You’ve probably heard of DeFi. But what is it? And why is there so much interest in it?

DeFi stands for decentralised finance. It’s a term that was created when finance projects launched on blockchain systems. These projects got their name from their “decentralised architecture.”

  • Decentralised is the opposite of centralised: it’s distributed. A decentralised system enables a direct connection between market participants. It cuts out unnecessary middlemen. 
  • Finance involves the handling and management of money. This includes moving money – like when you send money to a friend. And it includes receiving or offering loans. 

These two words give us a very simple and digestible definition of DeFi – distributed money management without the involvement of unnecessary central authorities or middlemen.

Eliminating middlemen in finance

Unnecessary middlemen often raise your costs while ensuring you receive less. Let’s use ordering pizza as an analogy:

  • When you order a pizza online, you pay for a whole pizza. You receive a whole pizza. There’s only one delivery person. This works well.
  • But what if your pizza was handed off consecutively to 5 different delivery people, each of which ate a slice of your pizza? By the time you received your pizza, there’d be a lot less of it even though you paid for a whole pizza.

DeFi is like the pizza parlor that sends your pizza directly to you.

The traditional financial industry is filled with middlemen who “eat a slice of your pizza” so you pay more for less.

For example, middlemen can raise the cost of borrowing substantially. Even small fees for everyday transactions – such as the fees you pay at an ATM or for sending money online – add up over time. 

DeFi: Flexibility and innovation

Now let’s add a bit of nuance. It could be argued that DeFi projects are not completely decentralised, since there are operations teams behind such projects and they shape how the service works.

And DeFi companies make a profit by charging a fee for all transactions that pass through their network.

But remember, one of the goals is to eliminate unnecessary middlemen and unnecessary fees. 

The real incentive proposed by DeFi advocates is that these services are less centralised than what conventional financial institutions offer.

  • DeFi fees are far lower than those of banks and government-backed institutions. 
  • Users are also incentivised by greater liquidity between network participants, a factor that also contributes to the appealing fees.

Unlike traditional financial structures, which are hierarchical and rigid, the flexibility and community aspect of DeFi allows for new and creative options to emerge, like:

  • Crypto loans that don’t require collateral.
  • New insurance products that protect against hacks, crypto volatility, and digital theft.

How do DeFi Projects work?

At this moment, the most popular type of DeFi projects are lending platforms and crypto exchanges. There are many plans in the works to extend DeFi horizon to other aspects of money management.

Any service or organisation wanting to provide a service that would traditionally involve a middleman could opt for a DeFi solution. This can actually include loan companies, brokers, and banks.

Before we dive into some examples, let’s define a few terms that may be new to you:

  • Blockchain: a system on which transactions are validated by a particular computational algorithm. Transactions are typically processed in “blocks” and linked together in chains, hence the name blockchain. It is a chain of transaction blocks.
  • Transaction block: a group of transactions that happen within the same computational period on a blockchain.
  • Smart contract: code that allows the creation of predefined conditions for outcomes of a transaction.

Let’s take a look at three DeFi projects, both operational and in development.

AAVE

AAVE is a decentralised finance platform built on the Ethereum blockchain. The service allows for peer-to-peer lending via smart contracts that are validated by a pool of cryptocurrency funds. 

The main dynamic of the platform is for lenders to seek interest from borrowers that need capital. AAVE supports 25+ different tokens, meaning network participants have a choice of currency to lend and borrow in. 

As a result of smart contracts, AAVE offers the ability to create different types of loans, like flash loans. Flash loans allow one to borrow without collateral, on the condition that the original figure is returned within the same block of transactions on the blockchain.

Uniswap

Uniswap is another DeFi platform, also built on the Ethereum blockchain. The exchange runs on two smart contracts, or programs. One facilitates the addition and withdrawal of listed assets, while the other manages the conditions for transactions. 

The Uniswap model also comprises something they call an automated liquidity pool, where all network users pool their money together in a secure token pool to make the exchange work. 

The liquidity pool’s incentive is that buyers and sellers don’t need to wait for an opposing party to complete a transaction. The pool defines what they can and can’t do based on current market conditions to provide what the algorithm deems the fairest possible trade.

ADALend

ADALend is one of many DeFi projects in development that aims to challenge the aforementioned services running on the Ethereum blockchain. 

This project is designed and runs on the Cardano blockchain, a network that theoretically offers cheaper and faster transactions.

As opposed to a single token pool, ADALend will have several asset pools. Flexible lending options are promised with native $ADAL token holders having the ability to participate in the governance of ADALend via voting rights.

Governance in DeFi

Projects built on the Ethereum blockchain have neglected the idea of distributed governance, since the foundational architecture of the network does not support the needs of building a voting system for token holders.

However, systems with a Proof of Stake (PoS) design, like Cardano (and its developing project ADALend) are built with governance in mind. DeFi projects built on PoS networks pose an entirely new aspect to decentralised finance – governance of how the system functions via voting rights.

It isn’t as simple as it sounds, since voting rights are based on the volume of tokens held. High balance account holders (also known as whales) would have multiple-fold voting rights over ‘small fish,’ so the potential for capital-driven power structures is likely.

Having users contribute to a financial system’s governance may be the key stepping stone for many to consider these services as truly ‘decentralised.’ 

With pooling and peer-to-peer transactions set in stone, governance is the next game-changer for DeFi.