What is DeFi? A Beginner’s Guide to Decentralized Finance

Summary

The video script from Crypto Whiteboard Tuesday, hosted by Nate Martin of 99Bitcoins.com, dives into the world of decentralized finance (DeFi). It explains that DeFi aims to offer financial services without a central authority, much like Bitcoin operates as decentralized money. The script outlines the infrastructure needed for DeFi, with Ethereum playing a pivotal role by enabling smart contracts to automate and manage financial services. It introduces stablecoins, particularly DAI, as a key component due to their stability and decentralized nature. The video also explores various DeFi services such as decentralized exchanges (DEXes), lending platforms like Compound, and the concept of 'yield farming.' Additionally, it touches on decentralized insurance and the 'money legos' analogy, which refers to the combination of different DeFi services to create new opportunities. While highlighting the benefits of DeFi, such as transparency and decentralization, the script also cautions about the risks involved, including the infancy of the technology and potential smart contract vulnerabilities. The host concludes by expressing optimism about DeFi's potential to revolutionize finance, especially for those facing financial discrimination and inefficiencies.

Takeaways

• 💡 DeFi stands for decentralized finance, which aims to recreate financial services without a central authority, similar to how Bitcoin decentralized money.
• 📈 You can use DeFi to earn interest on your cryptocurrency holdings through platforms like Compound, which is a form of 'yield farming'.
• ⚠️ DeFi is considered risky due to its infancy and potential for smart contract vulnerabilities that hackers could exploit.
• 🤖 DeFi operates on blockchain platforms like Ethereum, which allows for the creation of smart contracts to automate financial transactions.
• 💰 Stablecoins, such as DAI, are an essential part of DeFi as they provide a stable store of value, often pegged to real-world assets like the US dollar.
• 💻 Decentralized exchanges (DEXes) are a key component of DeFi, allowing for peer-to-peer trading of cryptocurrencies without a central authority.
• 🔗 DeFi services are interoperable, meaning they can be combined to create new financial opportunities, often referred to as 'money legos'.
• 🔐 Decentralized financial services offer benefits like transparency, flexibility, and lack of centralized control, which can lead to efficiencies and lower fees.
• 🚨 The risks of DeFi include the potential for mismanagement, fraud, and corruption, as well as the technical challenges of smart contract security.
• 🌐 DeFi has the potential to change the future of finance by offering financial services to those who are underserved by traditional financial systems.
• 📚 It's crucial to understand the workings of any DeFi product or service before investing, to be aware of the risks and how the system is truly decentralized.
• ⏱️ DeFi is currently in its early adopter stage, and its success in moving into mainstream adoption will be determined in the coming years.

Q & A

What does DeFi stand for?

DeFi stands for decentralized finance, which refers to financial services that operate without a central authority.

How does DeFi aim to change the current financial system?

DeFi aims to change the current financial system by decentralizing it, similar to how Bitcoin decentralized money, to create a financial system without the need for central control or intermediaries.

What are the risks associated with using DeFi services?

The risks associated with using DeFi services include the infancy of the technology, potential for smart contract vulnerabilities, and the possibility of partial decentralization which could retain some centralized aspects.

What is a stablecoin and how does it relate to DeFi?

A stablecoin is a cryptocurrency pegged to the value of a real-world asset, often a major currency like the US dollar. In DeFi, stablecoins like DAI provide a stable medium of exchange and store of value, which is crucial for building reliable financial services.

How does DAI differ from other stablecoins?

DAI differs from other stablecoins as it is not backed by fiat money reserves but by over-collateralized crypto assets, which are publicly viewable on the Ethereum blockchain, making it a truly decentralized and trustless stablecoin.

What is a decentralized exchange (DEX) and how does it operate?

A decentralized exchange (DEX) is a platform that allows users to trade cryptocurrencies in a peer-to-peer manner without a central authority. It operates based on smart contracts that enforce rules, execute trades, and handle funds securely.

What is 'yield farming' in the context of DeFi?

Yield farming refers to the practice of putting crypto assets to work to generate the most returns possible, often by lending, staking, or providing liquidity to DeFi platforms.

How does the Compound platform function within DeFi?

Compound is an Ethereum-based decentralized application (DApp) that allows users to lend and borrow cryptocurrencies. It automatically connects lenders with borrowers, enforces loan terms, and distributes interest.

What is the concept of 'money legos' in DeFi?

The term 'money legos' refers to the ability to combine different DeFi services, like building blocks, to create new financial products and opportunities. It emphasizes the modular and interoperable nature of DeFi components.

What are the advantages of using DeFi services?

The advantages of using DeFi services include transparency, interoperability, decentralization, freedom from centralized control, lower fees, and a more flexible user experience.

How should one approach investing in DeFi services considering the risks?

One should approach investing in DeFi services with caution, understanding the technology and risks involved, and only investing an amount they can afford to lose. It's also important to research each product or service thoroughly to be aware of potential issues.

Outlines

00:00

🤔 Introduction to DeFi and Its Potential

The first paragraph introduces DeFi (Decentralized Finance), a system that aims to decentralize financial services similar to how Bitcoin decentralized money. It discusses the potential of using DeFi to earn interest on cryptocurrency holdings and questions its risks and transformative impact on finance. The speaker, Nate Martin from 99Bitcoins.com, invites viewers to learn more about DeFi, which includes services like loans, savings, insurance, and stock markets without a central authority. The paragraph also highlights the risks associated with centralized financial systems (CeFi) and contrasts them with the decentralized approach of DeFi, which leverages smart contracts on platforms like Ethereum to create autonomous financial services.

05:04

💵 Building Blocks of DeFi: Infrastructure and Stablecoins

The second paragraph delves into the infrastructure needed to create a decentralized financial system, emphasizing Ethereum's role as a platform for decentralized applications (DApps) and smart contracts. It explains how these smart contracts can manage financial services in a decentralized and immutable way. The paragraph also introduces stablecoins as a necessary component for DeFi, given their stability compared to more volatile cryptocurrencies. It specifically mentions DAI, a decentralized stablecoin pegged to the US dollar and backed by crypto collaterals, as a key element for building reliable financial services within the DeFi ecosystem.

10:07

🌐 Services and Risks of Decentralized Finance

The third paragraph outlines various DeFi services, including decentralized exchanges (DEXes), money markets like Compound for lending and borrowing, and the concept of 'yield farming'. It also touches on decentralized insurance as a way to protect funds against risks. The paragraph highlights the interoperability of DeFi services, comparing them to LEGO blocks that can be combined to create new opportunities. It concludes with a cautionary note on the risks of DeFi, including the infancy of the technology, potential smart contract vulnerabilities, and the importance of understanding a service's decentralization level before investing. The speaker advises viewers to only invest what they can afford to lose and to thoroughly research any DeFi service before participation.

Keywords

💡DeFi

DeFi, short for decentralized finance, refers to financial services that operate without a central authority. It is a system that aims to mimic traditional financial services but in a decentralized manner using blockchain technology. In the video, DeFi is presented as a potential replacement for the current centralized financial system, offering services like lending, borrowing, and trading without intermediaries like banks.

💡Cryptocurrency

Cryptocurrencies are digital or virtual currencies that use cryptography for security and operate on a decentralized ledger known as a blockchain. The script mentions Bitcoin and Ether as examples of cryptocurrencies. They are integral to DeFi as they provide the base layer for creating and interacting with decentralized financial services.

💡Smart Contracts

Smart contracts are self-executing contracts with the terms of the agreement directly written into code. They automatically enforce, verify, or negotiate themselves when certain conditions are met. In the context of the video, smart contracts are used to create and manage decentralized financial services on platforms like Ethereum, ensuring trustless and automated operation.

💡Ethereum

Ethereum is an open-source blockchain platform that enables the creation of smart contracts and decentralized applications (DApps). It is highlighted in the video as the infrastructure that allows for the programming and running of decentralized financial services, making it a crucial component in building the DeFi ecosystem.

💡Stablecoins

Stablecoins are cryptocurrencies designed to minimize volatility by pegging their value to a stable asset, often a fiat currency like the US dollar. DAI, mentioned in the script, is a type of stablecoin that is decentralized and backed by crypto collaterals rather than fiat money reserves, making it suitable for use within the DeFi ecosystem.

💡Decentralized Exchanges (DEX)

A decentralized exchange (DEX) is a platform that allows users to trade cryptocurrencies in a peer-to-peer manner without a central authority. DEXes operate based on smart contracts and are part of the DeFi ecosystem. They offer benefits such as eliminating the need for depositing funds before trades and reducing the risk of exchange hacking.

💡Yield Farming

Yield farming is a term used to describe the practice of putting cryptocurrency assets to work to generate the most returns possible, often through lending, staking, or providing liquidity to DeFi platforms. It has become popular due to the potential for high returns and is an example of an innovative DeFi service.

💡Decentralized Money Markets

Decentralized money markets are platforms that facilitate lending and borrowing of cryptocurrencies. Compound, as mentioned in the script, is an example of a decentralized money market DApp where users can lend their crypto to earn interest or borrow against their crypto collateral. These platforms are automated and use smart contracts to enforce loan terms.

💡Decentralized Insurance

Decentralized insurance is a concept within DeFi that aims to provide coverage for users' funds without the need for traditional insurance companies or agents. It is designed to autonomously connect those willing to pay for insurance with those willing to insure, creating a peer-to-peer insurance model that operates on a decentralized platform.

💡Money Legos

The term 'money legos' is used in the video to describe how different DeFi services can be combined and customized, much like LEGO blocks, to create new financial products and opportunities. This illustrates the flexibility and interoperability of DeFi services, allowing users to build complex financial strategies from simpler, modular components.

💡Financial Discrimination

Financial discrimination refers to the unfair treatment or exclusion of individuals or groups from financial services based on factors such as their economic status or geographic location. The video suggests that DeFi has the potential to benefit those who suffer from financial discrimination by providing more accessible and efficient financial services.

Highlights

DeFi stands for decentralized finance, aiming to decentralize financial services in the same way Bitcoin decentralized money.

DeFi services are built on blockchain platforms like Ethereum, which allows for the creation of smart contracts to automate financial services.

Bitcoin, while decentralized, has limited programmable functionality and is not directly compatible with Ethereum.

Ether is volatile and not ideal for stable financial services, leading to the use of stablecoins in DeFi.

Stablecoins like DAI are pegged to real-world assets and are used for reliable financial services within DeFi.

DAI is a decentralized stablecoin backed by crypto collaterals, making it trustless and resistant to censorship.

Decentralized exchanges (DEXes) allow users to trade cryptocurrencies without a central authority and without the need for depositing funds.

Decentralized money markets like Compound enable users to lend and borrow cryptocurrencies and earn interest.

Yield farming is a popular practice in DeFi, where users seek to maximize returns on their crypto assets.

Decentralized insurance platforms connect those willing to insure with those seeking coverage, without intermediaries.

DeFi services are often referred to as 'money legos' due to their ability to be mixed and matched to create new opportunities.

DeFi offers advantages such as transparency, interoperability, and a flexible user experience.

DeFi is still in its early stages, and there are risks associated with smart contract vulnerabilities and hacking.

Investors should only use an amount they can afford to lose when experimenting with DeFi services.

Decentralization in DeFi is only as strong as its most central component, and some services may retain centralized aspects.

Understanding how a DeFi product or service works is crucial before investing to be aware of potential issues.

DeFi has the potential to benefit those who suffer from financial discrimination, high fees, and inefficiencies.

The future of DeFi will depend on its ability to transition from early adopter stage to mainstream adoption.

Transcripts

What is DeFi?

Can I use it to earn interest on my cryptocurrency holdings?

Is it risky?

And will it really change the future of finance as we know it?

Well, stick around.

Here on Crypto Whiteboard Tuesday,

we’ll tackle these questions and more.

Hi, I’m Nate Martin from 99Bitcoins.com

and welcome to Crypto Whiteboard Tuesday

where we take complex cryptocurrency topics,

break them down and translate them into plain English.

Before we begin, don't forget to subscribe to the channel

and click the bell so you’ll immediately get notified

when a new video comes out.

Today’s topic is decentralized finance, or DeFi for short.

If you’ve watched our previous videos

you already know that Bitcoin is a form of money

that isn’t controlled by any central bank or government.

It can be transferred to anyone from anyone around the world,

without the need of a bank or a financial institution.

Bitcoin is decentralized money,

and if you’re just starting out

you may want to catch our “What is Bitcoin” video

before moving forward.

However, transferring money is only the first of many building blocks

in a financial system.

Aside from sending money to one another,

there are a variety of services we use today.

For example, loans, saving plans, insurance and stock markets

are all services that are built around money

and together create our financial system.

Today, our financial system and all its services

are completely centralized.

Banks, stock markets, insurance companies

and other financial institutions all have someone in charge,

whether it be a company or a person,

that controls and offers these services.

This centralized financial system, or CeFi for short, has its risks -

mismanagement, fraud and corruption to name a few.

But what if we could decentralize the financial system as a whole

in the same way Bitcoin decentralized money?

That’s exactly what DeFi is all about.

DeFi is a term given to financial services

that have no central authority or someone in charge.

Using decentralized money, like certain cryptocurrencies,

that can also be programmed for automated activities,

we can build exchanges, lending services, insurance companies

and other organizations that don’t have any owner

and aren’t controlled by anyone.

Confused?

Don’t worry, we’ll break it down for you…

In order to create a decentralized financial system,

the first thing we need is an infrastructure

for programming and running decentralized services.

Luckily for us, Ethereum does just that.

Ethereum is a Do It Yourself platform for writing decentralized programs

also known as decentralized apps or Dapps.

Our “What is Ethereum” video explains Ethereum in great detail,

but for now we’ll just say that through the use of Ethereum

we can write automated code, also known as smart contracts,

that manage any financial service we’d like to create

in a decentralized manner.

This means that we determine the rules as to how a certain service will work,

and once we deploy those rules on the Ethereum network

we no longer have control over them - they are immutable.

Once we have a system in place

like Ethereum for creating decentralized apps

we can start building our decentralized financial system.

Now let’s take a look at some of the building blocks that comprise it.

The first thing any financial system needs is of course money.

You may be thinking:

“why not use Bitcoin or Ether, which is Ethereum’s currency?”

Well, as for Bitcoin, while it is indeed decentralized,

it has only very basic programmable functionality

and is not compatible with the Ethereum platform.

Ether, on the other hand, is compatible and programmable,

however it is also highly volatile.

If we’re looking to build reliable financial services

that people will want to use

we’ll need a more stable currency to operate within this system.

This is where stablecoins come in.

Stablecoins are cryptocurrencies

that are pegged to the value of a real world asset,

usually some major currency like the US dollar.

Our video “What are stablecoins” explains in more detail

how stablecoins are created

and what the different types of stablecoin pegs are.

Make sure to check it out if you want some additional information.

For the purpose of DeFi

we’ll want to use a stablecoin that doesn’t use fiat money reserves

for maintaining a peg,

since this will require some sort of central authority.

This is where DAI comes into play.

DAI is a decentralized cryptocurrency

pegged against the value of the US dollar,

meaning one DAI equals one US dollar.

Unlike other popular stablecoins

whose value is backed directly by US Dollar reserves,

DAI is backed by crypto collaterals

that can be viewed publicly on the Ethereum blockchain.

DAI is over collateralized,

meaning if you lock up in a deposit $1 worth of Ether,

you can borrow 66 cents worth of DAI.

As soon as you want your Ether back,

just pay back the DAI you borrowed and the Ether will be released.

If you don’t have any Ether to lock up as collateral

you can just buy DAI on an exchange.

Because DAI is over collateralized,

even if Ether’s price becomes extremely volatile,

the value of the locked Ether backing the DAI in circulation

will most likely still remain at 100% or more.

In essence, the DAI stablecoin is actually also a smart contract

that resides on the Ethereum platform.

This makes DAI a truly trustless and decentralized stablecoin

which cannot be shut down nor censored,

hence it’s a perfect form of money for other DeFi services.

Now that our decentralized financial system

has stable decentralized money,

it’s time to create some additional services.

The first use case that we’ll discuss is the decentralized exchange,

or DEX for short.

DEXes operate according to a set of rules,

or smart contracts,

that allow users to buy, sell, or trade cryptocurrencies.

Just like DAI they also reside on the Ethereum platform

which means they operate without a central authority.

When you trade on a DEX, there is no exchange operator,

no sign-ups, no identity verification, and no withdrawal fees.

Instead, the smart contracts enforce the rules, execute trades,

and securely handle funds when necessary.

Also, unlike a centralized exchange,

there’s often no need to deposit funds into an exchange account

before conducting a trade.

This eliminates the major risk of exchange hacking

which exists for all centralized exchanges.

But the range of decentralized financial services doesn’t stop there.

Let’s move on to decentralized money markets -

services that connect borrowers with lenders.

Compound is an Ethereum based borrowing and lending dapp,

meaning you can lend your crypto out and earn interest on it.

Alternatively,

maybe you need some money to pay the rent or buy groceries,

but the only funds you have are cryptocurrencies.

If that’s the case you can deposit your crypto as collateral,

and borrow against it.

The Compound platform automatically connects the lenders with borrowers,

enforces the terms of the loans, and distributes the interest.

The process of earning interest on cryptocurrencies

has become extremely popular lately, giving rise to “yield farming” -

A term given to the effort of putting crypto assets to work

while seeking to generate the most returns possible.

You can take a look at the description below this video

for some of the more exciting DeFi projects

that you can start using today.

So we have decentralized stablecoins, decentralized exchanges

and decentralized money markets.

How about decentralized insurance?

All of these new financial products definitely entail some risks

which we will cover shortly,

so why not create a service that insures my funds

in case something goes wrong?

Well, how about a decentralized platform

that connects people who are willing to pay for insurance

with people who are willing to insure them for a premium,

while everything happens autonomously without any insurance company

or agent in the middle.

DeFi services work in conjunction with one another,

making it possible to mix and match different services

to create new and exciting opportunities.

This kind of resembles how you can use different LEGO blocks

and get creative with whatever it is you want to build.

Hence the term ‘money legos’ has been coined to refer to DeFi services.

For example, you can build the following service

from different money legos -

You start out by using a decentralized exchange aggregator

to find the exchange with the best rate

for swapping Ether for DAI.

You then select the DEX you want and conduct the trade.

Then you lend the DAI you received to borrowers to earn interest.

Finally, you can add insurance to this process

to make sure you’re covered in case anything goes wrong.

That’s just one example out of the many opportunities DeFi offers.

By now you can probably imagine what advantages DeFi presents.

Transparency, interoperability, decentralization,

free for all services and flexible user experience,

to name just a few.

However there are also some risks you should be aware of.

The most important risk is that DeFi is still in its infancy

and this means that things can go wrong.

Smart contracts have had issues in the past

where people didn’t define the rules for certain services correctly

and hackers found creative ways to exploit existing loopholes

in order to steal money.

If you decide to test out any of the existing DeFi services,

make sure to do it with an amount of money

you can afford to lose in case anything goes wrong.

Additionally, you should remember that a system is decentralized

only as its most central component.

This means that some services may be only partially decentralized

while still keeping some centralized aspects

that can act as an achilles heel.

It’s important to understand exactly how a product or service works

before investing in it

so you can be aware of any issues that may come up.

To sum it up,

it seems that the DeFi revolution has reached its early adopter stage

and the coming years will tell

if it manages to cross the chasm into mainstream adoption.

There’s no doubt that a decentralized financial system

can benefit a huge portion of the population

that currently suffers from financial discrimination,

high fees and inefficiencies in managing their funds.

That’s it for today’s episode of Crypto Whiteboard Tuesday.

Hopefully by now you understand what DeFi is -

a term given for a variety of decentralized financial services

that aim to replace our current centralized financial system.

You may still have some questions.

If so, just leave them in the comment section below.

And if you want to take a look

at some of the more popular DeFi services in the works today

just check out the list in the description below.

Finally, if you’re watching this video on YouTube,

and enjoy what you’ve seen,

don’t forget to hit the like button, subscribe to the channel

and click that bell so that you’ll be notified as soon

as we post new episodes.

It really helps us out a lot.

Thanks for joining me here at the Whiteboard.

For 99bitcoins.com, I’m Nate Martin,

and I’ll see you…in a bit.