PYMNTS DeFi Series: What Is DeFi?

Welcome to the first of PYMNTS’ eight-part series on decentralized finance (DeFi).

Over the coming days, we’ll be looking at every part of DeFi — the biggest, hottest, most rewarding and risky part of the blockchain revolution.

At the end of it, you’ll know what DeFi is, how it works, and the risks and rewards of investing in it.

So, what is DeFi? Well, first, DeFi is red hot. It is the most promising — and problematic — part of cryptocurrency FinTech.

There is more than $107.6 billion locked in DeFi. In January 2020, that number was $10.67 billion.

More prosaically, DeFi is a peer-to-peer (P2P) financial service that has little, if anything, in the way of intermediaries.

In some ways, it is the purest form of blockchain. Blockchain technology began with the bitcoin white paper written by the anonymous Satoshi Nakamoto. Its first line describes bitcoin as a “purely peer-to-peer version of electronic cash [that] would allow online payments to be sent directly from one party to another without going through a financial institution.”

In other words, no bankers, no credit card issuers, no payment processors, really no financial middlemen at all. At least in theory.

DeFi encompasses nearly everything you can do at a bank or brokerage house with regular old (non-crypto) currency: send or receive it, borrow or lend it, and keep it in interest-bearing accounts. You can trade crypto assets, buy and sell derivatives like options and futures, and hold onto it on the assumption that it will increase in value.

That last one can be a good bet — if you pick right. Bitcoin (BTC) is up a mere 94% in 2021, but ether (ETH) is up 522%. However, Solana (SOL) is up nearly 13,000% and Polygon (MATIC) about 11,700%. And they’re not close to the biggest winners.

Code Is Law

DeFi apps work using smart contracts, which are self-executing contracts. That means there is no intermediary or third person to decide if a contract has been fulfilled. When a smart contract is created, the parties read the terms, and the necessary cryptocurrency for payment is locked into it. There is no backing out, no changing the terms, and no one to declare it unfair. There’s also no one to repair a poorly written smart contract.

The industry term is “code is law,” and it is why DeFi is the ultimate platform for caveat emptor — let the buyer beware.

Smart contracts were invented on ethereum, the second-largest cryptocurrency by market cap, and the vast majority of DeFi platforms run on it. So do most nonfungible tokens (NFTs), which is why ethereum is overloaded, barely able to handle all of the DeFi transactions made on it. It’s also why smart-contract platform tokens that are designed to fix it (Polygon) or replace it (Solana) have been growing so fast.

With DeFi, according to the Ethereum Foundation, “the markets are always open, and there are no centralized authorities who can block payments or deny you access to anything.”

There’s also not much in the way of policing, which is a problem because DeFi platforms are particularly susceptible to hackers. In August, a hacker stole $612 million in funds from the DeFi blockchain Poly Network (no relation to Polygon) — the largest cryptocurrency hack ever. The fact that the hacker returned it all a few days later made it an outlier. Cream Finance was not so lucky, losing $150 million in two separate attacks.

While all DeFi protocols are created by centralized groups, virtually all seek to become decentralized autonomous organizations (DAOs).

DAOs (in theory) have no centralized governance at all, with all decisions — whether it’s to change an interest rate or implement a code update — made by token holders. That also makes implementing legal requirements like anti-money laundering (AML) rules problematic.

Top DeFi Applications

Decentralized exchanges (DEXs): The same as any other crypto exchange, except that there’s no company operating it, and cryptocurrency transactions are fully P2P.

Borrowing/Lending platforms: Lenders can lock cryptocurrency into these platforms to earn interest, while users can borrow stablecoins by putting up collateral — 150% of the amount borrowed is common to account for price volatility. The point is to get funds out of crypto holdings without selling your bitcoin (or whatever) that you believe will continue to grow in value.

Wrapped cryptocurrencies: By wrapping bitcoin, you lock it into a platform that gives a token usable on ethereum. You get the bitcoins back by returning them. There are many variations on the tokens that can be wrapped.

Stablecoins: While most stablecoins keep their value by holding a one-to-one basket of fiat currency, algorithmic stablecoins can do this by automatically minting or buying and burning coins to keep the value at $1.

Yield farming: Lending out cryptocurrency to a DeFi protocol that puts it in a lending pool in order to earn interest. These can get very complex.

Next up: What Are the Top DeFi Platforms?

The projects we’ll be looking at include Curve, Compound, Sushi and PancakeSwap. And if those names don’t sound too serious, know that there are billions of dollars locked in that list.

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