Also known as DeFi is a collective term for financial products and services on public blockchains enabling anyone to use financial services anywhere. Unlike centralized finance, also known as CeFi, DeFi is not dependent on centralized authorities for its operations but uses smart contracts. "Smart contracts" are programs running on the blockchain that can execute automatically without a third party when certain conditions are met. Smart contracts allow developers to build far more sophisticated functional applications that goes beyond sending and receiving cryptocurrencies. These programs are called decentralized applications (DApps).
Differences between DeFi and CeFi
- DeFi applications do not depend on centralized authorities for its operation, instead the DApp follows the rules written in the smart contract. Once the smart contract is deployed on the blockchain, it is immutable and will run by itself with little to no human intervention (although in practice developers often do maintain the DApps with upgrades or bug fixes).
- The code is transparent and open on the blockchain for anyone to audit. This allows anyone to understand the contract's functionality or find bugs thus creating trust between the code and the user. These smart contracts are typically open source and when verified can be found on the corresponding block explorer.
- DApps are designed to be open for anyone around the globe giving users access to the same DeFi services and products.
- DeFi is permissionless allowing anyone to create DeFi applications and use them. This provides users with full control over their assets giving a greater degree of freedom and individual responsibility for the management of funds. Users interact directly with the smart contract from their crypto wallet.
- DeFi is interoperable as new applications can be built or composed by combining other DeFi products to create entirely new products.
A key concept for DeFi investors is to DYOR (Do Your Own Research) in order to ensure they understand what a DeFi protocol is, how it works, and the risks involved in using the protocol.
Kinds of protocols
A DEX (short for Decentralized Exchange) is a DApp used to allow exchanges (AKA swaps) between different cryptocurrencies. The most famous and best known DEX is Uniswap and it was the first to introduce the AMM model. Other DEX designs use the orderbook model, which makes them more similar to their centralized counterparty. A DEX is thought to be the central protocol in a DeFi ecosystem and all the other DApps rely on one or multiple DEXs to attract liquidity and gain market share.
A money market is a place where users can lend out their assets, earn an interest and use them as collateral to take out loans in a decentralized, trustless and permissionless manner. The most famous money markets are Aave and Anchor and they are at the core of DeFi liquidity. Money markets are also essential in a DeFi ecosystem since they allow to unlock liquidity and let users participate in all the different DeFi protocols with borrowed funds.
Yield farm is a general term which indicates any protocol that provides interest earning to its users. The mechanisms through which these interests are paid vary widely among different protocols but yield farms are the main reason why DeFi has gained such traction: they offer much higher interest compared to traditional finance. An honorable mention is made to Compound Finance which, in the summer of 2020, kick started yield farming through its COMP incentives liquidity mining program. This later caused dozens of other protocols to do the same and the subsequent period is known as DeFi summer 2020.
The financial derivatives market is a huge portion of the traditional finance world. It is still pretty small in DeFi, but many protocols are beginning to offer derivatives trading like perpetuals or options.