An Introduction to Decentralized Finance (DeFi)
A friend of mine that was familiar with Bitcoin, but a bit confused by all the developments that happened with DeFi this past year, asked if I could do an article explaining the basics. Here is my best shot at it.
The growing Decentralized Finance (DeFi) ecosystem has been one of the biggest stories in crypto this year, but things have developed so fast that many people are still trying to wrap their minds around what is going on. There is a whole lot of new information to sift through, even for those of us who are familiar with cryptocurrencies and how they have worked for the past several years.
Decentralization has been one of the primary goals of crypto culture, and in many ways, this goal has been achieved, but this is still a very new technology and we have a very long way to go before we realize its full potential.
In a general sense, the entire cryptocurrency ecosystem is sometimes referred to as “Decentralized Finance” but the area of innovation in the industry known as “DeFi” is a bit more specific, and this can be somewhat confusing, but really, this is just a part of the evolution in realizing the vision of true decentralization.
As it stands right now, Bitcoin, Ethereum, and other crypto networks are decentralized, but the vast majority of the applications that are needed to access them are not, which gives the entire ecosystem a few potential central points of failure.
For example, cryptocurrency exchanges and custodial wallet services have been forced to collect their customer’s private data for the government under the Bank Secrecy Act. A Custodial Wallet is defined as a wallet in which the private keys are held by a third party. Meaning, the third party has full control over your funds while you only have to give permission to send or receive payments. You can read more about custodial and non-custodial wallets here.
Exchanges have also been accused of gatekeeping tokens by deciding which projects get listed, and thus, which ones are more likely to succeed in the market. These centralized third parties have been almost unavoidable for crypto users, until recently with the deployment of DeFi platforms that are operated by smart contracts and governed by their users. For example, Uniswap, the largest and most popular decentralized exchange, does not require users to share their personal information and allows any development team to list their token without permission. On some days, Uniswap now does more volume than Coinbase. The identities of the team that built the project are well known, but they recently launched a token of their own, which allows users to contribute to the governance of the platform.
On the other hand, Sushiswap, a fork of Uniswap and one of the exchange’s top competitors, was founded by a team that has remained anonymous, with even more governance input from the user community.
In addition to exchanges, there are also DeFi lending platforms like AAVE that are offering services that were previously only available in the traditional financial system, but out of reach to people who didn’t have the required documentation.
Of course, the DeFi ecosystem is still incredibly new and may be intimidating or difficult to access for the average user. In their current form, which could reasonably be considered a beta version, these platforms can be expensive and require significant technical skill. There have also been a variety of hacks or exploits, although most of the popular services have reimbursed their customers when this has happened, which has earned them more trust in the community. It is important to note that the same thing could be said in the early days of Bitcoin when exchanges and custodial wallet services had far less trust than they do now.
The vast majority of these DeFi platforms are built on Ethereum, which makes sense because this is exactly the sort of thing that Ethereum was intended to make possible. Ethereum was built to be an all-purpose programmable blockchain for the creation of decentralized applications, whereas Bitcoin was built to be digital gold. Ethereum and Bitcoin set out to do two different things, which makes these technologies more complementary than competitive.
There are also ways that long-time Bitcoin holders can interact with DeFi, even though most of the development for these applications is taking place on the Ethereum blockchain. First, there are tokenized versions of BTC like Wrapped BTC or renBTC on the Ethereum blockchain. What this means is that there are Ethereum tokens pegged to the price of Bitcoin, which allows users to use Ethereum-based DeFi applications without losing their exposure to the price fluxations of Bitcoin.
There are also layer 2 solutions like Sovryn that are building DeFi applications on the Bitcoin blockchain. A “layer 2 solution” is an additional layer that is attached to a blockchain to allow it work better or to add more features. The Bitcoin Lightning Network is an example of a layer two solution that was built in order to speed up transactions and make them cheaper. This is the most well-known layer 2 protocol for Bitcoin, but the one used by Sovryn is called “Rootstock” and it was specifically implemented to enable smart contracts on the Bitcoin blockchain.
There are also bridges being developed that will allow different blockchains to interact with one another seamlessly, much like how databases at college campuses were bridged together in the early development of what we now know as the internet. Polkadot and Chainlink are examples of this, as their purpose is to connect all the blockchains that are doing different jobs into an internet of blockchains that creates a seamless user experience. Many industry experts expect that users will someday be able to interact with these applications in the near future, without even needing to know what blockchain they working on at any given time.
The entire blockchain industry is very new, and while it has already created revolutionary working products, they are still nowhere near complete and still have a long way to go before reaching their full potential. This gradual process of building and expanding upon the capabilities of the tech to add functionality and serve more people is known as scaling. Companies or networks need to make the scale of their operations larger in order to keep up with the demands of a quickly growing customer base.
In 2017, as most of the world was first learning about cryptocurrencies, there was such a massive demand for Bitcoin that it was difficult for the network to keep up, causing high fees and slow transaction times. As we have seen over the past few years, Bitcoin developers worked hard to scale the network and address these problems, which has significantly lowered fees and transaction times.
Ethereum is a few years younger than Bitcoin, and is now going through a similar scaling process to meet user demand. The explosion of DeFi this past year has led to an unprecedented level of development on Ethereum, and has caused significant congestion on the network, which is the reason why using DeFi platforms like Uniswap can be so expensive. However, this issue is a top priority for developers because the true vision of this technology is for it to be accessible by everyone.