How DeFi works
DeFi is a technology alternative to relying on centralized financial institutions such as banks, exchanges, and insurance companies. DeFi systems achieve distributed consensus by using "smart contracts" on blockchains such as Ethereum. Developers write smart contracts to perform specific actions only when certain conditions are met.
As a simple example, you could write a smart contract stating that you will pay $500 to another person if the Cardinals win the World Series this year. Once the smart contract is pushed to the blockchain, everyone in the blockchain's network can access and read the code, but no one can change it. Smart contracts are often what govern decentralized apps, or "dapps," which are not owned or managed by any one company or person. While Ethereum was the first platform to develop smart contracts, other blockchain platforms use them as well.
DeFi enables any two parties to securely and directly transact without involving an intermediary or central authority. The result is that many more people can access financial services at lower costs or receive better interest rates than those offered by traditional financial institutions.
Some of the most popular DeFi applications include the following:
Stablecoins
One of the earliest applications of DeFi was the creation of cryptocurrencies with stable values, also known as stablecoins. Stablecoins, by being much less volatile than other cryptocurrencies, are considered suitable for making ordinary purchases.
One example of a stablecoin is DAI (DAI -0.00%). Issued by MakerDAO, an open-source project on the Ethereum blockchain, the coin is pegged to the U.S. dollar and collateralized by Ether, the native Ethereum token. DAI is purposely overcollateralized by Ether, which enables the value of DAI to remain stable even as Ether's value fluctuates.
USDC (USDC +0.01%) is another stablecoin, but, unlike DAI, its collateral is centralized. USDC stablecoins are backed by a reserve of U.S. dollars held in an audited bank account.
Decentralized exchanges
Despite the decentralized nature of cryptocurrency, several cryptocurrency exchanges such as Coinbase (COIN -7.82%) function as centralized platforms to connect cryptocurrency buyers and sellers. Decentralized exchanges (DEXs) such as MDEX use smart contracts to perform the work of centralized exchanges, with the smart contracts providing pricing for each counterparty at or near prevailing market prices. Using a DEX allows each party to retain full control of their respective cryptocurrency holdings rather than depositing them in a wallet held by a centralized exchange that may be vulnerable to hacking.
DEX users who create liquidity by supplying cryptocurrency can, in certain markets, earn income by being awarded portions of the transaction fees.
Prediction markets
The prediction markets are what enable people to bet on the outcomes of certain events. DeFi prediction markets can offer better odds of winning by modifying the structures of bets. The associated fees are also lower, and market participants can bet on anything in unlimited amounts. Prediction markets, as compared with standard sportsbooks, are much harder for central authorities to dismantle.
DeFi prediction markets can provide value beyond increased access to gambling. Stock market predictions weighted by the size of the bets behind them are often fairly accurate.
Borrowing and lending
Perhaps the most traditional functions enabled by DeFi, borrowing and lending services are available to cryptocurrency users. Those who own substantial amounts of cryptocurrency but want liquidity in other currencies can borrow money by using their cryptocurrency holdings as collateral. Individuals can lend their cryptocurrency deposits to earn interest from borrowers, thereby profiting from the values of their holdings without triggering taxable events. The dapps that facilitate this decentralized borrowing and lending are designed so that interest rates automatically adjust based on the changing supply and demand of the cryptocurrency.
