Decentralized finance

The stablecoin-based lending platform, MakerDAO, is credited with being the first DeFi application to receive significant use.[5] It allows users to borrow Dai, the platform's native token pegged to the US dollar. Through a set of smart contracts on the Ethereum blockchain, which govern the loan, repayment, and liquidation processes, MakerDAO aims to maintain the stable value of Dai in a decentralized and autonomous manner.[6][7]

In June 2020, Compound Finance started rewarding lenders and borrowers of cryptocurrencies on its platform with, in addition to typical interest payments to lenders, units of a new cryptocurrency known as the COMP token, which is used for governance of Compound's platform but is also tradeable on exchanges. Other platforms followed suit, launching the phenomenon known as "yield farming" or "liquidity mining," where speculators actively shift cryptocurrency assets between different pools in a platform and between different platforms to maximize their total yield, which includes not only interest and fees but also the value of additional tokens received as rewards.[8]

In July 2020, The Washington Post wrote a primer on decentralized finance including details on yield farming, returns on investments, and the risks involved.[8] In September 2020, Bloomberg said that DeFi made up two-thirds of the cryptocurrency market in terms of price changes and that DeFi collateral levels had reached $9 billion.[9] Ethereum saw a rise in developers during 2020 due to the increased interest in DeFi.[10]

DeFi has attracted large cryptocurrency venture capitalists such as Andreessen Horowitz,[3] Bain Capital Ventures and Michael Novogratz.[11]

DeFi revolves around decentralized applications, also known as DApps, that perform financial functions on distributed ledgers called blockchains, a technology that was first made popular by Bitcoin and has since been adapted more broadly.[12][1] Rather than transactions being made through a centralized intermediary such as a cryptocurrency exchange or a traditional securities exchange on Wall Street, transactions are directly made between participants, mediated by smart contract programs.[3] These smart contract programs, or DeFi protocols, typically run using open-source software that is built and maintained by a community of developers.[13]

DApps are typically accessed through a Web3 enabled browser extension or application, such as MetaMask, which allows users to directly interact with the Ethereum blockchain through a digital wallet.[14][15] Many of these DApps can interoperate to create complex financial services.[1] For example, stablecoin holders can lend assets like USD Coin or DAI to a liquidity pool in a borrow/lending protocol like Aave, and allow others to borrow those digital assets by depositing their own collateral, typically more than the amount of the loan.[16] The protocol automatically adjusts interest rates based on the moment-to-moment demand for the asset.[3] Some DApps source external (off-chain) data, such as the price of an asset, through blockchain oracles.[17]

Additionally, Aave introduced "flash loans," which are uncollateralized loans of an arbitrary amount that are taken out and provably paid back within a single blockchain transaction.[18] While there can be legitimate uses for flash loans such as arbitrage, collateral swap, self-liquidation, and unwinding leveraged positions, multiple exploits of DeFi platforms have used flash loans to manipulate cryptocurrency spot prices.[19]

Another DeFi protocol is Uniswap, which is a decentralized exchange, or DEX, that runs on the Ethereum blockchain. Uniswap allows for the trading of hundreds of different ERC20 tokens issued on the Ethereum blockchain. Rather than using a centralized exchange to fill orders, Uniswap incentivizes users to form liquidity pools in exchange for a percentage of the trading fees that are earned from traders swapping tokens in and out of the liquidity pools.

These liquidity pools allow users to switch from one token to another, in a fully decentralized manner, while maintaining control over their funds. At the same time, liquidity providers are encouraged to deposit tokens for a portion of the fees generated by the exchanges. After having pooled their tokens, liquidity providers may remain completely passive as the smart contract takes care of automatically adjusting the liquidity-providing logic depending on the current market price.

Thus, DEXs are powered by automatic market makers which are based on mathematical formulas, making it possible to estimate the exchange rate between two assets by considering the liquidity present on the protocol.

Because no centralized party runs Uniswap (the platform is ultimately governed by its users), and any development team can leverage the open-source software, there is no entity to check the identities of the people using the platform to adhere to KYC/AML regulations. It is not clear what position regulators will take on the legality of a platform like Uniswap.[20]

Coding errors and hacks are common in defi.[21][1] Blockchain transactions are irreversible, which means that an incorrect or fraudulent transaction on a DeFi platform cannot be easily corrected. In 2020, one platform known as Yam Finance quickly grew its deposits to $750 million before crashing days after launch due to a code error. Additionally, the code for the smart contracts that implement DeFi platforms is generally open-source software that can be easily copied to set up competing platforms, which creates instabilities as funds shift from platform to platform.[13]

The person or entity behind a DeFi protocol may be unknown, and may disappear with investors' money.[13] Investor Michael Novogratz has described some DeFi protocols as "Ponzi-like."[11]

DeFi has been compared to the initial coin offering craze of 2017, part of the 2017 cryptocurrency bubble. Inexperienced investors are at particular risk of losing money using DeFi platforms due to the sophistication required to interact with such platforms and the lack of an intermediary with a customer-support department.[21][22]

While cryptocurrency-related crime (including ransomware) declined from a peak in 2019, DeFi-related crime has significantly increased. In 2021, over half of cryptocurrency crime was related to DeFi. This rise has been attributed to a combination of developer incompetence and non-existent or poorly enforced regulations.[23][24][25] Theft from DeFi can come from either external hackers stealing from vulnerable DeFi projects, or "rug pulls", where the developers and influencers promote a project and then exit with the money, as a form of pump-and-dump.[25]