DeFi revolves around applications known as dapps that perform financial functions on digital ledgers called blockchains, a technology that was invented for Bitcoin but has since caught on more broadly. Dapps let people lend or borrow funds from others, go long or short on a range of assets, trade coins or earn interest in a savings-like account. The transactions are governed by rules embedded in the software called smart contracts. Many of these apps can also hook on to each other and work together to create complex financial services.
2. What’s a smart contract?
It’s an “if x, then y” agreement. You could consider an automatic payment plan with a traditional bank to be a smart contract — it will withdraw money to send to your mortgage company on the first of every month till it’s told to stop. DeFi contracts can be far more complex. And instead of making an arrangement with a central intermediary, DeFi apps are meant to work independently, directly connecting counterparties. Once smart contracts are launched, they usually can’t be changed or tweaked by anyone. Many of these smart contracts run on a blockchain called Ethereum, which was designed to include more information and the kinds of transactions performed by dapps, unlike the original ledger invented for Bitcoin, which mainly keeps track of the transfer of coin ownership.
3. What’s a more typical example?
All DeFi apps work differently, but here’s the most basic way: People can connect an account on a cryptocurrency exchange to a DeFi app and then lend some of their coins, or borrow against their collateral. Many common transactions are far more complicated, with people buying things like “wrapped Bitcoin,” a token used on Ethereum that represents one Bitcoin, to speed up DeFi transactions, and entering into complex arrangements using multiple DeFi apps to amp up their earnings.
4. How is this different from “fintech”?
There are companies that allow what’s known as peer-to-peer lending, which routs capital from investors to borrowers without a bank’s traditional intermediation, but they are still companies overseeing the process. The makers of dapps seek to create a platform they step away from, on which counterparties interact directly.
Since many smart contracts require counterparties to post collateral as a guarantee, analysts track the growth of dapps by looking at the amount of money effectively locked in the DeFi ecosystem. In late August, the total amount of collateral people have poured into DeFi applications exceeded $7 billion, according to tracker DeFi Pulse. That was up from less than $1 billion at the end of May. (Even with that surge, DeFi is a drop in the $360 billion overall cryptocurrency market.) There are more than 200 DeFi applications, with more making their debut weekly. The first dapp to catch on broadly was MakerDAO, which has been evolving since 2015.
6. Why is there so much interest in DeFi now?
Several DeFi apps such as Compound debuted this summer with promises of triple-digit returns that pushed scores of speculators to dive in. Longer term, with global economies in turmoil amid the Covid-19 pandemic, the idea of global financial services independent of banks or other companies that can fail is gaining in appeal.
7. Besides speculation, what’s the big potential benefit here?
More than 1 billion people around the world still don’t have access to even basic banking services. DeFi holds the promise of offering anyone with an internet connection and a mobile phone access to a full array of banking services — and to earn a return on their savings, however small. One group in particular that turns to dapps is the so-called miners of Bitcoin and other cryptocurrencies — mining is a computational process used to verify a currency’s transactions that’s rewarded with grants of the currency. Miners are often unable to get loans through traditional financial institutions.
8. What are some pitfalls?
Like everything else in the realm of digital currencies, or software in general, DeFi accounts can be vulnerable to hackers. Even buggy code can destroy value. Take Yam Finance, which quickly amassed $750 million in value — and then crashed days after launch when a bug in its code made it impossible for the app to function properly. Speculators can also hype up a service — and when they bail, bring an app’s value down. A dapp’s internal logic can also potentially contract or expand supply, changing a coin’s value. That’s what happened with Ampleforth, whose coin’s market capitalization cratered by nearly two thirds in less than three weeks this summer. There’s no deposit insurance for DeFi apps, though that could change as teams like Nexus Mutual are building ways to provide a kind of insurance to the DeFi ecosystem. Users wiping themselves out by accident is dismayingly common, too.
Since there are no banks or other intermediaries to hold their hands, users of DeFi applications have to be very careful in everything they do: Their transactions can’t be reversed. DeFi users had also better understand exactly how a particular service works, by perusing related white papers and tutorials — or risk getting many unpleasant surprises. Another source of risk: many DeFi ideas are so new, it’s unclear whether they comply with existing regulations.