Decentralized finance (often stylized as DeFi) offers financial instruments without relying on

intermediaries An intermediary (or go-between) is a third party that offers intermediation services between two parties, which involves conveying messages between principals in a dispute, preventing direct contact and potential escalation of the issue. In law ...

such as brokerages, exchanges, or banks by using

smart contracts A smart contract is a computer program or a transaction protocol that is intended to automatically execute, control or document events and actions according to the terms of a contract or an agreement. The objectives of smart contracts are the re ...

on a

blockchain A blockchain is a type of distributed ledger technology (DLT) that consists of growing lists of records, called ''blocks'', that are securely linked together using cryptography. Each block contains a cryptographic hash of the previous block, ...

. DeFi platforms allow people to lend or borrow funds from others, speculate on price movements on assets using derivatives, trade

cryptocurrencies A cryptocurrency, crypto-currency, or crypto is a digital currency designed to work as a medium of exchange through a computer network that is not reliant on any central authority, such as a government or bank, to uphold or maintain it. It ...

, insure against risks, and earn

interest In finance and economics, interest is payment from a borrower or deposit-taking financial institution to a lender or depositor of an amount above repayment of the principal sum (that is, the amount borrowed), at a particular rate. It is distin ...

in savings-like accounts. DeFi uses a layered architecture and highly composable building blocks. Some applications promote high

interest rates An interest rate is the amount of interest due per period, as a proportion of the amount lent, deposited, or borrowed (called the principal sum). The total interest on an amount lent or borrowed depends on the principal sum, the interest rate, th ...

but are subject to high risk.

History

Decentralized exchanges (abbreviated DEXs) are alternative payment ecosystems with new

protocol Protocol may refer to: Sociology and politics * Protocol (politics), a formal agreement between nation states * Protocol (diplomacy), the etiquette of diplomacy and affairs of state * Etiquette, a code of personal behavior Science and technology ...

s for financial transactions that emerged within the framework of decentralized finance, which is part of

blockchain technology A blockchain is a type of distributed ledger technology (DLT) that consists of growing lists of records, called ''blocks'', that are securely linked together using cryptography. Each block contains a cryptographic hash of the previous block, a ...

and FinTech. CEXs, DEXs and DEX aggregators are all built on the multi-layered DeFi architecture or components, where each layer serves a well-defined purpose. (See Figure: ''Multi-layered Architecture of the DeFi Stack''). While they share common components of the first four layers, such as ''Settlement layer'', ''Asset layer'', ''Protocol layer'' and ''Application layer'', DEX aggregators have an additional component or ''Aggregator layer'', which allows them to connect and interact with other DEXs via smart contracts. The Ethereum blockchain popularized

, which are the basis of DeFi, in 2017. Other blockchains have since implemented smart contracts. MakerDAO is a prominent lending DeFi platform based on a stablecoin that was established in 2017. It allows users to borrow DAI, a token pegged to the

US dollar The United States dollar ( symbol: $; code: USD; also abbreviated US$ or U.S. Dollar, to distinguish it from other dollar-denominated currencies; referred to as the dollar, U.S. dollar, American dollar, or colloquially buck) is the officia ...

. Through a set of smart contracts that govern the loan, repayment, and liquidation processes, MakerDAO aims to maintain the stable value of DAI in a decentralized and autonomous manner. In June 2020, Compound Finance started rewarding lenders and borrowers with

, in addition to typical

payments to lenders, units of a cryptocurrency called COMP. This token, which is used for running Compound, can also be traded on cryptocurrency exchanges. Other platforms followed suit, leading to stacked investment opportunities known as "yield farming" or "liquidity mining," where speculators shift cryptocurrency assets between pools in a platform and between platforms to maximize their total yield, which includes not only

and fees but also the value of additional tokens received as rewards. In July 2020, ''

The Washington Post ''The Washington Post'' (also known as the ''Post'' and, informally, ''WaPo'') is an American daily newspaper published in Washington, D.C. It is the most widely circulated newspaper within the Washington metropolitan area and has a large n ...

'' described decentralized finance techniques and the risks involved. In September 2020, Bloomberg said that DeFi made up two-thirds of the

cryptocurrency A cryptocurrency, crypto-currency, or crypto is a digital currency designed to work as a medium of exchange through a computer network that is not reliant on any central authority, such as a government or bank, to uphold or maintain it. It i ...

market in terms of price changes and that DeFi collateral levels had reached $9 billion. Ethereum saw a rise in developers during 2020 due to the increased interest in DeFi. DeFi has attracted

venture capital Venture capital (often abbreviated as VC) is a form of private equity financing that is provided by venture capital firms or funds to startups, early-stage, and emerging companies that have been deemed to have high growth potential or which h ...

ists such as Andreessen Horowitz and Michael Novogratz. ''The Economist'' regarded the future of digital finance in 2022 as a "three-way fight" between:

Big Tech Big Tech, also known as the Tech Giants, refers to the most dominant companies in the information technology industry, mostly located in the United States. The term also refers to the four or five largest American tech companies, called the Big ...

, such as

Facebook Facebook is an online social media and social networking service owned by American company Meta Platforms. Founded in 2004 by Mark Zuckerberg with fellow Harvard College students and roommates Eduardo Saverin, Andrew McCollum, Dust ...

with its digital wallet; "big rich countries" that have been testing their own digital currencies; and software developers "building all sorts of applications" to decentralize finance. Handling the risks presented by crypto-assets already valued at $2.5 trillion was a particular challenge for US regulators.

Key characteristics

DeFi revolves around decentralized applications, also known as DApps, that perform financial functions on distributed ledgers called blockchains, a technology that was made popular by

Bitcoin Bitcoin (abbreviation: BTC; sign: ₿) is a decentralized digital currency that can be transferred on the peer-to-peer bitcoin network. Bitcoin transactions are verified by network nodes through cryptography and recorded in a public distr ...

and has since been adapted more broadly. Rather than transactions being made through a centralized intermediary such as a cryptocurrency exchange or a traditional securities exchange, transactions are directly made between participants, mediated by smart contract programs. These smart contracts, or DeFi protocols, typically run using

open-source Open source is source code that is made freely available for possible modification and redistribution. Products include permission to use the source code, design documents, or content of the product. The open-source model is a decentralized so ...

software that is built and maintained by a community of developers. DApps are typically accessed through a browser extension or application. For example,

MetaMask MetaMask is a software cryptocurrency wallet used to interact with the Ethereum blockchain. It allows users to access their Ethereum wallet through a browser extension or mobile app, which can then be used to interact with decentralized applicati ...

allows users to directly interact with Ethereum through a digital wallet. Many of these DApps can be linked to create complex financial services. 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. The protocol automatically adjusts interest rates based on the demand for the asset. Some DApps source external (off-chain) data, such as the price of an asset, through blockchain oracles. Additionally, Aave introduced "flash loans", which are uncollateralized loans of an arbitrary amount that are taken out and paid back within a single blockchain transaction. Many exploits of DeFi platforms have used flash loans to manipulate cryptocurrency spot prices. Another DeFi protocol is Uniswap, which is a decentralized exchange (DEX) set up to trade tokens issued on Ethereum. Rather than using a centralized exchange to fill orders, Uniswap pays users to form liquidity pools in exchange for a percentage of the fees collected from traders swapping tokens in and out of the liquidity pools. Because no centralized party runs Uniswap (the platform is governed by its users), and any development team can use the open-source software, there is no entity to check the identities of the people using the platform and meet KYC/AML regulations. It is not clear what position regulators will take on the legality of such platforms.

Decentralized exchanges

Decentralized exchanges (DEX) are a type of

cryptocurrency exchange A cryptocurrency exchange, or a digital currency exchange (DCE), is a business that allows customers to trade cryptocurrencies or digital currencies for other assets, such as conventional fiat money or other digital currencies. Exchanges may acc ...

which allows for direct

peer-to-peer Peer-to-peer (P2P) computing or networking is a distributed application architecture that partitions tasks or workloads between peers. Peers are equally privileged, equipotent participants in the network. They are said to form a peer-to-peer ...

cryptocurrency transactions to take place without the need for an intermediary. In transactions made through decentralized exchanges, the typical third party entities which would normally oversee the security and transfer of

assets In financial accounting, an asset is any resource owned or controlled by a business or an economic entity. It is anything (tangible or intangible) that can be used to produce positive economic value. Assets represent value of ownership that can ...

(e.g. banks,

stockbrokers A stockbroker is a regulated broker, broker-dealer, or registered investment adviser (in the United States) who may provide financial advisory and investment management services and execute transactions such as the purchase or sale of stocks a ...

, online payment gateways, government

institutions Institutions are humanly devised structures of rules and norms that shape and constrain individual behavior. All definitions of institutions generally entail that there is a level of persistence and continuity. Laws, rules, social conventions a ...

, etc.) are substituted by a

distributed ledger A distributed ledger (also called a shared ledger or distributed ledger technology or DLT) is the consensus of replicated, shared, and synchronized digital data that is geographically spread (distributed) across many sites, countries, or institutio ...

. Some common methods of operation include the use of

or order book relaying, although many other variations are possible and with differing degrees of

decentralization Decentralization or decentralisation is the process by which the activities of an organization, particularly those regarding planning and decision making, are distributed or delegated away from a central, authoritative location or group. Conce ...

. Because traders on a decentralized exchange often do not need to transfer their assets to the exchange before executing a trade, decentralized exchanges reduce the risk of theft from hacking of exchanges, but liquidity providers do need to transfer tokens to the decentralized exchange. Decentralized exchanges can also prevent price manipulation or faked trading volume through wash trading, and are more anonymous than exchanges which implement

know your customer Know Your Customer (KYC) guidelines in financial services require that professionals make an effort to verify the identity, suitability, and risks involved with maintaining a business relationship. The procedures fit within the broader scope of a ...

(KYC) requirements. There are some signs that decentralized exchanges have been suffering from low trading volumes and market liquidity. The 0x project, a protocol for building decentralized exchanges with interchangeable liquidity attempts to solve this issue.

Drawbacks

Due to a lack of KYC processes, and no way to revert a transaction, users are at a loss if they are ever hacked for their passwords or private keys.Additionally, users staking in DeFi protocols can suffer what is called an impermanent loss. Although liquidity pool DEX are the most widely used, they may have some drawbacks. The most common problems of liquidity pool DEXes are price slippage and

front running Front running, also known as tailgating, is the prohibited practice of entering into an equity ( stock) trade, option, futures contract, derivative, or security-based swap to capitalize on advance, nonpublic knowledge of a large ("block") pend ...

. Price slippage occurs because of the AMM (Automated Market Makers) nature itself — the larger the deal, the stronger impact it has on the price. For example, if the constant product AMM is in use, every deal must keep the product xy = k constant, where x and y are quantities of two cryptocurrencies (or tokens) in the pool. So the larger is the input amount Δx, the lower is the final ratio y / x that gives an exchange price. The problem is mostly significant for large deals or small liquidity pools. Front running is a special type of attack in public blockchains when some participant (usually a miner) seeing an upcoming trading transaction puts his own transaction ahead (playing with a transaction fee for example), making the initial transaction less profitable or even reverted.

Degrees of decentralization

A decentralized exchange can still have centralized components, whereby some control of the exchange is still in the hands of a central authority. In July 2018, decentralized exchange Bancor was reportedly hacked and suffered a loss of $13.5M in assets before freezing funds. In a Tweet, Charlie Lee, the creator of

Litecoin Litecoin (Abbreviation: LTC; sign: Ł) is a decentralized peer-to-peer cryptocurrency and open-source software project released under the MIT/X11 license. Inspired by Bitcoin, Litecoin was among the earliest altcoins, starting in October 201 ...

spoke out and claimed an exchange cannot be decentralized if it can lose or freeze customer funds. Operators of decentralized exchanges can face legal consequences from government regulators. One example is the founder of EtherDelta, who in November 2018 settled charges with the U.S. Securities and Exchange Commission over operating an unregistered securities exchange.

Errors and hacking

Coding errors and hacks are common in DeFi. Blockchain transactions are irreversible, which means that an incorrect or fraudulent DeFi transaction cannot be corrected easily. The person or entity behind a DeFi protocol may be unknown, and may disappear with investors' money. Investor Michael Novogratz has described some DeFi protocols as " Ponzi-like". DeFi has been compared to the initial coin offering craze of 2017, part of a

cryptocurrency bubble A cryptocurrency bubble is a phenomenon where the market increasingly considers the going price of cryptocurrency assets to be inflated against their hypothetical value. The history of cryptocurrency has been marked by several speculative bubbl ...

. Inexperienced investors are at particular risk of losing money because of the sophistication required to interact with DeFi platforms and the lack of any intermediary with customer support. On the other hand, as the code for DeFi smart contracts is generally

open-source software Open-source software (OSS) is computer software that is released under a license in which the copyright holder grants users the rights to use, study, change, and distribute the software and its source code to anyone and for any purpose. ...

that can be copied to set up competing platforms, experienced users and user-created bots might create instabilities as funds shift between platforms which share the same code. In addition, DeFi platforms might inadvertently provide incentives for cryptocurrency miners to destabilize the system. In 2021, 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. Theft from DeFi can come from either external hackers stealing from vulnerable projects, or "rug pulls", where the developers and influencers promote a project and then take the money, as a form of pump-and-dump.

Regulation

In October 2021, the FATF included DeFi in the guidance for crypto service providers, making the authority's aim to regulate this type of asset. They are expecting each individual country to determine if individuals involved in DeFi can be considered a virtual asset provider and be subjected to the FATF's guidelines.

References

{{Cryptocurrencies, state=collapsed Cryptocurrencies Ethereum Finance