Decentralized Finance (DeFi) is the concept of a decentralized financial system where there are open and decentralized alternatives to the closed centralized financial system. DeFi dapps and protocols use technologies like blockchain and smart contracts to offer financial services more transparently with fewer intermediaries.^[1][2][3]

Overview

DeFi (Decentralized Finance) generally refers to digital assets, protocols, and decentralized applications (dApps) that are built on the blockchain.^[4] DeFi is a financial service with no central authority. It involves taking traditional elements of the financial system and replacing the middleman with a smart contract.^[5]

Most DeFi protocols operate on the Ethereum blockchain, although a few have migrated to other competing blockchains to have higher scalability.^[6][7]

DeFi leverages all of the properties attributed to Ethereum:

• Permissionless: Anyone can access all DeFi services without a third-party engagement. Users do not have to seek permission to interact with a smart contract.
• Censorship Resistant: No person is restricted from using DeFi services due to any identifying characteristics such as nationality, gender, or political beliefs.
• Programmable: Any service which can be coded into a smart contract, can be introduced as a DeFi service.
• Transparent: All smart contracts are available for analysis and verification. Additionally, all user interactions can be tracked, making DeFi fully transparent.
• Compostability: DeFi services can leverage each other to create new offerings and servers.
• Trustless: All transactions and interactions with the smart contract are visible on the ledger and secured by the underlying blockchain.^[32]

History

Inception (2017-2018)

DeFi term was created in an August 2018 Telegram chat between Ethereum developers and entrepreneurs including Inje Yeo, Co-founder of Set Protocol, Blake Henderson of 0x, and Brendan Forster of Dharma. They were trying to find the name for the movement of open financial applications being built on Ethereum. Except for "DeFi", other options considered were Open Horizon, Lattice Network, and Open Financial Protocols.^[33] Finally, the chat members came up with DeFi.^[8]

Shortly after, on October 4, 2018, the group held its first DeFi summit in San Francisco in collaboration with Dharma Protocol, 0x Project, Coinbase, Abacus Protocol, and many others. Since the first summit, hundreds of conferences around the globe were held. Additionally, the DeFi Telegram has seen exponential growth.^[9][10]

Growth (2018-2022)

The value of DeFi protocols grew fast with the growth of the community. In July 2018, DeFi protocols were valued at $181 million. Almost exactly a year later, its collective value broke $500 million. In addition to this milestone, DeFi began to see the diversifying in where protocols are held, as MakerDAO previously held more than 91% of DeFi's value in December of 2018, and lowered its share by 20% that same July.^[11]

February 7, 2020, saw DeFi's value enter the billion-dollar milestone. Spencer Noon of DTC Capital said in a statement:

No other smart contract platform comes close in terms of its developer mindshare, tooling, and infrastructure, to the point where I don't believe DeFi could exist anywhere else today. And perhaps most surprisingly, we're finally seeing a credible case for ETH to accrue a long-term monetary premium as the only truly trustless collateral type in decentralized finance.^[12]

Shortly after, the total locked value saw a dip and swiftly returned back to its billion-dollar milestone around early June 2020. A major contributor to the growth was the DeFi governance tokens that began to appear on the market. The DeFi world saw the introduction of native governance tokens from firms including Compound, Balancer, UMA, Curve Finance, and pNetwork which can be acquired through protocol usage.^[13][14]

As a result, the total value locked (TVL) on protocols with governance began to see quick liquid growth.^[15]

Around early May 2020, Bitcoin entered the DeFi ecosystem through WBTC, as it was added to MakerDAO's platform, and came with a 0% USD Coin stability fee. RenVM, a platform used for minting Bitcoin, Bitcoin Cash, and Zcash into ERC20 tokens was launched. The introduction of the platform contributed to the increase in value, as Bitcoin holders were able to use their digital assets within the "DeFi landscape". Another major launch that contributed to the increase was dYdX's launch of Perpetual Contracts and its first product was the ability to trade BTC-USDC with up to 10x leverage on Ethereum. The growing interest in Bitcoin futures created a domino effect, adding to DeFi's total value-locked growth.^[16][17][18]

The increase in total value locked was also attributed to the introduction of Ethereum Merge, which launched phase one in July 2020. Companies including Nexus Mutual, a decentralized insurance protocol, expressed interest in its plans to stake a large portion of its current assets into Eth 2.0. Investors hoped that the introduction of Proof-of-Stake (PoS) would provide those who staked with the ability to earn rewards for "validating blocks".^[19][20][21]

In addition to the growing confidence in what the future holds for Ethereum and Eth 2.0, the Ethereum network began to hit all-time highs in traffic. As a result, the number of DeFi assets exponentially grew and even saw a doubling in assets being held between April and May of 2020, reaching 1,000 for the first time, and users reaching over 550,000. Also, the median transaction fees found in DeFi and stablecoin hit a 2-year high, with around $2.56 spent alone on Ether gas fees within the month of May 2020. The total value locked (TVL) in DeFi platforms exceeded the $5 billion mark in August 2020. This is a 5x increase in just 60 days since reaching the $1 billion mark in early June 2020.^[23][24][25]

As of August 16, 2020, a record high of $6 billion worth of crypto was locked in DeFi smart contracts, according to data analytics site DeFi Pulse. MakerDAO, Aave, and Curve Finance led the pack, with some $4.2 billion locked in between them.^[26]

As of March 2021, DeFi's total value locked (TVL) increased from about $25 billion to almost $100 billion. With a wealth of consumer success, DeFi began aiming for institutional adoption as its next objective.^[27]

On December 2, 2021, DeFi recorded an all-time high total value locked (TVL) of $256 billion. On April 3, 2022, the total value locked (TVL) in DeFi fell to $231 billion as it began to enter the bearish market. As of September 2022, the total value locked (TVL) in DeFi is approximately $54.95 billion. The TVL has not been this low in over five months since March 29, 2022.^[29][31]

Consolidation (2023-current)

While the rapid growth of the early years has slowed down, DeFi is entering a more stable and sustainable phase, laying the groundwork for broader adoption and integration into the traditional financial system. The period since 2022 has been characterized by:

• Market Correction and Consolidation: The dramatic market downturn of 2022 forced many DeFi projects to reassess their models and focus on sustainability. Less speculative and more utility-focused projects gained prominence.
• Regulatory Scrutiny: Increased regulatory interest has led to a more cautious approach by DeFi platforms, with a focus on compliance and risk management.
• Institutional Adoption: Despite market volatility, institutional investors have shown growing interest in DeFi, leading to a more mature and stable market environment.
• Technological Advancements: The underlying technology continues to evolve, with a focus on scalability, interoperability, and security.
• Expansion of Use Cases: DeFi is moving beyond simple lending and borrowing, with new use cases emerging in areas like insurance, derivatives, and payments.

On March 5, 2024, DeFi TVL reached $101.36 billion, with lending accounting for $32.62 billion (32.2%) of this total, with decentralized exchanges at $19.97 billion (19.7%), collateralized debt positions at $12.22 billion (12%), and restaking activities at $10.06 billion (9.9%).^[38]

Use Cases

Decentralized exchanges (DEXs)

Decentralized exchanges are typically built on top of different blockchains, making their compatibility specific to the technology on which they are developed. DEXs built on Ethereum’s blockchain, for example, facilitate the trading of assets built on Ethereum, such as ERC-20 tokens. DEXs allow users to store assets away from a centralized platform while yet enabling on-the-fly trading from their wallets via blockchain-based transactions. Automated market makers, a type of DEX, became prevalent in 2020 and use smart contracts and liquidity pools to facilitate the purchase and sale of crypto assets. For example, Fraxswap is the first AMM with an embedded time-weighted average market maker (TWAMM) for conducting large trades over long periods of time trustlessly. It is fully permissionless and based on the constant product invariant (xy=k).^[43][44]

Additionally, certain DEXs may have fewer features and higher associated financial fees than centralized exchanges.^[34]

Lending Platforms

In DeFi, lending and borrowing are now among the most common activities. Users can borrow money utilizing lending protocols while using their cryptocurrency as security. With loan solutions commanding billions of dollars in total value locked (TVL), decentralized finance has seen vast amounts of cash flow through its ecosystem.^[34]

For example, Fraxlend, protocol in Frax Finance, is a trustless, permissionless, and non-custodial lending platform that provides lending markets between any two ERC20 tokens. Each pair is an isolated market which allows anyone to participate in lending and borrowing activities.^[45]

Payments and Stablecoins

DeFi requires a stable unit of account, or asset, in order to be considered a financial system that consists of transactions and contracts. Participants must be able to anticipate that the value of the asset they are using won't change. Stablecoins are useful in this situation.^[34]

The lending and borrowing that are typical in the DeFi market are made stable using stablecoins. Stablecoins are preferred for trading and business because they don't display nearly as much volatility as cryptocurrencies do because they are typically fixed to a fiat currency, such as the U.S. dollar or the euro.

In 2020, stablecoins that existed at the time were either collateral-backed or were minted and burned algorithmically. Collateralized stablecoins are not capital-efficient, while fully algorithmic stables are intrinsically fragile and are vulnerable to breakage in erratic market conditions. Frax Finance brings together the best of both worlds, eliminating their issues to produce the first fractional-algorithmic stablecoin protocol.
The project, which started in May 2019, was formerly called Decentral Bank and is founded by Sam Kazemian, Travis Moore, and Jason Huan.

As of October 2022, the top five stablecoins include Tether (USDT), USD Coin, Binance USD, DAI, and FRAX.

Margin and Leverage

The margin and leverage components take the decentralized finance market to the next level, allowing users to borrow cryptocurrencies on margin using other cryptocurrencies as collateral. Additionally, leverage can be built into smart contracts to perhaps increase the user's returns. Given that the system is dependent on algorithms and lacks a human component, an event of a malfunction increases users' risk during the usage of these DeFi components.^[35]

Insurance

Another significant aspect of DeFi is insurance. A financial organization will insure clients against potential losses in exchange for a premium payment from them. Code and smart contracts manage a lot of money in the DeFi area, and there are already innumerable examples of smart contract exploits and attacks where billions have been taken. DeFi insurance protocols let users protect themselves against the possibility of a protocol being exploited when they have money locked. By employing permissioned-blockchains to store and manage policies, smart contracts help insurance companies create a more cost-effective business.^[35]

Decentralized Autonomous Organizations (DAOs)

DAOs have become increasingly sophisticated, managing substantial funds and making complex decisions. DeFi has played a crucial role in providing the infrastructure for these decentralized governance models.

Gaming and NFT Integration

DeFi is increasingly integrated into gaming and NFT ecosystems, providing in-game economies, tokenized assets, and decentralized marketplaces.^[42]

Emerging Trends

• Decentralized Finance for the Unbanked: Efforts are underway to make DeFi more accessible to people without traditional banking services, providing financial inclusion. ^[39]

• Green Finance: DeFi is being used to finance sustainable projects and create carbon markets, contributing to environmental sustainability. ^[40]

• Central Bank Digital Currencies (CBDCs): DeFi platforms are exploring integration with CBDCs, potentially bridging the gap between traditional and decentralized finance. ^[41]

Components

Smart Contracts

The exchange of products, services, data, money, and other items is made easier by the use of smart contract code, which is used by many DeFi protocols and decentralized applications (DApps). DApps must use smart contracts to make sure that every transaction is legitimate, transparent, and trustless — and that goods or services are, in fact, being transferred in line with the predetermined provisions of the agreement.^[36]

Aggregators and Wallets

Aggregators are the interfaces by which users interact with the DeFi market. They are essentially decentralized systems for asset management that automatically switch users' crypto assets between several yield-farming platforms to maximize returns.
Digital assets are stored and traded through wallets. Wallets can be found in a variety of formats, including software, hardware, and exchange wallets. They can contain a variety of assets or simply a single item. Wallets such as self-hosted wallets—wallets for which users manage their private keys are a crucial part of DeFi as they facilitate a variety of DeFi platform uses. ^[34]

Decentralized Marketplaces

Decentralized marketplaces represent a core use case for blockchain technology. They put the “peer” in peer-to-peer networks in that they allow users to transact with one another in a trustless way, that is, without the need for an intermediary. The leading blockchain allowing decentralized marketplaces is the Ethereum smart contract platform, but there are numerous others that let users sell or exchange particular assets, including Non-fungible tokens (NFTs).

Oracles/Prediction markets

Oracles deliver real-world off-chain data to the blockchain via a third-party provider. Oracles have paved the way for the prediction markets on DeFi crypto platforms where users can place rely on the outcome of an event, ranging from elections to price movements, for which the payouts are made via a smart contract-governed automated process.^[34]

Layer 1

Layer 1 represents the blockchain that the developers choose to build on. It is where the DeFi applications and protocols are deployed. Ethereum is the main layer-1 solution in decentralized finance but there are alternatives, including Polkadot, Tezos, Solana, BSC, Cosmos, and others.

Having DeFi sector solutions run on different blockchains has several potential benefits. Blockchains may be forced to improve speed and lower fees, based on the performance of competing blockchains, creating a competitive environment that potentially results in improved functionality. The existence of different layer-1 blockchains also leaves more room for development and traffic, instead of everyone trying to pile onto a single layer-1 option.^[34]