What is DeFi? A Decentralized Finance 101

Decentralized finance, or DeFi, is the ecosystem of financial applications being built with blockchain technology and without banks.

Money lives in cages:

Each financial system is locked within its own geographical borders and even then only some can access it. It’s also a system built on top of ancient technology; all the money transmitting protocols are messaging systems invented in the 1970s.

DeFi is setting it free.

And they way it’s doing so is replacing those outdated rails with the public blockchains, which are global, distributed, and decentralized networks specifically made to transfer value without the need of intermediaries.

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DeFi in Crypto: Origins of the Term

The term DeFi was born in an August 2018 Telegram chat between Ethereum developers and entrepreneurs including Inje Yeo of Set Protocol, Blake Henderson of 0x and Brendan Forster of Dharma.

They were discussing what to call the movement of open financial applications being built on Ethereum. Other options considered were Open Horizon, Lattice Network and Open Financial Protocols. Henderson said DeFi worked well, as it “comes out as DEFY.”

? Today marks the 1st year since #DeFi was conceptualized



It’s inspiring to see all of the progress that’s been made by everyone in just a year



This was a brainstorming session including @brendan_dharma, @HendoVentures, and me when we were deciding what to call the movement
? pic.twitter.com/mkjaWeYYB4



— Inje Yeo ◐ (Set) (@injeyeo) August 1, 2019

So, What Is DeFi?

1. Non-Custodial

Non-custodial distributed networks allow people to have control over their own assets and data and for value to be transferred from one person to another, without the need to use intermediaries like banks and other financial institutions.

Users are the only ones who hold the keys to their wallets and control their funds. The term used to describe this feature is that DeFi apps are “non-custodial,” as no third parties have custody of your assets — you do.

This reduces the risk of censorship and losing money in one of the many hacks suffered by centralized exchanges, but it also means individuals have a huge responsibility on their shoulders and often no recourse if something goes wrong (for example, losing your seed phrase).

2. Open

In these open networks, there are no borders in this parallel financial system and everyone can access it. It’s like the internet, but instead of information being transferred globally, seamlessly and creatively, the same is happening with money. It’s an internet of value.

All that’s needed is a blockchain wallet and an internet connection to start interacting with DeFi applications. They won’t ask for users’ personal information; not even a username and password is needed to join. your identity is the jumble of letters and numbers that make up your blockchain address.

3. Transparent

Transparency is key within these networks. The code for these financial applications is open for anyone to see and inspect. This is important because anyone is able to verify how the applications and protocols work, and track exactly where their money is.

Open-source code also enables developers to build on top of existing applications, accelerating innovation and creating an interconnected ecosystem that leverages the strengths of each piece, it’s why all the different DeFi protocols and assets are often referred to as “money legos.”

Transparent code also means developers are free to copy applications and build near replicas, that improve on some aspect of the original. For example, if a platform is raising fees, users are free to copy and create an identical application, with lower fees. The model takes competition to an extreme, forcing builders to deliver the best possible product.

4. Decentralized

Decentralized finance protocols are, of course, decentralized, built on public blockchains like Ethereum. These blockchains, the rails to this new financial system, are run by thousands of nodes –computers running the blockchain’s software– spread out across the globe, so that it’s almost impossible to censor or stop them.

On top of this base layer of decentralization, DeFi platforms are built to be managed by a community of users, and not centrally controlled. Users become owners of their financial applications; they’re able to participate in major decisions, including by proposing changes themselves, and benefit from their growth and success. The goal is that no centralized party can unilaterally take control of funds or change the rules of the game.

Open Finance

In open finance, most DeFi applications don’t meet all of the characteristics listed above. Ironically, considering the name DeFi, the decentralized aspect is the hardest to meet. Completely relinquishing control of an application makes it harder for developers to quickly react if there’s a problem, since they can’t unilaterally make changes to it without going through community consensus. This is hard for applications which are still at very early stages of development, so teams will often maintain some degree of control over their protocols.

Decentralization is a spectrum, and while not all DeFi apps are at the most decentralized end, they are working to get there with teams gradually relinquishing control over their protocols.

Rather than decentralization, the main characteristic which most DeFi protocols meet and has come to define the ecosystem is that these applications are open for anyone to access. All users need is an internet connection and a blockchain address. That’s why the term “Open Finance” is often used instead of DeFi.

DeFi History

One could argue that DeFi started with Bitcoin in 2009. BTC was the first-ever peer-to-peer digital money; the first financial applications built on blockchain technology.

But the turning point for financial applications allowing users to do more with their money than send it from point A to point B happened in December 2017, when MakerDAO launched.

MakerDAO

MakerDAO is an Ethereum-based protocol that allows users to issue a cryptocurrency that’s pegged at 1-to-1 to the value of the U.S. dollar by using digital assets as collateral. This mechanism effectively allowed anyone to borrow the Dai stablecoin against Ether (Ethereum’s native cryptocurrency). It created a way for anyone to take out a loan without relying on a centralized entity. It also created a dollar-pegged digital asset, which didn’t rely on holding dollars in a bank, like USDC, USDT and other stablecoins.

The MakerDAO lending protocol and its Dai stablecoin provided the first building blocks for a new, open, permissionless financial system. From there, other financial protocols launched, creating an increasingly vibrant and interconnected ecosystem. Compound Finance, released in September 2018, created a market for borrowers taking out collateralized loans, and lenders to rake in interest rates paid by those borrowers. Uniswap, launched in November 2018, allowed users to seamlessly and permissionlessly swap any token on Ethereum.

Just the Beginning for DeFi

Less than three years after MakerDAO placed the first money lego, there are now dozens of DeFi applications, from basic use-cases like enabling lending, borrowing, trading, to crazier ones like creating synthetic assets, streaming payments and playing in a lottery where you can always get your money back.

Assets held in these platforms’ smart contracts climbed to surpass $1 billion, then quickly $2, $3 and $4 billion and $10 billion just this year. It’s clear we’re just getting started.