017. He follows the crypto market every day of the year and is responsible for the daily operations of AboutBitcoin. Antti is not a maximalist regarding any cryptocurrency but looks at the industry objectively. Antti’s investment profile is “buy & hold,” i.e., he does not trade or use leverage. His crypto portfolio consists of mainly Bitcoin and Ethereum. Antti also follows macroeconomic events. In addition to cryptos, his interests include gold, silver, and the US stock market.