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DeFi Defined
DeFi, short for decentralized finance, is the ecosystem of financial products, protocols, and applications that run on public blockchain networks.
DeFi is an established, open alternative to traditional financial services, with a range of tools for putting crypto assets to work. It offers opportunities beyond simply buying crypto on a centralized exchange, and lets anyone build a decentralized, Bankless lifestyle.
Why DeFi?
DeFi gives anyone with an internet connection access to sophisticated financial tools: investing, trading, lending and borrowing, and staking.
DeFi offers these tools to users transparently and openly. Anyone can look at the code and verify that the contract does what it says it does, unlike what banks do with your money behind closed doors.
And there is no institution in the middle deciding who gets in: no one can turn you away, freeze your account, or close it down.
Knowledge Check 1
What does DeFi stand for?
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[ ] Digital finance
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[ ] Decentralized finance
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[ ] Deregulation field
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[ ] Decentralized funding
Earning Yield
Many DeFi protocols let you earn interest and other rewards by putting your crypto assets to work. You get access to financial products that would normally require a bank or financial services firm, without the paperwork, approval process, and other hassles of traditional finance.
DeFi is not free: you pay a small network fee for each transaction, and many protocols charge fees too. But these costs are typically lower and fully transparent, there is no bank overhead, and no institution can gatekeep your access or your earnings. This is why DeFi is popular.
Knowledge Check 2
How can you earn yield with crypto?
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[ ] Earning interest by depositing into a DeFi protocol
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[ ] Earning rewards by depositing into a DeFi protocol
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[ ] Both of the above
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[ ] You can’t earn yield on crypto
What You Can Do With DeFi
DeFi transactions are permissionless. This refers to a public blockchain that anyone can use to buy, sell, or trade assets. No third party controls or oversees activity. These transactions are carried out by decentralized applications, known as DApps.
DApps and DeFi platforms operate 24/7, all over the world. Many run on stablecoins, tokens designed to hold a steady dollar value (see our Understanding Stablecoins lesson). We will introduce four of the most common activities in DeFi: investing, trading, lending and borrowing, and staking.
Knowledge Check 3
Fill in the blank: DeFi transactions are ____.
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[ ] Free
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[ ] Controlled
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[ ] Permissionless
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[ ] Centralized
Investing
The most common DeFi transaction is to purchase some cryptocurrency with the expectation that it will be worth more in the future. This is known as investing.
HODL is a term used for keeping crypto assets for a long time. Depending on who you ask, the HODL meme either comes from a typo of HOLD or it stands for Hold On for Dear Life.
DeFi can give early access to new coins and tokens before they are listed on centralized exchanges (CEX).
Knowledge Check 4
What does HODL mean?
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[ ] It’s a misspelling of HOLD
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[ ] Hold On for Dear Life
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[ ] Keeping crypto for a long time
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[ ] All of the above
Trading
A decentralized exchange (DEX) shows current exchange rates between different crypto tokens and coins and serves as a digital marketplace that facilitates trading one currency for another by bringing together buyers and sellers.
The parties involved in a DEX trade don’t need to know or trust each other. In fact, it may appear that you are trading with the DEX. However, in most cases, the DEX creates liquidity pools that facilitate the trade between two traders’ wallets in a permissionless fashion.
So What?
Anyone can trade and participate in markets regardless of your net asset worth. Anyone can enter or exit a position via on-chain protocols.
Knowledge Check 5
What is a DEX?
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[ ] A decentralized exchange
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[ ] A derivatives exchange
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[ ] A crypto index fund
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[ ] None of the above
Lending & Borrowing
DeFi lending and borrowing offers loans without the need for a bank or intermediary institution. Instead, lending is done on a peer-to-peer level: DApps connect lenders and borrowers directly. The lender earns interest, and the borrower pays back the loan plus interest.
To borrow, you first deposit crypto worth more than the loan as collateral. If your collateral's value falls too far, it is automatically sold to repay the loan. This is called liquidation, and it is how DeFi loans stay safe without credit checks.
Knowledge Check 6
Fill in the blank: DeFi lending is done on a _____ level.
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[ ] income to debt
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[ ] peer-to-peer
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[ ] banks to customers
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[ ] income to interest
Staking
Staking is often grouped with lending, but it is different: there is no borrower. You lock your ether to help keep the Ethereum network secure, and the network pays you rewards in return.
Staked funds can be locked for a period of time, and validators who misbehave lose part of their stake, so honesty pays. Centralized exchanges offer staking too, but DeFi gives you more options while you stay in control of your assets. Learn more in our Staking on Ethereum lesson.
Knowledge Check 7
Locking your crypto to help secure a network, in exchange for rewards, is an example of?
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[ ] Trading
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[ ] Staking
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[ ] Borrowing
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[ ] HODLing
DeFi Downsides
Hackers
Where there is money and technology, there are people looking for ways to hack the system. DeFi protocols and their users are frequent targets, so security habits matter.
Risk
DeFi runs on code: smart contracts. An error or loophole in that code can be exploited to drain funds. Markets bring risk too: loans can be liquidated when prices fall, and stablecoins can lose their steady value.
No recourse
There is no customer support line, and no company or government agency to appeal to if something goes wrong. Lost or stolen funds usually cannot be reversed or refunded.
Knowledge Check 8
What is a risk in DeFi?
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[ ] There are no risks
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[ ] The bank might turn down your loan
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[ ] A central authority could freeze your funds
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[ ] There may be an error in the code