What is DeFi?
Everything you want to know about DeFi (but were afraid to ask)!
In this article:
- What is DeFi?
- How is DeFi non-custodial?
- What is a DEX?
- DeFi functions and terms
- What are dApps?
- How do I connect to dApps with the Exodus Browser Extension?
- Safety and security for DeFi and dApps
What is DeFi?
DeFi, or decentralized finance, is also known as open finance or money legos. DeFi is a blanket term for financial services that use decentralized infrastructure such as blockchain technology and smart contracts. Some examples of what you can do in DeFi include:
- Peer to peer trading
- Providing liquidity
Because of the decentralized infrastructures that DeFi uses and its accessibility to anyone with an internet connection, it can give people access to financial tools that could previously only be done through a bank or other financial institution. This is made possible by the use of smart contracts.
With DeFi, you can receive a near-instant loan without needing approval, earn interest on your assets, and complete peer-to-peer trades, all while maintaining custody of your crypto.
As DeFi has brought the power of code to financial services, it has opened the door to new potential: yield farming, arbitrage optimization, automated market makers (AMM), and decentralized organizations (DAOs).
If this is a lot to take in, we get it! In the rest of this article, we'll review some of these terms and functions in more depth.
Please note: Exodus is a non-custodial software wallet that provides the interface for you to connect to the world of DeFi and dApps. DApps are platforms that are external to Exodus, so please make sure to do your own research before connecting. For more information on how to stay safe, you can read our guide: Safety and security for DeFi and dApps.
How is DeFi non-custodial?
With many DeFi protocols, it would be easy to think that by using a protocol you've given it custody of your funds. However, thanks to smart contracts, this isn't necessarily the case.
When you interact with a DeFi smart contract, it doesn't gain access to your funds right away. Instead, you give the smart contract permission to make a transaction with your assets under certain conditions. Only when those conditions are met will the smart contract execute and take custody of your funds.
Up until the smart contract executes, however, the funds remain in your wallet and under your control.
Because of the access that smart contracts can have to your funds, it's important to always do your research on the protocols you interact with. All smart contracts are open-source and anyone can review and audit exactly what the code is designed to do. That way, you're able to tell if the protocol is trustworthy or not before entrusting it with access to your funds.
Please note: For more information on how to stay safe, you can read our guide: Safety and security for DeFi and dApps.
What is a DEX?
A DEX (decentralized exchange) is a crypto exchange where the liquidity for the trades is provided by multiple liquidity providers instead of one centralized entity.
Additionally, with DEXes, traders maintain custody of their assets without having to trust them to a centralized party in order to complete their trades.
This is made possible by smart contracts which allow you to trade directly with another person. The code of the contract executes the trade, and the funds transfer only between the contract and the involved traders.
Please note: Always do your research before using any crypto protocol or service.
DeFi functions and terms
AMM stands for automated market maker. A market maker is an entity that connects buyers and sellers in order to conduct their trades. These are traditionally run by people and institutions.
An AMM is a market maker that is automated. It facilitates trading via code without a human intermediary.
AMMs run by the conditions as specified in their smart contracts. When using a DEX, you may want to understand its smart contracts before you lend liquidity to it.
Arbitrage is a trading strategy that comes from traditional finance. When the same asset is listed for different prices in different markets it's called an arbitrage opportunity.
Taking advantage of an arbitrage opportunity can be difficult as the variation often is not very significant and the discrepancy might not last long. Additionally, you would be required to constantly monitor all assets in all markets in order to spot an arbitrage opportunity.
Automated algorithms in DeFi can find arbitrage opportunities for you. DeFi protocols are able to keep up with the latest market prices and spot any differences between platforms.
Interested in Arbitrage? Check out Balancer, a DeFi protocol that specializes in arbitrage trading.
DAO stands for decentralized autonomous organization. These are organizations that are run by code instead of people.
With DAOs, there's no need for centralized leadership. Decisions can be made from the bottom-up and the code administers and executes those decisions.
This is especially helpful for setting limitations to when, how, and for what treasury funds are spent on, administering votes, and executing contracts.
The structure of a DAO lends itself well to organizing work between freelancers or people who live in different countries.
Lending and Borrowing
With DeFi, not only can you take out a loan, but you can provide one too! The loans are all governed and enforced by code.
Typically, DeFi loans require the borrower to overcollateralize the loan, meaning they deposit crypto worth more than the amount that they're borrowing. If they pay back the loan, then they get their crypto back. If not, then the protocol liquidates the collateral in order to pay back the loan.
This means that the borrower doesn't need to go through an approval process to take out a loan and the lender doesn't need to do anything to ensure the loan is paid back.
While it may not make sense at first to put down collateral greater than the loan amount, if we think in terms of crypto and DeFi, it makes more sense. If you have 1 SOL, but don't want to sell it, you can use it as collateral in exchange for stablecoins. You can then use those stablecoins to earn yield or other returns from DeFi. As soon as you pay the loan back, you'll get your SOL back as well.
Lending and borrowing protocols can allow you to get more out of your assets, as long as you have a plan to pay back your loan.
Yield farming, AKA liquidity mining, is a term given to crypto protocols that lock your assets into liquidity pools. A liquidity pool is a collection of funds locked in a smart contract. Liquidity pools are used to facilitate decentralized trading, lending, and more.
A liquidity pool requires an equal value of two different assets. For example, $100 of SOL and $100 of USDC.
DEXes and AMMs use liquidity pools to ensure they have liquid assets on hand for trading. In return, they give liquidity providers (LP) IOU tokens (LP tokens) that can be given back in order to reclaim funds.
In exchange for providing funds, LPs are able to earn interest fees proportional to their share of the liquidity pool.
Some DeFi protocols, such as Tulip, can automatically move your crypto from protocol to protocol depending on which one is offering the highest interest rate in order to maximize your returns.
You can reclaim your funds at any time by returning your LP tokens.
Before you engage in yield farming, you may want to learn about one of its main risks, impermanent loss.