Nansen breaks down the basics for one of blockchain's most important subsectors
Crypto is a vast and ever-growing landscape. It can seem like every single day hosts the birth of novel applications, use cases, and new jargon that participants need to learn in order to stay up to date. The ecosystem not only evolves rapidly, but crypto developers are likewise are highly encouraged to embrace the open-source ethos, creating an abundance of information and occasionally turning the blessing of transparency into an information overload for the retail investor.
Decentralized Finance (DeFi) is one of the most vibrant blockchain subsectors. But as lively as it is, it is also filled with ladders of abstractions that make navigation difficult without a solid foundation in the underlying technology.
This article aims to provide that solid foundation to readers by painting an overall picture of DeFi. We will talk about the industry's fundamental logic and unique value proposition, some of the financial services Defi provides, possible investment strategies and risks for users, what DeFi's future might look like, and what you can do to get become knowledgeable on DeFi.
In essence blockchains are tools for coordination. They replace human-centric trust assumptions with open-source software and enable new avenues for building coordinative ventures. Decentralized Finance is one of the major verticals born from blockchain-based coordination in recent years with the aim to increase transparency and inclusivity in financial services with minimized trust.
A straightforward explanation for decentralized finance is that it is an umbrella term used for applications that provide financial services for digital assets on immutable and permissionless environments (a.k.a blockchains). They alleviate the necessity for intermediaries by replicating core services offered by traditional financial institutions through open-source code and in some cases provide innovative services unique to the digital world.
There are still ongoing discussions regarding the kind of properties a protocol needs to possess to be called "decentralized." For instance, is having non-custodial transactions on a fairly decentralized blockchain enough for a finance service to be called decentralized (e.g., on a blockchain that is "sufficiently decentralized" according to certain metrics)? What about the governance of the project? Or its development? Or even the practical centralization coming from liquidity sink caused by network effects?
While these debates are engrossing, let’s not get lost in details as this article aims to be an introductory resource for DeFi. Ultimately, permissionlessness happens to be the most crucial aspect of DeFi as it not only constitutes the foundations for an inclusive financial system, but also paves the path for its continuous global development. Anybody can create a DeFi application on a public blockchain and integrate their service into a vast, interoperable system. As these financial products are built on a shared infrastructure (e.g., Ethereum), they are all composable by nature. They can communicate seamlessly and integrate with other services built on the same blockchain without arduous integration hurdles. That's why they are often called "money legos."
While Bitcoin only supports transactions with simple value or information transfers, blockchains like Ethereum, Avalanche, and Solana are designed as smart contract platforms that support arbitrary state transitions. All transactions are made through unique accounts called smart contracts, which are recipes with logical directives that incorporate conditionality to transactions. A less fancy explanation is that these smart contracts are computer programs that live on the blockchain. Decentralized applications, NFTs, fungible tokens, and anything claiming to be a somewhat complex on-chain product are all powered by smart contracts.
The permissionless and immutable nature of public blockchains combined with this possibility for complexity constitutes the foundations for DeFi applications. Through the conditionality, decentralized lending platforms are able to hardcode the rules for loans, decentralized exchanges enable trading without a centralized clearing mechanism, and developers can introduce unique financial instruments to the digital economy.
There are layers to every DeFi application. When a user interacts with one through a website, like with Uniswap to supply ETH and USDC as liquidity, they are essentially using an interface to call the smart contract on the Ethereum blockchain. The main immutable product is the smart contract, while the website is a mere layer that facilitates access to the chain. Shutting down the website or disbanding the team behind the project will not affect the continuity of the application. The immutability of smart contracts means that funds and services live on as long as node operators continue to power the underlying blockchains.
To learn more about smart contracts and how to read them, refer to this thread.
As discussed above, there is not full consensus as to the properties that define DeFi. However, protocols that are considered to be part of the decentralized finance landscape tend to share certain traits marking them as distinct from traditional finance, such as:
Non-custodial: Users have complete control and responsibility for their assets.
Inclusivity: Anyone with the minimum hardware equipment (a device and Internet connection) can access decentralized finance. In contrast, traditional finance holds artificial or natural limits on who can participate in what kind of financial services.
7/24 Access: The automated nature of DeFi allows anyone to reach services as long as the underlying blockchain is online. Traditional finance, on the other hand, has working hours.
Transparency: The transaction history of a public blockchain can be seen in full detail by anyone (a caveat is that privacy-enabling public smart contract platforms like Secret Network prevents seeing them in full detail). Although fully on-chain services may protect users against macro collapses by revealing systemic risks sooner, the price paid for that is often the user privacy.
Pseudonymity: In contrast to TradFi, users can technically choose to access DeFi services without revealing their credentials or their real names.
Composability: As mentioned above, DeFi applications work like money legos. Traditional finance is built as separate closed systems that need immense effort for integration between service providers.
Regulation: DeFi is often called the Wild West of crypto as it is currently unregulated and thus allows predatory acts due to the lack of accountability. Traditional finance, on the other hand, is highly regulated and focuses on accountability.
Governance: With all its flaws, governance in DeFi remains to be one of the main differentiators between DeFi and TradFi as it contributes to the alignment of the project and the community (and the users of the application occasionally) Token holders can play an active role in changing service parameters, deciding where the treasury funds should be allocated, coming up with expansion strategies, and determining changes in other vital parts of the application. This alignment and empowerment of the stakeholder are limited in TradFi.
It should be apparent that these comparisons are according to the current situation of both industries. While some of the differences constitute the core tenets of decentralized finance thus unchangeable, some of them like pseudonymity and regulation might be subject to change in the coming years.
One of the first few things you can do with your on-chain funds is to use them for acquiring other digital assets or more sophisticated financial instruments like perpetual futures contracts and options.
While centralized exchanges like Binance and Coinbase only allow users to trade in a permissioned and custodial manner, a decentralized exchange (DEX) provides peer-to-peer trading services without a centralized clearing mechanism or external custody of funds. Users are able to trade on the existing markets permissionlessly, or alternatively, freely create new markets for their desired assets and make them accessible to everyone.
The main technical difference between a DEX and a centralized exchange is the design choice for the matching mechanism and how they manage liquidity. The most popular DEXs for spot trading adopt automated market makers (AMMs) with different models (i.e. PMM, CPMM, TWAMM, etc.,) where both sellers and buyers trade against a pool of liquidity. Uniswap and Sushiswap on Ethereum, Pancakeswap on Binance Smart Chain, Trader Joe on Avalanche, Quickswap on Polygon, basically almost every major spot DEX (with Serum as an exception) is based on a version of AMM —which is convenient since they are all essentially based on Uniswap’s smart contracts.
The first iterations for DEXs mainly focused on providing spot trading services. However, as the industry matured, more sophisticated financial instruments started to join the space. Then we witnessed the proliferation of DEXs like dYdX and Perp Protocol with CLOBs for perpetual contracts. The potential use cases for DEXs expanded further with the adoption of Opensea as a trading venue for NFTs, trading of more niche financial instruments (e.g. yields) with protocols like Pendle Finance, and even experimentation with AMMs for NFT trading with Sudoswap.
DEXs are the backbone of on-chain activities involving any kind of tangible value transfer. They help the industry function in efficient markets by allowing the continuous reevaluation of digital assets.
Another service widely provided by traditional financial institutions is loaning. DeFi applications like Aave, Compound, and Maker focus on connecting users who seek funds (borrowers) with others who want to bring productivity to their idle capital (lenders). They achieve that by allowing lenders to generate revenue on their digital assets and borrowers to access liquidity without selling their holdings.
In contrast to centralized crypto lending platforms like Gemini and Coinbase, decentralized lending markets work permissionlessly through smart contracts, meaning that taking loans, depositing and withdrawing funds, yield distributions, and liquidations are all conducted through code and without the presence of a central authority.
Lenders can freely deposit funds to the market pools and start earning passive income on their assets. Due to the lack of viable implementation of on-chain user credit scores and the possibility to show real-life assets as collaterals, most of these markets only offer collateralized loans and require borrowers to lock a great amount of highly liquid digital assets in order to acquire funds. However, applications like TrueFi and ReputationDAO are aiming to solve the problem with on-chain credit scores while Aave is innovating on the latter front with its loans to small businesses.
Although over-collateralization can be an inconvenience for the borrower, loans are still valuable for those who are in need of funds desperately but don’t want to liquidate their stack to access liquidity as loans allow them to avoid the opportunity cost of selling.
The total value locked in lending platforms has been in a sharp decline in recent months due to the market downturn. Yet as of mid-2022, Aave still has more than $10 billion in deposits and serves in more than 30 markets. Meanwhile Compound follows it with $3.7 billion TVL and 18 markets.
On top of countless iterations inspired by Compound and Aave, there are numerous other decentralized money markets experimenting to address specific problems. To give a few examples; platforms like MetaLend and JPEG’d focus on NFT-backed loans, fixed income protocols like 88mph and Notional Finance aim to give stable returns on fungible assets, Maple Finance provides uncollateralized loans to crypto institutions, and Abracadabra Finance allows taking loans against interest-bearing assets.
The volatility in crypto is seen as a blessing by the traders, but it is one of the most fundamental barriers practically preventing technology to achieve any kind of mass adoption. To make crypto suitable for storing wealth and pursuing commercial activities, the industry created cryptocurrencies with the sole mission to stay pegged to a certain value (e.g. $1) through specific stabilizing mechanisms.
There are three main mechanisms that these price-stable assets can adopt to maintain their peg. The most popular and battle-tested one is full collateralization where the coin is completely backed by valuable assets that users can redeem their asset for. Top stablecoins in the market such as USDT, USDC, and BUSD are designed to be backed by cash and cash-equivalent real-world assets. Meanwhile, DAI is backed by a basket of on-chain assets like ether and USDC. There are also niche and experimental fully collateralized stablecoins like UXD which is backed by delta-neutral positions.
The second type of peg mechanism is algorithmic. Stablecoins of this type are not backed by any asset and instead rely on seignorage activities to meet supply with demand. When the demand for a stablecoin pushes its price above its peg, the issuer increases the supply and reduces it through burning when the price is below the peg. Ever since the monumental collapse of UST, there is no highly-scaled algorithmic stablecoin in operation. Check our in-depth report on UST depegging to learn more about how it fell into the death spiral.
The third mechanism is an amalgam of the previous ones: partially collateralized. Cryptocurrencies like FRAX aim to bring stability and capital efficiency to the market by partially backing the asset with collateral and complementing it algorithmic supply management.
Stablecoins constitute the largest portion of decentralized finance by market cap with their total valuation passing $140 billion. Their dominance in DeFi applications is quite high as they provide protection against the unfavorable effects of market volatility.
As DeFi might pose serious security risks to users, applications like InsurAce Protocol and Nexus Mutual step up to offer insurance services on digital assets, mainly focusing on fungibles. Smart contract and wallet exploits, exchange hacks, stablecoin depegs, and any other damages caused by specific failures intrinsic to decentralized finance are covered through these services.
The most basic version of payments has been functionally present way before DeFi emerged as oneo f the core use cases of cryptocurrencies. The introduction of conditionality through smart contracts on the other hand allowed DeFi to incorporate programmability to these services. Applications like Superfluid on EVM chains and MeanFi on Solana allow parties to stream money with a continuous settlement with sub-second updates. Having the money sent equally in a time period facilitates recurring payments such as rewards and subscriptions.
Since blockchains are isolated environments, smart contracts cannot access data shared outside the system, which significantly reduces their integrability to real-world operations. That’s why the overwhelming majority of decentralized applications rely on third-party entities called oracles to bridge information between on-chain and off-chain mediums.
Commodities, forex, and many more assets that cannot be integrated into blockchains naturally can be thanks to the data feed services provided by oracles like Chainlink. DeFi applications use oracle price feeds in many areas including managing liquidations for loans and trade positions, calculating collateralization ratios and interest rates for decentralized money markets, reward calculations for staking, and peg maintenance for stablecoins.
Assets originating from one chain cannot be used on other chains by default. They first need to go through a simple process called wrapping. If a bitcoin holder wants to carry their assets to Ethereum, they’ll soon realize there is no direct way of sending non-native assets between blockchains since the two are isolated environments. However, they can mint an Ethereum-equivalent bitcoin with their holdings.
As Bitcoin doesn’t have smart contracts, both minting and redeeming are done custodially. User trades their bitcoins with a custodian and mints an ERC-20 version of bitcoin on Ethereum, be it WBTC, renBTC, or any other wrapped representation depending on the custodial organization responsible for issuance. Thus an investor gets WBTC; an ERC-20 token pegged to the price of bitcoin and available to use in DeFi applications like DEXs and lending platforms.
Transferring assets between smart contract platforms (e.g., Ethereum to Avalanche) doesn’t necessarily require custodial intermediaries. Although there are trusted bridges, the ones with the most integrated chains are trustless (e.g. Synapse Protocol), meaning that they enable cross-chain transfers of assets and information without using any custodians. Instead, they use smart contracts and supervising third-party messenger to satisfy the custody, minting, and redeeming activities.
Bridges enable liquidity to flow seamlessly between chains while potentially boosting the interoperability between isolated environments. This allows users to favor one design choice over another (e.g. speed over security) in certain cases without burdening any significant exit costs.
Bridges also come with their own security risks and may cause capital inefficiencies in certain scenarios with liquidity fragmentation. The total value lost with bridge hacks recently passed $1 billion.
DeFi apps offer several passive income investment strategies bundled under the name “yield farming.” A yield farmer aims to maximize the return on their assets through actively searching market opportunities in the following domains: staking, lending, and liquidity mining. Let’s explore each one by one.
Advantages: Grants protection against dilution, allows earning passive income, and is a tool for actively participating in the project.
Disadvantages: Potential financial risks of locking highly volatile assets for a long time.
If you are new to crypto, you must have heard the word staking in different and perhaps inconsistent contexts. The word originates from the security mechanism of proof-of-stake (PoS) blockchains where asset holders lock their funds to a validator to secure the transactions. And since any malicious behavior on a PoS blockchain is punished by the burning of a portion of the funds, those who lock their funds to validators are basically putting their assets at the stake for getting the right to validate.
A second meaning for the word was born when DeFi applications replicated the act of locking user funds to orchestrate incentives. Staking on DeFi applications (but not on application-specific DeFi blockchains like Osmosis or Injective) neither is for securing transaction validity nor involves a direct punishment mechanism for malicious behavior. Instead, it means locking funds onto a DeFi application’s smart contract to acquire exclusive benefits. These include rights to governance, a share from protocol fees and new token issuance, airdrops, as well as an exclusive opportunity on taking a more active role in protocol development and access to job positions.
Although staking in DeFi first appeared as a tool for applications to reduce selling pressure on their tokens and ensure continuous incentivization, it gradually evolved out of unsustainable models. Recently, a new version of staking called vote-locking (or vote-escrow) gained popularity between DeFi apps since Curve Finance has become the flagbearer for the model. VeToken model involves users locking their CRV in a smart contract for a time period ranging from 1 week to 4 years and in return getting voting rights, a portion of trading fees, and new CRV tokens proportional to their lock period. This form of staking aims to reduce speculative participation and create a community aligned with the long-term success of the protocol.
As the options for earning passive income on long-tail assets are quite limited, staking becomes the only available investment strategy for most of the micro and midcap tokens. If the rewards for staking involve giving out freshly minted tokens to stakers, then investors holding any stakeable token idle risk having their capital diluted. This means it can become a necessary activity for an investor to protect their funds against inflation.
Check out Nansen’s DeFi Paradise dashboard to see the active staking opportunities in the market and how smart money is positioned for their staking strategy.
Advantages: A safer way of putting funds to utilization.
Disadvantages: Yields are relatively low—opportunity cost in bull markets.
Pretty much every major asset in DeFi can be lent to other parties. It is the safest and simplest way to keep the money working in a risk-averse environment. And unlike staking, the rewards are strictly financial and easily quantifiable. There are quite a few avenues an investor can park their holdings, depending on the type and the amount of asset they want to lend.
Major platforms like Aave and Compound specialize in enabling users to lend the most popular crypto assets like WBTC, USDC, and ETH in great amounts and distribute variable returns on their assets. For those who want to harbour against the interest rate volatility, fixed income platforms like Element, and 88mph offer a fixed return on investments. And alternatively, users can create their own lending markets on Rari’s Fuse pools or search from the existing markets for their long-tail assets.
Certain platforms support a very short-term loan intrinsic to DeFi called flash loans. It’s a special type of uncollateralized lending where users can borrow funds for a single block (i.e., they borrow and pay the amount in the same block) to take advantage of market opportunities like arbitrage.
The soundest advice for those willing to deposit their funds to a decentralized money market is to make sure the case for the sustainability of yields is supported with readily available on-chain data. The great collapse of Anchor and Terra reminded everyone always to check the source of yields. Conveniently, hosts a dashboard showcasing yields currently available in major DeFi apps.
Advantages: DEXs sometimes have special offers that boost rewards for liquidity mining, making the activity yield more lucrative returns than lending.
Disadvantages: Impermanent loss.
Decentralized exchanges pool two or more assets in one place and on price functions. An efficient DEX requires deep liquidity in its pools so that users don’t suffer from slippage (link to definition) and trade assets at a fair market price. That’s why DEXs constantly optimize for liquidity efficiency and invite asset owners to supply their pools, and in return, reward them with a portion of trading fees.
Here is how it works, basically. Say an investor holds ether. And as they head over to Uniswap Pools, they see that supplying liquidity to the ETH-USDC pool is the most suitable choice for their risk appetite. However, most DEXs do not support single-sided liquidity provision and require liquidity providers to supply both assets in the pool in the same USD amount. Therefore, our investor converts half of their ether to USDC to supply liquidity. And as a liquidity provider, they get rewarded for renting out their assets.
The best way for you again is to try it out yourself. Head over to the Uniswap pools linked above, make sure you are on one of the Ethereum testnets, and use the assets you acquired from Chainlink Faucet to provide liquidity.
Also the liquidity mining tool on Nansen's DeFi Paradise dashboard helps you see the best deals in the liquidity provision market.
Smart contract risk: Providing financial services without traditional intermediaries requires extreme vigilance for smart contract security. Hackers are highly incentivized to search for security breaches and any weakness in smart contract code carries the potential to cause millions of dollars to be lost through exploits. DeFi applications commission external audits on their smart contracts and have their core logic battletested before releasing it into the wild. Yet even audited contracts might carry the risk of exploitation.
Insolvency risk: The default transparency in DeFi allows users to easily access the information on protocol solvency (reserves, debt, etc.) This makes the insolvency risk more detectable and avoidable compared to the potential risk present in a centralized counterpart. However, the recent Terra crash showed that obfuscation of certain facts can result in DeFi applications growing beyond a sustainable limit without notice. The risk of dangerous shadows among the light of transparency should keep an investor sharp-eyed.
Irreversibility risk: Due to the immutable nature of blockchains, transactions are not reversible and any wrong transfer can result in people losing their funds completely. This is one of the greatest user-experience problems for general adoption.
Miner Extractable Value (MEV): Being on-chain means your hand is mostly open. A validator (miner) can detect your transaction request involving profitable actions (e.g. an arbitrage opportunity) and can decide to take advantage of the market opportunity themselves before pushing it on the chain, killing the profitability of the action for the user and putting an invisible tax on using open systems. There are several MEV-protected DEXs (e.g. Cowswap) but the most popular ones with the deepest liquidity are susceptible to it.
Getting too lost in abstractions: Once an investor gets familiar with DeFi, they’ll see that a great amount of work in the industry is dedicated to wrapping an asset beneath layers and layers of financial instruments. Getting entangled in too much abstraction might make an inexperienced investor take unsound investment decisions.
Rugpull risk: Accountability in DeFi is quite limited. Predatory founders have been using this to their benefit for a while now, gathering funds from investors to siphon them out of the smart contract through back doors in the code.
Nonetheless, being able to see the code for the smart contract allow investors to avoid any "hard rugs" (direct siphoning of the funds) as it will be apparent in the contract logic. "Soft rugs" persist as founders continue quitting without any consequence or liability and platform treasury getting slowly siphoned out for misuse.
The substance beneath DeFi, finance, is not something that changes very often. Although it gradually got better, faster, cheaper, and more accessible to the masses throughout the years, the core of the financial activities mostly stayed the same. However, let's not reduce its potential scope to the legacy of older domains. This is a rapidly evolving industry that relentlessly optimizes to bring services on par with their centralized counterparts and occasionally invents previously non-existent financial tools in the process.
It is hard to know what the future will bring yet here are some of the possibilities that might be valuable to contemplate:
Hopefully, this article did help the readers to have a basic understanding of DeFi. By signing up for Nansen, users can access market-leading crypto intelligence tools to help them guide their crypto investing.
Additionally, there are countless free resources at our disposal to expand on this knowledge and help us keep up with the latest developments in the industry. Here are some of the well-curated resources for you to access the best information and content creators in the space.
Subscribe to the Nansen newsletter to keep up-to-date with the latest news in DeFi!
A guide hub: Pentacle