DeFi is a decentralized financial system that includes protocols, standards, and applications. It’s a new way of building financial services as well as managing risk.
The goal is to provide increased transparency and security for users in comparison with the current centralized systems, at lower costs. DeFi applications are open-source, decentralized (no single point of failure), and non-proprietary. The aim is to have an ecosystem that can evolve independently from any particular entity or jurisdiction.
The term DeFi was first used in 2018 by Nick Tomaino, a partner at crypto fund 1 confirmation, who reported on the potential of protocols such as Ethereum’s ERC-20 and 0x. Many other systems are also emerging, including MakerDAO and Dharma. For example, they are creating decentralized exchanges (DEX) that don’t hold user assets but instead work on the blockchain to enable immediate trading and settlement.
The future of finance may well be decentralized. But it will be a long way from this to the system described here.
DeFi systems currently enable users to trade using existing tokens, in particular Ethereum’s ERC-20 and 0x protocols. They also include elements of crowdfunding and initial coin offerings (ICOs). Other applications have been developed to enable lending, insurance, prediction markets, and more. And they aim to provide increased transparency and security for users compared with the current centralized systems, at lower costs.
These systems aren’t just emerging; they already exist. Examples are Ethereum’s ERC-20 and 0x protocols, as well as elements of crowdfunding, initial coin offerings (ICOs), and lending. The latter two, in particular, demonstrate the opportunities DeFi can offer: financial instruments that were previously not available.
DeFi protocols are open-source, decentralized (no single point of failure), and non-proprietary. The aim is to have an ecosystem that can evolve independently from any particular entity or jurisdiction.
Protocols establish standards for how to build applications that use them. They are evolving quickly, many with governance and support models based on the Ethereum community. The DeFi protocol is different from the typical blockchain protocol in that it enables new financial instruments to be built on top of it.
At their simplest, protocols define how data is communicated between different types of smart contracts and users. Another type of protocol is governance, which governs the ecosystem’s evolution.
Applications are the use-cases—the specific ways in which people will use the system and run their financial lives. They include decentralized exchanges (DEXs) that don’t hold users’ assets but instead work on the blockchain to enable immediate trading and settlement; protocols that enable lending via credit scoring; prediction markets; securities lending and borrowing among others.
The following are examples of protocols, standards, and applications. The list is by no means exhaustive, but it’s intended to illustrate the potential of DeFi.
