What is DeFi: History and Use Cases

DeFi, short for decentralised finance, is a term used to describe financial blockchain applications that work to provide trustless, decentralised financial services. These applications serve various use cases, such as allowing decentralised lending/borrowing or allowing users to swap assets through a decentralised exchange.

The main issue DeFi works to resolve is the dangers of centralisation and using intermediaries. A common example of the ideal DeFi user is the unbanked. These individuals have little opportunity or ability to benefit from financial services as their unbanked status means that traditional financial products are inaccessible. Using DeFi, these individuals could potentially take out a short-term loan with their collateral without KYC requirements, participate in market-making activities such as providing liquidity, or receive interest on their savings without the need of a bank account (yield farming).

History of DeFi

The history of DeFi can be traced back to the invention of Bitcoin as a decentralised, peer-to-peer form of money. Bitcoin ingrained the importance of decentralisation into the cryptocurrency space and has since prompted newer projects to incorporate decentralisation into their design.

However, while Bitcoin was the precursor, the key breakthrough came from Ethereum and its smart contract capabilities. Smart contracts allow two parties to form an agreement in a completely trustless manner. Smart contracts are what allows applications such as exchanges and games to run on top of a blockchain. In their simplest form they are computer code that is executed when a set of agreements (as written in the smart contract) are met. For example, if a user were to swap Ethereum to USDT, a smart contract could execute a trade that would swap the token when the correct parameters are met (parameters such as agreed price, agreed gas fee, agreed token transfer, etc.).

A good example of DeFi is one of the oldest and most well-known DeFi protocols, MakerDAO. Maker protocol was created in 2014 and produced one of the most successful examples of a decentralised stablecoin (a coin that is pegged to another asset, often USD). Today Maker is seen as one of the most battle-tested DeFi solutions in the space, giving users both a decentralised stablecoin, and the ability to take out non-KYC loans.

DeFi further expanded in 2017 with decentralised exchanges like EtherDelta. Although it has since been replaced by more prominent decentralised exchanges like Uniswap, EtherDelta was the most prominent and one of the first of its kind to allow traders to swap tokens without the need to go through a centralised body.

Another popular form of DeFi that also gained popularity at this time were ICOs (initial coin offerings). Similar to IPOs (initial public offerings) in stocks, ICOs were a way for non-institutional, non-venture capitalists to participate in the early funding of a project. ICOs were popular as regular investors had the same opportunity as bigger players. Everyday investors could get the same prices of a project before it launched without the need to become an accredited investor or go through a third party service.

While these early examples of DeFi illustrate different applications of decentralised finance, it wasn't until 2020 onwards that DeFi and its myriad use cases really came to fruition, making the term DeFi common among cryptocurrency holders.

The major catalyst for DeFi's popularity can be attributed to Compound protocol and its yield farming mechanics. Compound was revolutionary in the way that it rewarded users for lending and borrowing by distributing the protocol's governance token, COMP, to users, providing them a yield. This was the beginning of APY (annual percentage yield) and APR (annual percentage rate) in DeFi. This mechanic has now been replicated by many other protocols and has become commonplace for DeFi participants.

DeFi has continued to expand and new innovations and use cases are emerging frequently. Below we outline some of the most popular DeFi use cases.

Popular DeFi use cases

Lending/Borrowing

This allows users to borrow using their asset/s as collateral or lend their asset/s to other users for a fee. Most DeFi protocols will automatically match borrowers and lenders, so that all a DeFi user needs to do is deposit funds and choose whether to lend or borrow. Many lending and borrowing platforms also provide additional yield in the form of the project's governance token, allowing lenders and borrowers to “yield farm” in addition to using the financial service.

Popular lending/borrowing protocols: Compound, Aave, Maker

Stablecoins

While there are stablecoins governed by a centralised body such as Tether (USDT), stablecoins such as DAI, MIM, and a number of algorithmic and collateral-backed stablecoins have become one of the more common use cases of DeFi. These tokens are pegged to an underlying asset such as USD, EUR, gold and Bitcoin, with the method that maintains this peg varying depending on the mechanics of the project. The decentralised nature of these pegged assets have recently prompted governments worldwide to enact regulatory frameworks for their use.

Popular stablecoins: USDT, USDC

Insurance

DeFi is not without risk. The biggest risk in DeFi is third-party risk. This pertains to vulnerabilities in the protocol, as a user must interact with a protocol's smart contracts and therefore be exposed to risks the protocol might have. These can range from contract risks (vulnerabilities is the coding of the smart contracts) or oracle risk (the ability for bad actors to influence the oracle information a protocol uses to generate the price of assets). Insurance protocols allow DeFi users to insure their funds within a protocol. This provides them with another level of protection unseen in other projects.

Popular insurance protocol: Nexus Mutual

Decentralised Exchanges

Decentralised exchanges (DEXs) are exchanges that function through smart contracts. Most inceptions are automated market makers (AMM), meaning they use mathematics to initiate swaps opposed to order book mechanics on traditional exchanges. DEX's have become one of the more popular forms of DeFi with most generation 2 DeFi protocols implementing their own exchange function. As new smart contract-enabled blockchains begin to build out their ecosystem, most will have a native DEX where a user may swap tokens.

Popular DEX's: Uniswap, Pancake Swap, Sushi

Yield Farming

Yield farming is when a user stakes their asset to generate a yield. The method in which yield is generated can vary. A user could earn yield by staking a single asset such as Ethereum on protocols like Yearn Finance or another example would be a DeFi user earning yield by providing liquidity. Generally, a protocol will define the yield APY by the relative risk of the asset being staked. For example, protocols will often give higher yield APY for providing liquidity with their native token and established token such as Ethereum, and will give lower yields to users only single-side staking Ethereum.

Popular yield farming protocols: Yearn Finance, Curve, Synthetix

Liquidity Providing

Liquidity providing is the act of providing funds (liquidity) to market participants often for decentralised exchanges. While liquidity providing mechanics can vary, most early liquidity providers were required to provide a 50/50 split of the asset pair being added to the liquidity pool e.g. 50% Ethereum and 50% DAI would need to be added to provide liquidity for an ETH/DAI pair. Often protocol's will give the liquidity provider trading fees, for example Uniswap liquidity providers gain the 0.3% trading fee that is paid when a user swaps tokens. It is now common for newer protocols to also reward liquidity providers with their native token often in addition to fees, giving the liquidity provider better yield.

Popular places to provide liquidity: Uniswap, Curve, Sushi

Wrapped Bitcoin/Tokens

Wrapped tokens are tokens that have been replicated to function on a different blockchain, the most prominent example is wrapped Bitcoin (WBTC). WBTC is essentially Bitcoin on Ethereum. The need for wrapped tokens is to allow users to move assets cross-chain and participate in different protocols. Bitcoin by itself does not have the infrastructure in place to earn yield on a decentralised platform as it does not have smart contract capabilities. Currently, Bitcoin yields are generated by centralised bodies. Therefore, users may wrap their Bitcoin to be able to participate in decentralised protocols on Ethereum or other chains.

Popular wrapped tokens: Wrapped Bitcoin

DAOs

Decentralised Autonomous Organisations are how decentralised protocols enact changes or decide on the future direction of the project. DAO members will often vote for changes, with the number of votes a participant has being proportional to the number of governance tokens they own. DAOs have become more prominent with crowdfunding projects such as Constitution DAO that raised funds to buy a rare print of the US constitution, and protocol controlled-value (PCV) projects like Fei Protocol, that control the deposits from users, which in Fei's case is used to back their stablecoin (FEI) with decisions being made by Tribe (FEI's governance token) holders.

Popular DAO governance tokens: Compound, Ethereum Name Service, Tribe

If you'd like to take the next step in your DeFi journey, sign up to CoinSpot, grab your favourite DeFi coins and begin experimenting with different DeFi protocols.

FAQs

Does Bitcoin have DeFi?

Bitcoin does not currently have smart contract capabilities, therefore does not have DeFi protocols built on top of the Bitcoin network. Currently most Bitcoin holders that wish to participate in DeFi will need to wrap their Bitcoin to join a blockchain with smart contract capabilities like Ethereum.

What are DeFi risks?

The primary risks with DeFi are protocol and bad actor risks. Bad actors can come in many forms, but one of the most prominent is malicious developers who control the keys to either the protocol or the liquidity. A rug pull is when a project decides to pull all the liquidity of their native token pool (often paired with a stronger asset like Ethereum) leaving holders of the project's native token with nowhere to exchange it. Effectively leaving the user with a worthless coin.

Protocol risk refers to the risk that the code or infrastructure of the project has vulnerabilities and can be exploited, but can also refer to the designed mechanics of the protocol. This could be bad code that allows a user to call particular functions in the smart contract to drain its funds or even more complex vulnerabilities like poor oracle (how a DeFi protocol determines the value of assets) choice. The biggest hacks in DeFi history often come from flash loan attacks. A flash loan attack is when a malicious actor uses a flash loan (an instant loan that must be repaid in the same block) to manipulate a project's oracle, changing the price of an asset and allowing the hacker to drain the funds.

Designed protocol risks can refer to concepts like impermanent loss (IL). IL refers to the loss a liquidity provider will occur when the two tokens provided for liquidity change dramatically in price leaving the liquidity provider with smaller or negative gains opposed to if they had held each asset separately.

At CoinSpot we always recommend customers do their due diligence on projects they wish to invest in. Doing your own independent research is essential, as you should always be careful when trading digital currencies.

How do I make money with DeFi?

The most common way to make money in DeFi is by “yield farming”. Yield farming refers to generating yield by staking an asset. In DeFi many different kinds of assets can be staked such as single-staking assets like Ethereum or by staking LP (liquidity provider) tokens. The yields given are often correlated to the risk of the asset staked. For example, staking an LP token with the new projects governance token and ETH will often give the highest yield, as the new governance token will be extremely volatile and may potentially not succeed, meaning the liquidity provider may end up losing money despite the high yields.