What is DeFi?

Decentralised finance (DeFi) is an open financial system that operates entirely through the internet.

It uses blockchains and smart contracts to provide financial services. This includes things like banking, trading, lending, insurance and payments.

It even includes services that you wouldn't normally think of as "finance", such as social media, marketplaces for music and art, gaming and advertising. In this case, DeFi provides the transactional layer for users to buy, sell and interact with these Web3 services.

As opposed to traditional finance, DeFi is largely autonomous and typically operates peer-to-peer, reducing the need for intermediaries who control what people can and can't do. It also helps drastically cut down the costs involved with using these services, as there are no "middlemen" to take a cut.

Some have likened DeFi to "the financial layer of the internet" because of its web-native approach to finance. It offers most of the features you would expect to find on the regular web, plus some that are unique to blockchain-based systems.

For instance, zero-knowledge proofs are privacy-preserving technology used by blockchains. They allow customers to prove things like how much money they have in a bank account or that they're over the age of 18, without having to give away the exact details of their bank balance or age.

This could help mitigate how much sensitive information companies collect and store about their customers and help prevent things like massive data breaches that plague modern technology today.

In coming years we may see more and more traditional assets and institutions become part of DeFi.

Central banks like the Reserve Bank of Australia (RBA) are exploring the digitisation of the dollar, while payment providers PayPal, Visa and Mastercard are all exploring the use of stablecoins. Stablecoins are cryptocurrencies tied to the price of another asset, like the US dollar. Physical assets like gold, real estate and energy may also be tokenised, in order to make them easier to trade.

This guide explains how DeFi works, why it's important and how it may change traditional finance forever.

How does DeFi work?

Decentralised finance is a network of software applications that are able to interact with each other and that anyone can use. DeFi software is referred to as decentralised applications, or dapps for short.

This is radically different to the regular internet, where software is typically restricted if someone does not have permission to use it and most software applications don't interact with each other.

This interactivity is called composability and is one of the core features that makes DeFi fundamentally different to traditional finance. Composability refers to the ability for dapps to "plug in" to each other.

This means you can build more complex applications by connecting several together and has been likened to "monetary Lego".

Dapps can host things like banking services, financial markets and more run-of-the-mill financial services like insurance.

So for instance, let's say you wanted to build a new round-up app for investing, where the spare change from card payments goes into an investment account.

In the traditional financial system you would need to build or rent access to a number of different pieces of software to get your app to work. You might need bank accounts for your users, access to a payments network like Visa or PayPal, insurance, various licences and finally access to an investing platform.

To get this up and running would be expensive, complicated and time-consuming.

Alternatively, in a composable system of dapps, you would be able to plug in to each of those existing products for free or at low cost. All you would need to do is focus on building the new parts of the app and leverage the existing pieces of open-source software.

This is possible because most blockchains are decentralised, open-source networks. This means that there is no owner of the network, instead it is supported by a distributed network of nodes, known as validators.

Another feature of blockchains – and DeFi – is that all transactions on the network are authorised by a sophisticated network of computers, rather than humans or business entities. This makes it very difficult to cheat or defraud the system and provides certain assurances between parties.

How blockchains keep money secure.

DeFi vs CeFi

CeFi is centralised finance, which is the traditional way of doing things.

In CeFi we solve problems such as liquidity and matchmaking by entrusting them to a central authority, such as a bank or a cryptocurrency exchange.

In DeFi, these responsibilities are split up among different dApps.

The benefits of DeFi

The advantages of spitting the system up this way include:

• Security. By splitting everything up, the system loses many of its weak points and gets many redundancies.
• Competitiveness. Because anyone can build dApps to integrate with other dApps and anyone can access this system, the market for providing financial services becomes very lean, competitive, innovative and consumer-friendly.
• Virtuous cycles. The interdependence between dApps means they can keep driving value to each other and growing rapidly.
• Novel applications. There are many things you can do with blockchain and DeFi that simply can't be done with CeFi.
• Cost-effectiveness. Because dApps can offer services autonomously, they can also offer them at much lower cost than their centralised equivalents can.

The overwhelming nature of these advantages means much of the global financial system will move from CeFi to DeFi in the coming years.

What holds a DeFi ecosystem together?

So, we have an entirely new, open, permission-less and extraordinarily effective financial system built on the internet, composed of countless dApps.

But what keeps it growing and what prevents it from falling apart?

There are two main things: a circular economy and blockchain technology itself.

1. A circular economy

The first bit of glue holding DeFi together is the mutual driving of value. In other words, if money keeps circulating it keeps working, just like any other economy.

In the case of the above example, the swap dApp might pay a service fee to both the pricing oracle and liquidity pool for their services, which can then pay it on further. For example, the pricing oracle might re-invest in network security, while the liquidity pool pays people a yield on their deposits into the pool.

With all the elements harmoniously working together, paying and receiving fees from each other, the DeFi ecosystem can become financially self-sustaining.

It can also become very profitable for people who have invested in the creation of the best and most widely used dApps as they can often pick up a portion of the revenue earned by those systems.

New value enters the system from two main places:

• Deposits. People deposit funds into the system to earn an annual percentage yield (APY) from it being put to work in the DeFinancial system, similar to how people earn interest in bank savings accounts by putting their money to work in the traditional financial system – but with added risks.
• Practical blockchain applications. Applications such as data marketplaces, games, accounting software, distributed computing services and much more are all part of the DeFi landscape and can collect fees for service.

In this way, the endless drive to capture value in the DeFi ecosystem means everyone's incentives are aligned around creating and supporting the most genuinely useful dApps.

The second thing holding DeFi together is blockchain itself.

2. Blockchain

The reason dApps work so reliably and can integrate so seamlessly with each other is that they're based on blockchain technology. This means they're fully transparent, that anyone can look at their programming to see exactly how they work and that they are guaranteed to follow their programming.

As a result, dApps can instantly trust each other and start doing business together without needing to hire lawyers, sign contracts and so on.

This is made possible through underlying blockchain protocols which support dApps and let them communicate with each other. In the end, the DeFi ecosystem is only as secure as the blockchain fabric supporting it.

Today the most popular blockchain fabric is the Ethereum blockchain, which hosts a wide range of DeFi dApps.

Finder survey: How many Australians own cryptocurrency at different ages?

Features of the DeFi ecosystem

Automated market makers and liquidity pools

Automated market makers (AMMs) are at the core of DeFi. These are used by decentralised exchanges and lending platforms. They were invented by Uniswap creator, Hayden Adams, and are unique to cryptocurrency.

They work by having users – known as liquidity providers (LPs) – add funds to a pool of assets.

The pool is typically made up of 2 assets, but can include more.

Traders are able to buy or sell assets from the pool any time they like. The pool determines the price of the asset based on its balance in the pool (more on that in the example below).

This is different from a traditional exchange which uses an order book.

Order books require hundreds or thousands of buyers (takers) and sellers (makers) to simultaneously come together and make offers.

As a result, buyers and sellers dictate the price of assets with their offers, whereas an AMM dictates prices based on the balance of assets in the pool.

Another advantage is that AMMs can operate with drastically fewer users, provided there is enough liquidity.

Must read: How price works in a liquidity pool

In an ideal world, liquidity pools would maintain an equal 50/50 balance of assets which would keep prices stable and in line with the rest of the market (e.g. the same price as what you might see on Coinbase or Binance).

However, pools often become imbalanced over time as one asset becomes more popular to purchase than another. This causes prices to change and exposes liquidity providers to a unique risk called impermanent loss.

It is a bit like how supply-and-demand dynamics affect prices, but the big difference is that the price change is contained entirely within the pool.

So for instance, in a BTC/ETH pool, liquidity providers add both BTC and ETH to a pool.

A trader can buy either BTC or ETH any time they like.

But if traders are only interested in buying BTC and not ETH, then the pool will become imbalanced.

Within the pool, this will cause the price of BTC to rise, while ETH will fall.

When this happens, it creates an arbitrage opportunity, as the ETH in the pool is now selling at a discount (relative to the wider market).

Arbitrage traders then come along and buy the discounted ETH with the goal of selling it elsewhere for a quick profit.

This reblances the pool, as the arbitragers had to deposit BTC into the pool in order to take ETH out of it. Prices return to the market average for both BTC and ETH as a result.

AMMs and liquidity pools help eliminate many of the overheads required by a classic exchange or marketplace. With a little bit of computer code and some liquidity, anyone can create a marketplace for any 2 assets.

Normally you would need to set up a business, apply for licences, be subject to regulation and need to attract buyers and sellers to provide capital.

Furthermore, AMMs operate 24/7 and are trustless – buyers and sellers never hand over ownership of their funds to a "middleman" like an exchange. This can help prevent events like FTX – where executives mismanaged user deposits – from ever occurring.

AMMs and the decentralised exchanges that use them are a cornerstone of DeFi.

Decentralised exchanges

A decentralised exchange (DEX) is a non-custodial exchange that runs on a blockchain.

That's a bit of a mouthful. Essentially it means that users can trade cryptocurrencies directly with other users, straight from their wallet. Users maintain ownership of their assets at all times and don't need to trust that a third party – like a centralised exchange – will keep them safe.

This is done through the use of automated computer code called smart contracts.

Liquidity pools are one type of smart contract used by DEXs. These are community-owned pools of assets that traders can buy and sell into. This allows DEXs to operate autonomously 24/7.

Another common feature of DEXs is that they can be governed by a decentralised autonomous organisation (DAO) which allows token holders to have a say in how the platform is managed. Tokens can be earned by using the platform or purchased on the open market.

Decentralised exchanges create a more equitable financial system by granting greater autonomy and control to users. The same technology could one day be applied to traditional stock exchanges or banks.

On the other hand, because of their decentralised nature, anyone can use a DEX without needing to provide ID or pass a Know Your Customer (KYC) check. This means that they can be used for fraudulent activities such as money laundering. As such, they live in somewhat of a legal grey space and are occasionally the target of law enforcement.

How is a DEX different from a centralised exchange?

For a quick rundown of the key differences between centralised and decentralised exchanges, check out the table below.

	Centralised exchange	Decentralised exchange
Trading	Conducted through the exchange	Conducted peer-to-peer
Control of funds	Exchange controls your coins and tokens	You control your coins and tokens
Anonymous trading?	No	Yes
Hosting	Centralised servers	Distributed network
Prone to hacks?	Yes	Yes
Subject to government interference?	Yes	No
Account withdrawal limits?	Yes	No

Compare some of the most popular centralised exchanges side-by-side.

• Risks of using a decentralised exchange

  While tackling some of the security and trust issues of centralised exchanges, decentralised exchanges are not without their own associated risks. These risks should be carefully evaluated before utilising any exchange.

  • Smart contracts. Decentralised exchanges run on smart contracts. Although innovative, smart contracts can contain vulnerabilities in their code which can be exploited or lead to malfunctions within the associated system. This can result in the funds being stolen from liquidity pools.
  • Phishing. Despite operating on a blockchain, DEXs still need to use some centralised services. This typically involves a website, which is referred to as the DEX's front-end or interface. These websites can be hacked and replaced with malicious code which steals funds from users' wallets. This is a phishing type of attack, but not a true hack of a blockchain or wallet.
  • Price fluctuations. Automated market makers rely on a balanced pool to give you a price that's in line with the rest of the market. If the pool becomes too imbalanced, you might find yourself paying more (or less) for an asset relative to the rest of the market.
  • Customer support. Customer support is non-existent for most decentralised exchanges.
  • Regulation. Being decentralised by definition means the exchanges are not regulated which may concern some users.
  • Irreversible. All transactions on a decentralised exchange are irreversible.

What is impermanent loss?

reward users for lending their assets to the pool by paying them yield, which is generated from trading fees.

Acting as a liquidity provider (LP) can be a useful way to earn a return on your cryptocurrency holdings, but lending your crypto this way can come with the risk of impermanent loss.

When you provide liquidity to a pool, you deposit an equal value of each asset (e.g. $100 of ETH and $100 of DAI).

You then receive liquidity provider tokens (LP tokens) which are a receipt that entitles you to a certain portion of assets in the pool.

When you're finished lending, you exchange your LP tokens for assets from the pool.

But if the pool is imbalanced at the time of your withdrawal, then you will receive a weighting of assets accordingly. This could result in a loss, relative to what you deposited.

	Providing liquidity	Held in wallet
Date 1 (deposited)	Value of asset pair = $200	Value of asset pair = $200
Date 2 (withdrawn)	Value of asset pair = $270	Value of asset pair = $300

Let's say you deposited 50 DAI and 50 ETH into a pool.

When you come back to withdraw it, the pool is now imbalanced because traders purchased more ETH than DAI. You receive 30/70 ETH/DAI back.

This has a different value to the original 50/50 ETH/DAI you put in.

So if the price of ETH increased in that time, then you may experience a loss, compared to if you had just held and left your original assets in your wallet.

Impermanent loss earns its name because any losses are only realised once the funds are withdrawn from the liquidity pool.

Until then, any losses are only on paper and may reduce or disappear completely depending on how the market changes.

Anytime you deposit assets into a liquidity pool you expose yourself to the risk of impermanent loss and should factor this in alongside any profits you stand to make from LP rewards or yield farming.

Yield farming

Yield farming is the process of lending cryptocurrency assets to a liquidity pool to be rewarded with more tokens.

It is a way for cryptocurrency investors to earn passive income from digital assets that would otherwise be sitting idle. It's one of the major forces behind DeFi's rapid growth and appeal to investors.

The process is similar to staking as it involves depositing and locking cryptocurrency holdings for a certain period of time. However, while staking uses cryptocurrency to power a blockchain or protocol, yield farming involves lending cryptocurrencies for trading purposes.

This is primarily done by being a liquidity provider (LP) to a decentralised exchange or lending platform. In return, farmers are paid with a portion of the platform revenue which is derived from fees.

Additionally, yield farmers often receive additional rewards in the form of a token which is issued by the platform and used to reward engagement with the platform. For instance, Compound (a lending protocol) rewarded early users with COMP tokens in return for providing liquidity in the platform's earliest days.

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The 2 major risks associated with yield farming are impermanent loss and the rapid devaluation of reward tokens. The later occurs because reward tokens often have a highly inflationary supply, which can lead to devaluation as traders rush to sell them and lock in profits in another asset like stablecoins or ETH.

As such, yield farming is often unsustainable and farmers need to switch between multiple farms to get the best yields before they devalue.

This issue has also led to a movement known as "real yield" which is where farmers pursue opportunities that pay rewards in stablecoins or ETH, instead of a random platform token that rapidly loses value.

Risks of yield farming

Although dramatically increasing in popularity over the last year, the DeFi sector is still a young industry which means that risks need to be evaluated carefully.

• Smart contracts. Smart contracts are the backbone of DeFi protocols and allow for many of the brilliant yield farming opportunities on offer. However, smart contracts are programmed by humans, so errors can occur. There are systems in place to mitigate this risk, but if a smart contract does malfunction, it could mean that a user's liquidity deposit is lost in the DeFi ecosystem.
• Composability. Smart contracts increase the composability of DeFi protocols. Composability refers to the interaction of different protocols within the DeFi ecosystem (think of different mobile apps all working together for a seamless experience). This is one of DeFi's greatest strengths, but it can also be considered a secondary risk as it can amplify any issues within a smart contract system.
• Hacks. The decentralised applications that front the DeFi protocols are connected via the internet. Like anything connected to the internet, there is always a risk of a security breach from hackers. Hackers also look for cracks in smart contract code that they can use to their advantage.
• Rug pulls. With any new industry, there are always those looking to exploit new users. Rug pulls are one such exploitation. Rug pulls are a risk primarily associated with decentralised exchanges (DEXs). Due to the open-source nature of the blockchain, anyone can create a new cryptocurrency token. On a DEX, scammers can then create a new liquidity pool and pair the worthless token with a valuable one, such as ETH. Once enough liquidity enters the fraudulent liquidity pool, the owners pull the pool and leave with the valuable ETH, leaving little to no trace.
• Impermanent loss. When depositing liquidity into liquidity pools, this is usually completed in equal proportion. For the ETH-USDC liquidity pool, you would need to deposit the same amount of each as set by the current exchange price. However, if one of those assets significantly increases in price, the liquidity pool would not automatically adjust. This provides an opportunity for arbitrage traders. They can use the liquidity pool to buy assets at a discount and sell at real-world prices. This process eventually brings the liquidity pool back to a balance. However, the process will also mean a liquidity provider may end up with a slightly different ratio of assets compared with when they deposited. When withdrawing those assets from the liquidity pool, impermanent loss occurs if the value of the new ratio of assets is less than if they had just remained on an exchange or digital wallet.

Decentralised autonomous organisations (DAOs)

As the name suggests, a decentralised autonomous organisation (DAO) is an organisation with no fixed leadership. It is collectively owned and managed by its members.

Membership is granted through ownership of a DAO token. These tokens may be issued as a reward for participation with the underlying protocol or can be simply purchased on the open market.

DAOs are an essential part of DeFi and critical to keeping systems decentralised, while still allowing groups to come together and make decisions democratically.

The degree to which a DAO governs something – like a DeFi protocol – is on a spectrum.

Some protocols are managed entirely by their DAO and require the DAO to vote on-chain before any actions – like code changes or the movement of funds – can be performed.

Others may use a DAO in conjunction with a private entity that owns the protocol. The owners may then make proposals which the DAO can then vote on.

Many DAOs allow the delegation of votes, so that token holders can choose someone to vote on their behalf.

DAOs are typically managed on-chain, which is how voting, proposals and changes are enforced.

The first-ever DAO was created by Ethereum engineer Christoph Jentzsch for the purpose of creating an investment fund that could be managed collectively by its members. In return for depositing funds to the DAO, members received a token which granted them voting rights in the DAO.

How cryptocurrency and DeFi work together

Cryptocurrencies are digital tokens for use in DeFi ecosystems. The best known are Bitcoin and Ether (the native resource of the Ethereum blockchain), but beyond them there are countless more, including many created for use in specific dApps.

The main cryptocurrency and token types include:

• Governance tokens. These entitle holders to participate in the governance of a dApp.
• Admission or gas tokens. These are used as access or to pay for services on specific dApps.
• Staking tokens. These are used as blockchain resources in areas that need a separate layer of security over the underlying blockchain fabric.
• Stablecoins. These are designed to be pegged to a fixed price, such as 1 each, for use in everyday payments. They are typically backed by some kind of collateral.
• Security tokens. These are securities, such as stocks or derivatives, which have been tokenised for use in DeFi.
• Asset-backed tokens. These are assets, such as art, cars, real estate, gold, frequent flyer points and coupons which have been tokenised for use in DeFi.
• CBDCs. Central bank digital currencies (CBDCs) are fiat currencies, such as US dollars issued by the central bank, which have been tokenised for use in DeFi.

Why DeFi is a game changer

As you can probably imagine, the rise of DeFi will likely prove to be a major occasion in financial history.

Some of the outcomes of this are quite straightforward: you can expect almost instant transfers with low and no transaction fees to become the norm and you can earn a higher APY rates on your capital.

And if your bank won't pass these benefits on to you, you can just go around it and get it directly from the dApp yourself.

Other changes are less predictable. As DeFi helps break down the walls between asset classes, letting people unlock the value stored in other possessions such as home equity, it could also push all currencies onto a competitive playing field, raising questions about the future of fiat currency in this space.

DeFi and the current economic crisis could also be a portentous combination. With the "real" economy struggling and an entirely new online economy successfully emerging, it's possible for cryptocurrencies to very quickly become the currency of choice for people around the world.

What blockchain pioneers think about DeFi

How to get started with DeFi

Want to explore the DeFi frontier? You will need:

• An elementary background of what Ethereum is and how it works.
• A personal cryptocurrency wallet and knowledge of how to use it safely. A combination of a hardware wallet for security, and DeFi wallet for usability, may be helpful for safely getting the most out of DeFi.
• Some cryptocurrency, since it's the native currency of the internet. The vast majority of the DeFi ecosystem is found on the Ethereum blockchain, so a sizable amount of ETH tokens is helpful for paying gas fees. Fortunately, it's very straightforward to buy some ETH.

Tips and risks when investing in DeFi

With DeFi ecosystems set to grow rapidly, many people are entering in the hopes of striking it rich in the digital economy by buying cryptocurrency.

If you're one of them, these tips and risks might help give you a sense of what to expect.

Tips

• Know the network. It's valuable to have a mental map of the new digital landscape and an understanding of how different dApps fit together.
• Know what each cryptocurrency actually does. Pay attention to the different types of cryptocurrency and what exactly you're purchasing with a cryptocurrency. Are you buying governance rights without caring about governance? Is it an admission token that doesn't actually have to be used?
• Look beyond centralised exchanges. Most of the action happens outside crypto exchanges, where people trade directly from their wallets.
• Practice proper wallet safety. Diving into DeFi means you need a wallet of your own and not just an exchange wallet. Make sure you know how to use it safely. A hardware wallet is strongly recommended.
• Don't underestimate compound earnings. Cryptocurrency used to just be only about flipping coins to turn a profit. But these days it's about making your cryptocurrency work for you and pulling in a long tail of compounding APY. You don't have to trade to make DeFi profitable.

Risks

• Be prepared to lose everything. The DeFi frontier is still an experimental mashup of economics, cryptography and computer science. The results can be unpredictable and you should always consider your funds at risk.
• Mind the scams. There are countless scams in the mostly-lawless DeFi space and there will always be people trying to take advantage of beginners. Never send money to anyone unless you know exactly why you're doing it.
• Trust no one. As above, mind the scams. Additionally, take everything you read with a grain of salt and do your own research. The idea of DeFi is still new, so there are lots of conflicting opinions on it. It's important to do your own research and make your own judgments when entering the unknown.
• Expect volatility. The DeFi space is composed largely of over-leveraged gamblers making large bets on small-cap cryptocurrencies in an illiquid market. Exercise caution.
• There are no authorities. Legally speaking, theft and scams are still crimes in the DeFi space. But practically speaking, authorities aren't able to enforce laws in the DeFi space. Remember that you will likely have no recourse if something goes wrong.

How to get started with DeFi

Want to explore the DeFi frontier? You will need:

• An elementary background of what Ethereum is and how it works.
• A personalcryptocurrency walletand knowledge of how to use it safely. A combination of a hardware wallet for security, and DeFi wallet for usability, may be helpful for safely getting the most out of DeFi.
• Some cryptocurrency, since it's the native currency of the internet. The vast majority of the DeFi ecosystem is found on the Ethereum blockchain, so a sizable amount of ETH tokens is helpful for paying gas fees. Fortunately, it's very straightforward to buy some ETH.

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