Skip to content

What is DeFi? How blockchain tech democratizes financial access

Decentralized finance — or DeFi, for short — is a term used to describe financial products and services deployed on a blockchain that do not require interference or oversight from a centralized authority, as is the case with traditional financial institutions. The term was first coined in 2018, but the idea took off most notably in the summer of 2020.

DeFi represents a collection of open financial services where transactions are made by interacting with code transparently deployed on a blockchain. DeFi protocols first began to be created on Ethereum in 2017. Still, exponential growth in usage only began in 2020, sparked by a rush of capital coming onto blockchains supporting DeFi apps built using smart contracts. While these open financial products and services come with their own risks, the main benefits include self-custody of funds, the ability to move assets freely and make transactions 24/7, and the immutability of historical data. 

There are many types of decentralized applications currently available, and the most popular include lending and borrowing platforms, decentralized exchanges, and staking solutions. 

OKX provides curated access to many passive income-generating opportunities at established DeFi protocols via our MetaX product.

What makes DeFi useful?

The foundation of blockchain technology is decentralization. This manifested in Bitcoin as a peer-to-peer currency controlled by a network of independent miners rather than a central authority. 

While this is a great use case, the Bitcoin network is practically limited to sending and receiving BTC. Before Ethereum, there was no decentralized way to mimic services provided by traditional finance such as lending, borrowing and exchanging assets. The development of smart contract platforms allows for these financial services to be written as programs and then deployed on a blockchain, maintaining their decentralization. 

Some of the advantages of DeFi protocols:

  • Trustlessness — users maintain custody of their crypto assets without trusting a third party to keep their assets and data safe.
  • Immediacy — transactions take just moments to be confirmed. They can be made at any time that a user has internet access, compared to hours or even days, at times, in traditional finance.
  • Composability — DeFi protocols can use one another as building blocks to create robust applications leveraging the capabilities of multiple financial services.
  • Transparency — transactions are immutable once confirmed and easily reviewable, making for efficient auditing of personal finances.

How do DeFi protocols work?

The building blocks of DeFi applications are smart contracts or self-executing programs deployed onto a blockchain. Users can access them at any time by sending a transaction calling one of the functions defined in the program. An example might be a function to deposit USDT into a vault that is then lent out to borrowers, accruing interest. 

In practice, these smart contracts are regularly called by a user-friendly frontend that will create and send the transaction from a backend service. Participants can connect a browser wallet like MetaX to the frontend application and execute transactions without technical expertise.

Uniswap’s frontend showing an ETH-DAI swap. Source: Uniswap

Once the transaction is sent, it is confirmed by miners or validators securing the network and then becomes immutable data stored on the blockchain. Auditing transactions is extremely transparent, and data can be traced back to a blockchain’s first block — known as the genesis block — when necessary. Users do not have to rely on an authority to maintain records of their finances as they will permanently exist on-chain. 

History of DeFi

DeFi’s beginnings

Many point to MakerDAO as the start of DeFi as we know it today. MakerDAO is a lending and borrowing platform founded by Danish entrepreneur Rune Christensen in 2014. The project’s smart contracts were first deployed on Ethereum in 2017, allowing users to borrow a stablecoin, DAI, using their ETH as collateral. 

DAI’s price is soft-pegged to the value of the U.S. dollar, and the protocol successfully maintained this peg throughout ETH’s 80% drop from 2018 to 2020. This gave users greater confidence to use DAI and more certainty that DeFi has long-term staying power.

In 2017, initial coin offerings — or ICOs — became one of the first widely used applications of smart contracts. Users could exchange their ETH for a new project’s token using a smart contract rather than a centralized fundraising platform off-chain. This ICO method led to many projects abusing investor excitement by overhyping raises to obtain funding without a fleshed-out product. However, it also highlighted an early DeFi use case.

In late 2018, the influential lending platform Compound launched, allowing users to borrow one volatile digital asset against another (i.e., borrowing ETH against WBTC). This provided a new layer of composability and alternative possibilities to the options available at MakerDAO. 

A few months later, we saw the launch of Uniswap, the first decentralized exchange to popularize the AMM — or automated market maker — trading model. This allowed for quick swaps between crypto assets using liquidity pools and algorithmic pricing rather than the order book method used by traditional finance, centralized exchanges and early DEXs like EtherDelta. 

DeFi summer and the advent of yield farming

Early DeFi platforms were up and running during the cryptocurrency bear market from 2018 to early 2020. Still, the sector’s growth was slow before Compound’s liquidity mining incentives program began in June 2020. 

Compound awarded users a governance token, COMP, that can be used to vote on changes to the platform. This led to a massive increase in the total value locked to the protocol as yield farmers scrambled to lend and borrow the assets that would award the most tokens. This experience was a revelation for builders and proved that providing token incentives is a great way to bootstrap liquidity while getting people excited about a product. 

Liquidity mining kicked off in June 2020, sparking the parabolic rise in Compound TVL. Source: DeFi Pulse

Yearn Finance was another significant development in the sector during this period. Yearn, founded by former Fantom developer Andre Cronje, is a yield aggregator that allows users to deposit crypto assets that are automatically rotated between lending protocols to optimize returns. Yearn’s governance token, YFI, was distributed strictly through liquidity mining and had no team or venture capitalist allocation. As yield farmers piled in, Yearn’s TVL rapidly grew from around $8 million at the time of Cronje’s announcement on June 17 to greater than $1 billion three months later in September.   

As investors and developers saw the rapid growth possible in DeFi, projects and capital began flooding the space. Many were copycats that co-opted the liquidity mining process but, lacking innovation, quickly burned out. At the same time, many cutting-edge projects were kick-started that still exist today.

Total value locked across chains

In 2020, DeFi existed almost entirely on Ethereum, but things would change in 2021 as the Ethereum blockchain became more and more congested and transaction fees rose. It became impossible for users with smaller portfolios to participate in DeFi as fees were routinely upward of $100 per transaction. 

Alternative blockchains offer cheaper fees and faster confirmation times, and many are implementations of the Ethereum Virtual Machine. This enabled developers to fork Ethereum applications to other chains easily, providing users with familiar decentralized financial products and services more cost-effectively. 

TVL changes April 1, 2021, to Jan. 1, 2022 (Source: Defi Llama):

  • Avalanche — $189.17M → $11.7B (+6,084.91%)
  • Solana — $216.07M → $11.2B (+5,085.19%)
  • Polygon — $115.99M → $5.45B (+4,598.68%)
  • Terra — $1.02B → 18.45B (+1,708.82%)
  • Ethereum — $58.27B → $147.39B (+152.943%)
Ethereum TVL dominance has decreased from ~96% in December 2020 to ~55% in April 2022. Source: Defi Llama

While Ethereum is still the dominant smart contract platform, the world of DeFi is becoming increasingly multi-chain. 

Types of DeFi applications

Lending and borrowing platforms

Lending and borrowing applications allow lenders to earn interest on their assets by depositing them into a smart contract and enabling borrowers to leverage positions or gain exposure to different crypto assets without selling their holdings. Any user can borrow assets under the condition that they have supplied enough collateral. 

In DeFi, loans are generally over-collateralized, as there aren’t credit systems in place due to the anonymous, permissionless nature of transacting. Interest rates are determined by the ratio of supplied tokens to the amount borrowed and fluctuate automatically according to supply and demand. 

The most-used lending platforms on Ethereum include:

  • MakerDAO — Maker was the first popular lending platform that allowed users to borrow DAI against other digital assets, providing exposure to the value of the U.S. dollar. It is one of the most battle-tested DeFi protocols due to its long tenure.
  • Aave — Aave offers a wide variety of collateral options and pioneered the concept of flash loans in the DeFi sector. Flash loans allow a user to borrow digital assets without collateral, as long as the value and interest are repaid within the same block. This is useful for arbitrage trades that need quick access to large sums to be profitable. If the position is not repaid, the transaction will simply fail without harming the protocol.

Decentralized exchanges

Decentralized exchanges allow users to exchange crypto assets without an intermediary facilitating the trade. The most popular DEXs are automated market makers, where liquidity is provided via pools by users who earn rewards based on the pool’s total trade volume. This means that a DEX trade does not have an individual counterparty like a trade on a centralized exchange would. Instead, a DEX trade pulls the token being bought from the pool and rebalances the pool with the token being sold.  

The most popular decentralized exchanges include:

  • Uniswap — Uniswap popularized the AMM model of exchange as well as the airdrop method of crypto asset distribution, retroactively distributing its governance token, UNI, to platform users in September 2020. 
  • SushiSwap — SushiSwap is a fork of Uniswap deployed in August 2020. It initially attempted to siphon TVL and volume from Uniswap by providing liquidity mining rewards in the native SUSHI token. While lagging behind Uniswap in volume, Sushi has taken a more cross-chain approach, deploying on 15 different blockchains as of April 2022. 
  • 1inch — 1inch is a DEX aggregator that aims to capture the best price across exchanges. DEXs often have different rates on digital assets. Aggregators will calculate which offers the best price, sometimes splitting the order between exchanges if it results in a better price. 
SushiSwap bypassed Uniswap’s TVL during its initial hype in the fall of 2020 but lost ground against the market-leading DEX for much of 2021. Source: The Block

Staking solutions

Staking solutions enable users to earn rewards for securing proof-of-stake blockchains without setting up the hardware to run a node themselves. They also allow depositors to maintain exposure to the staked asset through interest-bearing tokens that can be used elsewhere in DeFi.

Some well-known staking solutions include:

  • Lido DAO — Lido lets users earn staking rewards by depositing their assets into a smart contract that replaces funds deposited with an interest-bearing token to be used elsewhere in DeFi. For example, users could stake their ETH with Lido and receive STETH, earning interest. They could then use the STETH as collateral on Aave and borrow DAI to pay for an unforeseen expense without touching their ETH position.
  • RocketPool — RocketPool is a similar service to Lido but differentiates itself with claims of greater decentralization. RocketPool is permissionless. Anyone with 16 Ether can participate in Ethereum’s transaction validation process, whereas Lido’s validators are determined by governance voting from LDO holders. 
The market share for liquid staking has been dominated by Lido due to its scalability, even though it may not be the most decentralized solution. Source: Dune Analytics

DeFi risks

While DeFi presents unique opportunities for self-custody and transparency, it also comes with inherent risks of which users must be conscious.

Smart contract risk

The code underlying smart contracts is generally available for all to see. While this is great for savvy developers interested in learning how their money is being lent out, malicious actors can easily scope out vulnerabilities. Due to the finality of the blockchain, if a contract is exploited and funds are drained, they cannot be returned. 

Self-custody risk

When holding assets on a centralized exchange, the exchange maintains private keys, removing the responsibility of wallet security from the individual. As a DeFi participant, one must manage their own keys. Wallet funds can be drained entirely if a private key is given away through a phishing attack or a software exploit. It is recommended to use a hardware wallet and keep a separate computer for cryptocurrency transactions to mitigate some of this risk.

Underlying blockchain risk

When participating in DeFi, you rely not only on the smart contracts you interact with but also on the integrity of the chain on which those contracts are deployed. If the consensus mechanism of the underlying chain is vulnerable to exploitation, your funds can be lost even if you take the appropriate security measures in all other areas. This is why decentralization is so important and the reason that Ethereum maintains the largest TVL even with its high fees and slow confirmation times.

Not a part of the OKX community yet? Sign up and join us today!