How does DeFi work?

Decentralised Finance, or DeFi for short, represents a system of financial products built on top of decentralised and open-source blockchains. As opposed to centralised finance there are no central authorities and financial institutions to facilitate transactions and financial access.

DeFi offers higher levels of financial access by offering the possibility of a suite of financial products built on permissionless (i.e. anyone is free to participate) blockchains. Financial products and services can be programmable on the blockchain and participants can interact with each other cutting out the middleman of financial institutions who traditionally provided the service of intermediation. In addition to providing alternative access to traditional financial products (borrowing, lending, saving, exchange, insurance etc) it offers a platform for new innovation and challenges for regulation. The field has recently seen phenomenal growth in the blockchain and cryptocurrency space and is increasingly being recognised as a potential disruptor to traditional centralised finance.

Ethereum blockchain

DeFi also offers the possibility of unique financial architecture to be added piecemeal as “money legos’’ to the financial ecosystem. The Ethereum blockchain (which most DeFi applications are built on) being open-source and permissionless means anyone can deploy transparent code and users can interact with each other through computer code without the need for intermediaries such as banks, brokers and lawyers etc. The first Bitcoin blockchain was designed as a mechanism for transactions using digital money with the Bitcoin cryptocurrency. In contrast, the Ethereum blockchain was designed as a general purpose blockchain.

Smart contracts

Users on the Ethereum blockchain can interact through Smart contracts which can be thought of as small computer programs that bind counterparties e.g. buyers and sellers through self-executing code on the blockchain. This allows decentralised applications (dapps) to be uploaded and run with smart contracts autonomously with little to no human support needed.

Gas

Gas can be thought of settlement fee needed to be paid for transactions on the Ethereum blockchain. Gas is a unit that measures the computational effort required to perform a transaction on the network. The fees thus can vary depending on the nature of transaction i.e. more complex transactions will require more gas fees and also depending on congestions on the Ethereum network (more gas fees are charged similar to an Uber peak hour surcharge).

DEXs

A novel product that has seen increasing success are DEXs (decentralised exchanges) that allow users to trade and exchange cryptocurrency tokens by interacting through protocols coded as an algorithm that provides an automated market making function. This means instead of an buying an asset from a traditional exchange (e.g. buying a stock on the Australian Stock Exchange) which typically has a buy and sell mechanism called an order book, users interact through a DEX protocol. This is essentially an algorithm (again computer code!) that allows traders to transact 24/7. Not only can users trade or source liquidity from DEXs they can themselves also seed this liquidity pool with their own existing assets.

Liquidity pools

A liquidity pool is essentially a smart contract that contains funds of crypto assets. Any user is free to deposit their tokenised assets (assets converted into a smart contract) no matter how small in quantity into this pool and earn fees as a liquidity provider. In addition to fees, liquidity providers can also earn rewards from the underlying DeFi platform in other ways e.g. being rewarded interest for loaning or governance tokens of the protocol that itself has tradeable value.

Yield farming

Yield farming is this process of earning a financial return this way by engaging their crypto assets as a liquidity provider in liquidity pools. Thus DeFi offers a new way to earn money akin to yields, dividend and yields from bonds, equities and interest from bank deposits in traditional finance. Instead the user with their idle crypo assets can themselves act like a bank charging interest on loans or lending out held assets.

Flash loans

Another key concept in DeFi is Flash loans. This allows to borrow from from a smart contract pool without providing any collateral. The loan is only valid within the confines of one Ethereum transaction and paid back at the end of the transaction. When the transaction goes through the loan is paid back. If the repayer does not repay their debt the transaction is reversed and balances go back to its original states. This process ensures there is no counterparty risk for the lender. The main uses for flash loans are refinancing and arbitrage.