By Molly Cyrus 
Introduction
The financial world has witnessed tremendous change through various technological innovations over the last ten years. In spite of many innovations that changes things most fundamentally is DeFi Decentralised Finance. DeFi refers to a revolution in how we use and access financial systems including blockchain that enables open permissionless decentralised alternatives to traditional financial services.
While traditional finance relies on the presence of central institutions which include banks brokerage firms and clearing houses the basis of DeFi stems from blockchain networks in general and in this case from Ethereum the functionality provided by smart contracts. DeFi eliminates intermediaries and enables peer to peer transactions and any financial services through DApps.
We have created this all inclusive guide deep into various aspects of DeFi its technological foundation its main components advantages challenges and its potential to evolve and revolutionise the financial world.
What is Decentralised Finance?
Decentralised Finance or DeFi is a finance environment that’s built on blockchain. In this environment users can avail themselves of finance services without having to rely on intermediaries which include banks payment processors or brokerage firms. The functioning of DeFi is through decentralised applications or DApps and smart contracts which would allow a user to trade lend borrow save and invest in completely decentralised manners.
It refers to a decentralised open financial system that is accessible to everyone solely based on geographical location by no one and wealth and history in terms of finance. It eliminates the need for trusted third parties based on cryptographic protocols enforcing rules and automating operations in a safe transparent and efficient manner.
Technological Base Blockchain
Under pinning the concept of DeFi sits blockchain technology which is a distributed ledger tracking transactions across a network of computers. Since blockchain is decentralised no single authority controls the network so it should be inalienably transparent and resistant to censorship. Among all the blockchains Ethereum is the most widely adopted one and is fundamentally employed to perform DeFi because it can execute smart contracts or self executing contracts wherein the terms of an agreement are directly written into code.
The decentralised network of Ethereum has enabled developers to design sophisticated financial applications that are capable of being executed automatically and transparently in a secure manner. Among the various features provided by the blockchain that power DeFi are
Transparency
Every transaction and all activities can be verified publically on the blockchain.
Security
The transactions are cryptographically secured so that they cannot be altered or modified.
Immutability
Once a transaction gets onto the blockchain it can never be changed or reversed.
Permissionless
Any person with access to the internet can join DeFi protocols and access it. The backbones of DeFi are known as smart contracts. These are self executing runs on blockchain networks thereby automatically enforcing the terms and conditions of an agreement. Thus the entire process of intermediaries is eliminated as once the conditions are fulfilled the contract is fulfilled without human interference.
For example a lending protocol smart contract automatically makes deposits to a borrower in case of sufficient collateral provision. DApps are transparent and open source and therefore secure to provide trust and reliability within the DeFi system.
DApps
DApps are decentralised applications that run on blockchain networks. They also allow interaction with users when accessing DeFi services. While traditional apps run on central servers DApps run on a blockchain providing much more secure censorship resistant environments and much more transparency. DApps provide an easy way to access services involving Lending borrowing trading and staking without any intermediaries. Popular DeFi DApps include
Uniswap
This is a decentralised exchange DEX from which users can swap tokens without any intermediary.
Aave
Lending and borrowing protocol that pays yields for deposits and users can borrow assets by offering collateral.
Maker DAO is a decentralised service that issues stablecoins like DAI and offers the possibility of taking out loans using crypto as collateral.
Stablecoins
Stablecoins are part of the architecture of the latter in the DeFi ecosystem. These are cryptocurrencies designed with stable values and they often peg to traditional fiat currencies such as the US dollar. The stability of stablecoins gives users an opportunity to interact with DeFi without exposing them to volatility that is generally associated with cryptocurrencies.
Types of stablecoins
Fiat Collateralized Stablecoins
These are kept against a reserve of fiat currency. Example USDC USDT.
Cryptocurrency Collateralized Stablecoins
They are supported by a reserve of other cryptos. Example DAI.
Algorithmic Stablecoins
These depend on algorithms to maintain a stable price without direct support from other assets. Example Ampleforth.
Stablecoins can serve a variety of functions within DeFi such as liquidity provision easier trades and stable value at volatile times in markets.
Liquidity Pools
Liquidity pools are what make DeFi work. In decentralised exchanges like Uniswap a liquidity provider is an LP that offers a pool of tokens to traders so they can trade using them. They receive fees generated from these transactions for the provision of liquidity.
Liquidity pools backup AMM where the price is determined algorithmically with a proportion of assets in the pool. Unlike the traditional finance system it does not have an order book nor does it have a centralised exchange in its standard form but it supports continuous trading without central authority.
Use Cases and Applications of DeFi
Decentralised Exchanges (DEXs)
Decentralised exchanges often abbreviated to DEXs are systems that allow users to trade cryptocurrencies directly without the interference of some central authority. Since it is noncustodial users remain in control of funds throughout the process. This is in contrast to centralised exchanges where users deposit funds into an exchange wallet controlled by the platform like Binance or Coinbase. Some of the most popular decentralised exchanges are
Uniswap
This is one of the most widely used DEXs based on the AMM model.
Sushi Swap
This is a community driven DEX that is also based on the AMM model.
Curve Finance
A stablecoin trading DEX characterised by low fees and slippage. DEX provides users with an upper hand over traditional exchanges in a number of ways such as
Higher Security
Because the users have complete control over their funds there is a reduced risk of hacking or theft.
Resistance to Censorship
DEXs operate on decentralised networks and thus an authority such as the government cannot halt or turn down such operations.
Accessibility Globally
All traders can access trading over the internet with no limitations of geographical and regulatory boundaries.
Lending and Borrowing
The DeFi lending sites enable lenders to upload their cryptocurrencies and earn interest or allow borrowers to draw funds by providing collateral. Unlike the traditional lending process which relies on a centralised institution DeFi lending occurs through smart contracts where the entire process is automated. Some of the Top DeFi Lending Sites such as
Aave
This facility allows the users to lock their assets in liquidity pools. They can lend it out to earn interest and allow users to borrow against collateral.
Compound Similar to Aave
Compound lets users lend and earn interest on their crypto holdings by lending crypto assets to the protocol.
Maker DAO
By locking up some Ethereum or another accepted cryptocurrency as collateral users can borrow.
Advantages of DeFi Lending and Borrowing
No credit checks
Since a form of collateral secures all loans there is no need for credit checks and the necessary sanctions.
Instant Transactions
Loans and repayments are automatically executed using smart contracts.
Terms are clear the blockchain contains the terms of interest and loans therefore transparent.
Yield Farming and Liquidity Mining
Yield farming is another way in which the reward can be earned by giving liquidity to the DeFi platforms. Users deposit their assets into the liquidity pools and the same becomes used for trading lending or borrowing. In return users earn interest or governance tokens as rewards.
Liquidity Mining
It is the type of yield farming in which users are rewarded with tokens of the protocol they use to give their liquidity.
In 2020 yield farming became more and more in vogue during the so called DeFi Summer and is connected with attractive rewards provided by protocols like Yearn Finance and Sushi Swap. Nevertheless yield farming is also dangerous using totally volatile prices and especially leveraging impermanent loss it becomes a real challenge to navigate between various protocols.
Decentralised Insurance
DeFi has managed to find a niche in the insurance sector as decentralised platforms offer products such as risks tied to smart contract failure hacks or protocol exploitation. Users can purchase their policies directly from decentralised platforms. The claims are handled by smart contracts with no scope for bias or manipulation. Some of the most popular decentralised insurance platforms are
Nexus Mutual
Coverage against the risk of smart contract failure hacks or protocol exploitation.
Cover Protocol
It provides coverage for numerous DeFi protocols and events.
Decentralised insurance would potentially be more transparent and accessible than traditional forms of insurance but it is in a very nascent stage.
Synthetic Assets
Synthetic assets are tokens that mimic the value of an underlying realworld asset such as stocks commodities or even fiat currencies. These assets allow users to gain indirect access to traditional financial markets without having to hold the actual asset directly.
For example a DeFi application can be created to produce a synthetic token that reflects the price of Apple stock where users trade this on a decentralised exchange. This is forming part of the new frontiers for international investors in accessing financial products that were previously out of reach by geographical and regulatory boundaries.
The leading player in the creation and trading of synthetic assets in the DeFi space is Synthetix.
Advantages of DeFi
Accessibility
One of the most popular advantages of DeFi is its ability to be accessible. Traditional financial systems often leave out huge segments of the global population because of geographical economic or regulatory barriers. DeFi however operates on a permissionless basis. This means anybody with an internet connection is free to access and use DeFi services.
This can be very transformative for those in developing economies or areas not able to access much banking. DeFi avails new opportunities for financial inclusion and economic empowerment by access to saving lending insurance and investment.
Transparency and Trustlessness
In the traditional finance system trust is inserted by relying on centralised institutions that can be opaque and susceptible to corruption mismanagement or failure. DeFi eliminates the need to rely on any degree of trust while executing operations on transparent and public blockchains where every transaction takes place with all transactions being observable and verifiable.
Smart contracts automate the enforcement of rules and ensure there are no errors by humans in its enforcement. Agreements executed are thus made with greater guarantee and assurance in this trustless nature of DeFi reducing the risk of counterparty and increasing the safety and reliability of financial services.
Cost Efficiency
DeFi cuts costs mainly by eliminating the intermediaries and automating process flows with the help of smart contracts. In a traditional financial system intermediaries such as banks and payment processors charge high fees for these services. Often transactions may slow down with accompanying cost increases on the other hand the cost and by extension every financial service is dramatically decreased in DeFi.
Financial Innovation
DeFi enables fast innovation for financial products and services. Traditional finance is said to be very conservative with a very slow adoption of any form of new technologies or innovative products as opposed to DeFi which runs in an open and dynamic environment where developers create fast protocol and application development.
These include but are not limited to automated market makers (AMMs) flash loans and synthetic assets all of which represent just a few examples of groundbreaking financial products made possible by DeFi.
Risks and Challenges of DeFi
Smart Contract Vulnerabilities
Smart contracts automate procedures and eliminate human error. Nevertheless risks remain. Bugs or vulnerabilities in the code of a smart contract mean that hackers can take control and steal money. Several hacks of DeFi hacks and exploits have been reported due to flaws in smart contract code.
For example in early 2020 a protocol called bZx was hacked not just once but twice within days due to vulnerabilities in its smart contract code. It lost nearly $1 million in crypto assets.
Regulatory Uncertainty
DeFi functions in a rather non regulated environment that has in a sense elicited anxiety from governments and other regulatory bodies. Because DeFi functions in a decentralised manner it brings about many unknowns for regulators in enforcing the already existing laws and therefore uncertainty as to the future regulatory landscape.
Governments could introduce tight regulations to curb money laundering and fraud among others to nefarious practices with DeFi. However this could suffocate innovation and the full potential of DeFi to truly revolutionise the financial sector remains an incomplete dream.
Liquidity and Scalability Issues
Even though DeFi continues to grow exponentially the problems of liquidity and scalability are yet to be solved. Most DeFi protocols are based on liquidity pools and hence when the liquidity of such pools is low the user may have to suffer from high slippage or possibly fail to carry out his desired trades.
The other issue is scalability. The blockchains of Ethereum for example can become congested if there is high demand at certain times and this could lead to slow transaction times and a high price in gas charges that disincentivize participation.
Impermanent Loss
Impermanent loss refers to the risk experienced by liquidity providers in a DeFi protocol whereby the price of assets deposited in a liquidity pool has shifted significantly since its deposit. This puts users in a position where they tend to lose value for the assets locked in it compared to if they had not contributed to the pool in the first place.
Impermanence loss is a major risk for liquidity providers it can offset any reward related to providing such liquidity.
User Experience and Complexity
One critical disadvantage to DeFi however is that it can be complex and intimidating to those just beginning to use it. The creation of wallets interaction with DApps and risk assessments surrounding smart contracts all contain layers of technical complexity. Most often this raises the difficulty of entry for users to use DeFi especially if they are less familiar with blockchain technology.
Great effort is being put into improving the user experience and making DeFi more accessible but there is still much work to be done in this area.
Future of DeFi
Layer 2 Solutions
One of the major development directions in DeFi will be the adoption of Layer 2 solutions. These are protocols stacked on top of the already existing blockchain network to improve scalability and reduce transaction costs. Solutions like Optimism and Arbitrum offer faster and cheaper transactions at the expense of a little less security compared to the underlying blockchain.
As DeFi continues its scaling trajectory Layer 2 will ensure that the ecosystem scales for hundreds of millions of users without some loss of those safety and decentralisation characteristics.
Interoperability and Cross Chain DeFi
Interoperability would be another critical issue. Today almost all DeFi activity takes place on Ethereum but other blockchains like Binance Smart Chain (BSC) Polkadot and Solana exist with alternative ecosystems. Asset and liquidity movement between these different blockchain networks will be the key to more growth and adoption in DeFi.
Projects such as Cosmos and Polkadot are working towards establishing an interoperable blockchain ecosystem that can easily allow the movement of assets and data between different networks. Cross Chain interoperability will give users wide avenues of DeFi services while contributing to liquidity across the ecosystem.
Decentralised Governance
DeFi also spearheads decentralised governance models in which decisions about protocol will be made by the users rather than by a central authority. Governance tokens give users voting rights and allow them to vote on proposals that they develop for changes in a protocol.
As the world of DeFi continues to mature decentralized governance will increasingly be an important component of that ecosystem users will be able to have greater control over which direction protocols are being taken.
Conclusion
The most promising innovation and disruption in the financial world is definitely Decentralised Finance or DeFi. Leveraging blockchain technology smart contracts and decentralised applications DeFi is opening the financial system so it can be transacted provided and accessed way more openly and transparently than before. Its promise is thereby full financial inclusion cost efficiency and transparency a promise that would disrupt the traditional financial system and empower every individual around the world.
But DeFi is fraught with challenges. Vulnerabilities in smart contracts regulatory uncertainty and the complexity of the entire ecosystem all need to be solved in order for DeFi to unlock the truest potential. Furthering progress in this space should be ushered in by improving scalability interoperability and decentralised governance.