One of the most rapidly growing blockchain use cases is Decentralized finance (DeFi).

It has been making waves within the finance and blockchain sectors.

At the time of writing this post about $34.55 billion worth of crypto assets were locked up in different DeFi protocols. DeFi has created a turning point as to how the financial sector operates. In this post, we shall take a deeper look at what Decentralized Finance (DeFi) is, how one can invest in it and how it works.

What is DeFi?

Through blockchain technology, people around the world can anonymously pay for goods or even send and receive cryptocurrencies (digital currencies) to and from any geographical location respectively. Another breakthrough is all this takes place without the need for intermediaries such as banks or brokers. And as if that is not enough blockchain has led to the development of another sector referred to as decentralized finance, which is turning tables against the traditional financial systems as we knew them.

Decentralized Finance (DeFi), also referred to as Open Finance, is a network of assimilated blockchain protocols and digital assets that are configured to offer conventional financial services. The current DeFi industry as we know it has been made possible by smart contract technology, which was first introduced by Ethereum blockchain before other blockchains followed.

DeFi platforms, also referred to as DeFi protocols, have given blockchain technology a lifeline by providing decentralized financial services that offer an alternative to almost every financial service offered by the traditional financial system ranging from insurance, savings, loans, trading, staking. Most importantly, the services offered by the DeFi protocols are not limited to any geographical location since the protocols are not centralized to a certain area/region. What one requires to access a DeFi protocol is a good internet connection and a device that can connect to it (PC, Desktop, tablet, or smartphone).

Smart contracts

Smart contracts are blockchain-based computer programs that are designed to automatically execute, control, and record legal events and actions as per the terms outlined within the code behind the programs. In a nutshell, they are contracts or agreements that have been written down on a computer program. They make it possible to automate transactions and other activities within a blockchain network.

They check whether the conditions outlined in the code have been satisfied before initiating the next cause of action. Besides Ethereum, other blockchains that now allow the use of smart contracts include NEO, NEM, EOS, Waves, and Hyperledger Fabric. Through the use of smart contracts, parties within a blockchain protocol can engage in trusted transactions without having to involve legal authorities like attorneys.

Example of a smart contract in operation

Let say two users in a blockchain named A want to carry out some business where one of the participants is selling something to the other where the payments are being made in the blockchain’s cryptocurrency. By using a smart contract, the sale agreement can be written into a code (computer program) stipulating that the buyer shall first place the cryptocurrency funds in an escrow account, then the seller shall send the item he/she is selling. And when the buyer receives the item and gives the program a signal that he/she has received the item, the program will release the cryptocurrency funds into the seller’s crypto wallet.

By using the smart contract, the seller is guaranteed that he/she shall receive his funds and the buyer is assured that he/she shall receive the purchased item. There is no need of involving lawyers and a lot of paperwork to guard against fraud. If the outlined events do not take place, the program simply terminates the contract and returns the funds to the buyer, and authorizes the item to be sent back to the seller.

How smart contracts have contributed to DeFi

Developers use smart contract technology to build applications called decentralized applications (DAaps) on blockchain networks. These DApps are designed to offer specific financial services like savings, insurance, loans, trading, etc.

Therefore, people from various corners of the world can log into the applications and receive financial services without the need of presenting themselves physically to a bank or insurance body.

Characteristics of DeFi protocols

For a blockchain application to qualify as a Decentralized Finance (DeFi), it must have some unique characteristics that include:

  • Must be decentralized
  • Its code should be an open-source code
  • It should be open for all
  • It should offer non-custodial services. Meaning it does not hold the crypto assets of the participants but rather the participants remain in full control of their crypto assets.

Types of DeFi protocols that you can invest in

The different DeFi protocols that are currently available can be categorized into various groups as below:

  1. Decentralized Exchanges (DEXs)

Most crypto exchanges especially those that were the first to be invented are centralized and have a central body that oversees their day-to-day running. However, through DeFi, other types of crypto exchanges are coming up that use autonomous DApps to allow sellers and buyers to exchange while still retaining control of their crypto assets rather than depositing them with the crypto exchange.

One of the key characteristics of DEXs is that they do not require users to deposit any crypto assets with them. The crypto assets remain in the custody of the users. Some popular DEXs include Uniswap, StellarTerm, SushiSwap, Waves DEX, Matcha, AirSwap, Bancor, Oasis, dYdX, OpenSea, Kyber Network, 0x, 1inch, and Binance DEX.

  1. DeFi Lending protocols

These are blockchain-based protocols that are created to offer lending and borrowing services using crypto assets. They are one of the best performing protocols within the Defi industry. They use smart contracts to provide a link between borrowers and lenders.

The lenders offer their crypto assets for borrowers to use and in return, the borrowers pay back with an interest that is shared among the lenders.

The entire borrowing and lending process is controlled by smart contracts. If you have some crypto holdings, this is one of the best ways of earning from the crypto holding instead of just letting them stay idle into your wallet. Examples of the common lending protocols include Aave, Yearn.finance, Compound, dYdX, mStable,  Balancer, bZx, Curve, MAKER, and Synthetix,

  1. Decentralized Prediction Markets

These are blockchain-based protocols that provide crypto holders with the chance of using their crypto assets to bet on the outcome of future events.

They offer the same services offered by traditional prediction markets, only that they eliminate the need for intermediaries. Common decentralized prediction markets include Gnosis, Guesser, and Augur.

Common terms you will come across in Decentralized Finance (DeFi)

  • Yield Farming

This is mainly associated with the lending protocols and it refers to the process of locking up crypto assets (segregating some crypto assets in your crypto wallet and putting them under a different address within your wallet where you cannot use them unless you remove them from that address).

These locked-up crypto assets are used for lending on the lending pools of the DeFi Protocol you are working with and you in return receive rewards. You may ask yourself what is given to the borrowers if the crypto asset does not leave your crypto wallet. And the answer is that different lending protocols have different mechanisms of transferring the value of the locked-up crypto assets into their lending pools.

  • Liquidity Mining

This is mostly associated with decentralized exchanges (DEXs) and it is also sometimes referred to as yield farming. It refers to the process through which DEX users provide liquidity (capital) to DEXs at a fee (reward).