Decentralised finance (DeFi) is an open financial system that operates entirely through the internet.
It uses blockchains and smart contracts to provide financial services like banking, trading, lending, insurance and payments.
It even includes services that you wouldn't normally think of as "finance", such as social media, marketplaces for music and art, gaming and advertising.
In this case, DeFi provides the transactional layer for users to buy, sell and interact with these Web3 services.
As opposed to traditional finance, DeFi is largely autonomous and typically operates peer-to-peer, reducing the need for intermediaries who control what people can and can't do.
It can also help drastically cut down the costs involved with using these services, as there are no "middlemen" to take a cut.
Decentralised finance is a network of software applications that are able to interact with each other and that anyone can use. DeFi software is referred to as decentralised applications, or dapps for short.
This is radically different to the regular internet, where software is typically restricted if someone does not have permission to use it and most software applications don't interact with each other.
This interactivity is called composability and is one of the core features that makes DeFi fundamentally different to traditional finance. Composability refers to the ability for dapps to "plug in" to each other.
This means you can build more complex applications by connecting several together and has been likened to "monetary Lego".
Dapps can host things like banking services, financial markets and more run-of-the-mill financial services like insurance.
So for instance, let's say you wanted to build a new round-up app for investing, where the spare change from card payments goes into an investment account.
In the traditional financial system you would need to build or rent access to a number of different pieces of software to get your app to work. You might need bank accounts for your users, access to a payments network like Visa or PayPal, insurance, various licences and finally access to an investing platform.
To get this up and running would be expensive, complicated and time-consuming.
Alternatively, in a composable system of dapps, you would be able to plug in to each of those existing products for free or at low cost. All you would need to do is focus on building the new parts of the app and leverage the existing pieces of open-source software.
This is possible because most blockchains are decentralised, open-source networks. This means that there is no owner of the network, instead it is supported by a distributed network of nodes, known as validators.
Another feature of blockchains – and DeFi – is that all transactions on the network are authorised by a sophisticated network of computers, rather than humans or business entities. This makes it very difficult to cheat or defraud the system and provides certain assurances between parties.
In crypto terms, CeFi stands for centralised finance, which is the conventional way of doing things.
In CeFi we solve problems such as liquidity and matchmaking by entrusting them to a central authority, such as a bank, payment provider or financial services company.
In DeFi, these responsibilities are split up among different dApps.
| Response | 75+ yrs | 65-74 yrs | 55-64 yrs | 45-54 yrs | 35-44 yrs | 25-34 yrs | 18-24 yrs |
|---|---|---|---|---|---|---|---|
| No | 98.08% | 92.59% | 77.92% | 73.84% | 48.6% | 48.4% | 68.63% |
| Yes - For long-term growth | 1.92% | 5.56% | 14.29% | 16.86% | 39.11% | 36.7% | 19.61% |
| Yes - for day trading | 1.92% | 0.62% | 2.6% | 5.81% | 2.79% | 5.32% | 4.9% |
| Yes - for short-term growth | 1.92% | 1.23% | 5.19% | 8.72% | 12.29% | 12.77% | 10.78% |
| Yes - to use it with blockchain application | 0.62% | 1.95% | 0.58% | 3.35% | 1.6% | ||
| Yes - as a hedge against AUD or central bank currencies | 0.58% | 3.35% | 3.19% |
Want to explore the DeFi frontier? You will need:
Automated market makers (AMMs) are at the core of DeFi. These are used by decentralised exchanges and lending platforms. They were invented by Uniswap creator, Hayden Adams, and are unique to cryptocurrency.
They work by having users – known as liquidity providers (LPs) – add funds to a pool of assets.
The pool is typically made up of 2 assets, but can include more.
Traders are able to buy or sell assets from the pool any time they like. The pool determines the price of the asset based on its balance in the pool (more on that in the example below).
This is different from a traditional exchange which uses an order book.
Order books require hundreds or thousands of buyers (takers) and sellers (makers) to simultaneously come together and make offers.
As a result, buyers and sellers dictate the price of assets with their offers, whereas an AMM dictates prices based on the balance of assets in the pool.
Another advantage is that AMMs can operate with drastically fewer users, provided there is enough liquidity.
AMMs and liquidity pools help eliminate many of the overheads required by a classic exchange or marketplace. With a little bit of computer code and some liquidity, anyone can create a marketplace for any 2 assets.
Normally you would need to set up a business, apply for licences, be subject to regulation and need to attract buyers and sellers to provide capital.
Furthermore, AMMs operate 24/7 and are trustless – buyers and sellers never hand over ownership of their funds to a "middleman" like an exchange. This can help prevent events like FTX – where executives mismanaged user deposits – from ever occurring.
AMMs and the decentralised exchanges that use them are a cornerstone of DeFi.
A decentralised exchange (DEX) is a non-custodial exchange that runs on a blockchain.
That's a bit of a mouthful. Essentially it means that users can trade cryptocurrencies directly with other users, straight from their wallet. Users maintain ownership of their assets at all times and don't need to trust that a third party – like a centralised exchange – will keep them safe.
This is done through the use of automated computer code called smart contracts.
Another common feature of DEXs is that they can be governed by a decentralised autonomous organisation (DAO) which allows token holders to have a say in how the platform is managed. Tokens can be earned by using the platform or purchased on the open market.
Decentralised exchanges create a more equitable financial system by granting greater autonomy and control to users. The same technology could one day be applied to traditional stock exchanges or banks.
On the other hand, because of their decentralised nature, anyone can use a DEX without needing to provide ID or pass a Know Your Customer (KYC) check. This means that they can be used for fraudulent activities such as money laundering. As such, they live in somewhat of a legal grey space and are occasionally the target of law enforcement.
For a quick rundown of the key differences between centralised and decentralised exchanges, check out the table below.
| Centralised exchange | Decentralised exchange | |
|---|---|---|
Trading | Conducted through the exchange | Conducted peer-to-peer |
Control of funds | Exchange controls your coins and tokens | You control your coins and tokens |
Anonymous trading? |
|
|
Hosting | Centralised servers | Distributed network |
Prone to hacks? |
|
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Subject to government interference? |
|
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Account withdrawal limits? |
|
|
As the name suggests, a decentralised autonomous organisation (DAO) is an organisation with no fixed leadership. It is collectively owned and managed by its members.
Membership is granted through ownership of a DAO token. These tokens may be issued as a reward for participation with the underlying protocol or can be simply purchased on the open market.
DAOs are an essential part of DeFi and critical to keeping systems decentralised, while still allowing groups to come together and make decisions democratically.
The degree to which a DAO governs something – like a DeFi protocol – is on a spectrum.
Some protocols are managed entirely by their DAO and require the DAO to vote on-chain before any actions – like code changes or the movement of funds – can be performed.
Others may use a DAO in conjunction with a private entity that owns the protocol. The owners may then make proposals which the DAO can then vote on.
Many DAOs allow the delegation of votes, so that token holders can choose someone to vote on their behalf.
DAOs are typically managed on-chain, which is how voting, proposals and changes are enforced.
The first-ever DAO was created by Ethereum engineer Christoph Jentzsch for the purpose of creating an investment fund that could be managed collectively by its members. In return for depositing funds to the DAO, members received a token which granted them voting rights in the DAO.
Cryptocurrencies are digital tokens for use in DeFi ecosystems. The best known are Bitcoin and Ether (the native resource of the Ethereum blockchain), but beyond them there are countless more, including many created for use in specific dApps.
The main cryptocurrency and token types include:
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