What is DeFi? If it’s a set of financial tools, which ones? How many can you remove before it no longer is?
Whatever those are, the DeFi ecosystem can’t be simplified to just yield farming, stablecoins, or decentralized exchanges (DEXs). Its definition is as decentralized as the many components that form the DeFi ecosystem. And as new ones appear, the DeFi definition becomes broader and vague.
So let’s find out from most to least essential what makes DeFi what it is. And also some of the newer components that make one ecosystem different from another.
Summary:
- The DeFi ecosystem has at least five essential components, including stablecoins. Without them, DeFi services would be more limited, both because of missing infrastructure and the cost of building it individually.
- Developed ecosystems tend to outgrow even the most efficient ones. They attract new developers with a large community and dApp selection who eventually expand both.
- For successful adoption, DeFi networks not only need to be functional but convenient for other users to switch in the first place. The ideal DeFi ecosystem has Ethereum compatibility, secure blockchain bridges, and other cross-chain tools like oracles.
DeFi 101: How It Works
Decentralized Finance (DeFi) is a category of blockchain-based platforms with financial use cases. The goal is to eventually offer as many or more services as traditional finance, except without private ownership, asset custody, or ID verification requirements.
This financial ecosystem would allow anyone worldwide to access or provide DeFi services, whether it’s liquidity for DEXs, stability for stablecoins, or loans for collateral-based borrowing.
It’s possible because the DeFi system doesn’t require users to trust each other to guarantee security. No one directly controls a platform (in theory), and you don’t have to trust anyone with your coins, because there’s no central entity.
Instead, DeFi platforms leverage public blockchains that enable on-chain computing— better known as smart contracts. These already existed on Bitcoin, but Ethereum was the first network to develop Turing-complete, autonomous programs. This expanded the utility of smart contracts beyond simply validating transactions, and so Ethereum became the first and largest DeFi ecosystem.
Developers can combine smart contracts with traditional software so that users can interact with these. They’re called decentralized applications (dApps) as they follow the same DeFi principles. Dapps have broad applications, but the simplest way to recognize one is the need to connect a crypto wallet.
Almost every dApp uses DeFi tools because of how essential they are for the overall blockchain ecosystem.
What’s So Special About The DeFi Ecosystem?
DeFi disrupts blockchain and web development in a similar way that Bitcoin did. Blockchains had already existed for decades as a method for securing data. Bitcoin applies this information technology to payments.
Then, Ethereum applied it to app development, and DeFi linked app development to payments (programmable money).
Similarly, digital payments expanded when the Internet shifted from Web 1.0 (read-only) to Web 2.0 (read-write). This introduced modern online businesses and sped up Internet adoption. Information became decentralized, but payments weren’t yet.
DeFi does just that. It makes finance and ecommerce more accessible, both of which can reach broader markets. There are dApps for social media, gaming, real estate, healthcare, governance, and supply-chain management, and all of them use DeFi components.
There’s no blockchain “ecosystem,” but rather the DeFi one and its niche use cases.
Top 10 DeFi Elements From Most To Least Essential
From most essential to most dependent, here are the Top 10 DeFi components:
#1 Functional Smart Contracts
Smart contracts alone might not define the DeFi ecosystem, but they’re essential for every dApp to work. Without these programs, crypto finance would need some sort of central company to manage user requests. DeFi wouldn’t be possible.
But DeFi didn’t appear despite smart contracts existing for decades. That’s because Bitcoin’s aren’t Turing complete, so their functions are limited. Versus Ethereum, it’s like comparing a pocket calculator to a smartphone.
Bitcoin was intentionally designed this way for its purpose as a store-of-value cryptocurrency. Turing completeness would complicate its security with unintended uses, especially with looping functions. Ethereum and all compatible blockchains (BnB, Polygon, Pulsechain…) can limit those loops by using tokens as gas fees, and also the proof-of-stake (PoS) consensus model to incentivize or penalize validators.
These contracts allow us to build the foundational DeFi dApp:
#2 Web3 Wallets
Web3 wallets are called that way because you can access (almost) any dApp using the same wallet. Instead of registering/logging into every Web3 website, it’s one “account” for the entire network. There’s no need for verification because these wallets are permissionless and non-custodial (or self-custody).
Web3 wallets are different from traditional non-custodial ones because they’re dApps and only work with compatible blockchains.
E.g. The Metamask dApp is EVM compatible, so it supports Ethereum, Pulsechain, Optimism, among others, and all tokens ever created.
E.g. Exodus wallet is non-custodial but not a dApp, so it can’t connect to, say, Uniswap, and the features/token selection is limited.
Web3 also allows developers to create exclusive wallets for smart contracts. So when you interact with DEXs or liquidity pools, your tokens go from one non-custodial wallet to another. These follow different conditions to automatically return your tokens, such as timers and withdrawal requests.
Developers can also reduce token supply with so-called burn addresses. Simply send crypto to a smart-contract wallet without admin keys.
User tokens kept in those wallets are called TVL or total-value-locked.
Some DeFi developers keep admin keys for governance, code upgrades, and security emergencies. One decentralized way to achieve this is multi-signature wallets like Gnosis Safe. It links all Web3 wallets from the core team and every action needs approval from all or most members.
E.g, For a 5-member wallet, sending crypto requires 4 of 5 confirmations.
Smart contract wallets create the essential component for DeFi exchanges:
#3 Liquidity Pools
If all cryptocurrency were in user wallets, DeFi would be very limited. It would be a peer-to-peer (P2P) marketplace like NFTs. There’s not always someone willing to buy/sell, and that would limit both traders and newer platforms.
So DeFi needs liquidity, but how do you store crypto without trusting specific users? Smart-contract wallets funded by platform users. These “liquidity providers” (LPs) can add different tokens and proportions to this “pool,” which the contract offers to trades swapping those tokens.
E.g.:
- Provider adds $1,000 of USDT and $1,000 of UNI on the Uniswap DEX
- Other users might already have UNI tokens and want USDT instead. They can sell their UNI for up to the entire pool’s USDT. With just one provider, it’s 1000 USDT.
- As a provider, you can anytime reclaim back the same amount of tokens and proportion.
Liquidity providers also earn fee revenue from traders. This increases with your contribution percentage and the trading volume of the platform. Exchanges use hundreds of pools as a way to replace traditional order books and market makers.
Not only does DeFi have more liquidity, but today’s pools are more efficient both for DEXs and LPs. Providers can add liquidity for specific price ranges, choose different ratios other than 50-50, or join single-token pools.
#4 Decentralized Exchanges (DEXs)
DEXs are a major component and a big reason DeFi took off in 2020. Because for most crypto investors, exchanges are the no.1 tool. Not everybody uses liquidity pools or lending protocols, but almost every holder is familiar with CEXs or DEXs.
Well before 2020, the risks of custodial exchanges became clear. Around 2018 the first DEXs came out, allowing traders not only to control their wallets but access thousands of tokens. You can instantly trade any token from that network, even if there are no buyers or sellers available.
DEXs leverage liquidity pools, arbitrage trading, and AMMs to guarantee liquidity for most tokens:
- Traders unbalance the number of pool tokens
- Automated Market Makers (AMMs) adjust both token prices to rebalance the pool proportion. It sells the surplus token at a discount and buys the deficient one at a premium from arbitrageurs.
- Arbitrageurs trade across platforms to profit from those deviations and rebalance the pool
There’s an inverse relationship between DEXs and liquidity pools. Deep liquidity means less revenue for new providers but better rates for traders, and bad rates might mean that there’s a high-yield pool that needs LPs. That’s why DEXs and pools often use the same platform (Uniswap, PancakeSwap, Sushiswap…).
As there more and more DEXs appear, it’s more time-consuming to find the best deal for every swap. One quick way to compare them is DEX aggregators like Matcha.xyz or 1inch. These can find the most efficient one and exchange tokens directly, sometimes with better rates than the quoted DEX.
#5 Fully-Backed Stablecoins
Without reliable stablecoins, DeFi liquidity is like a game of musical chairs. Everything works smoothly until crypto markets crash. Along with black swan events, the DeFi TVL can plummet by several billion just as quickly.
Stablecoins are the non-fiat alternative for traders to get in and out of crypto. Users can use them to reenter the markets quicker while avoiding custodial wallets. It also helps the TVL because DeFi dApps (for staking, LP providing, lending) also accept stablecoins.
There’s no question about the utility of stablecoins, but there is as for how they are backed. Some use fiat reserves held by private companies, and others use cryptocurrency. The latter isn’t always practical, and there’s a high collateral to offset price volatility.
So far the most effective types are:
- Decentralized stablecoins (like DAI) that mix both stablecoins and cryptocurrencies.
- Algorithmic stablecoins (like LUSD and USDL) with reliable redemption and liquidation systems.
Properly backed stables lead to better lending protocols.
#6 Lending Protocols
A big “problem” in crypto is the hold-and-hope mentality. Not because it slows down its economy or devalues, but because it limits the utility of that cryptocurrency. For a store of value like Bitcoin, this is no problem. But for complex ecosystems, it can be, and that’s what lending protocols are for.
To free up idle crypto that would otherwise be locked for years.
The risk of lending isn’t that different from holding (market volatility), except with more benefits. Lenders earn interest and lend for collateral. Borrowers access more crypto without credit scores, sometimes with low collateral, no repayment schedules, and 0% interest.
Today’s protocols have added features like:
- Leveraged lending to increase interest revenue and risk
- Stablecoin loans to avoid market exposure and liquidation risks
- Liquid staking. Staking is a form of network security and consensus model that involves locking (or lending) tokens for interest rewards. Liquid means you receive equivalent tokens, which you can use on other dApps or trade on behalf of your actual tokens. But to un-stake them, you need the equivalents as a receipt (e.g, stake ETH to get stETH, trade with stETH, and redeem it for ETH later).
Lending protocols are the last essential DeFi component. The next four can enhance dApp features, but it’s not always the case.
#7 Decentralized Oracles
As secure as can be on-chain information, real-world data is where potential utility is. The applications of smart contracts are limited to the data they can interact with, and without “oracles,” they’d be limited to the DeFi ecosystem. With oracles, DeFi dApps can use, for example:
- Weather and energy consumption data for supply-chain networks.
- Internet-of-Things (IoT) device data for insurance protocols
- Social media data to recognize real from fake interactions
- Sports and games data for betting
- On-chain information from other blockchains
Oracles are considered “layer zero,” meaning they don’t belong to specific blockchains and can easily integrate with any. The most important properties are the same as with blockchains: lots of nodes, and accurate consensus.
Ideally, a dApp where users themselves can connect, review, and report data for incentives. Tellor seems to do just that. Centralized oracles may win in efficiency, but it wouldn’t be DeFi anymore.
#8 Cross-Chain Communication
One shortcut to DeFi ecosystems is cross-chain bridges. Interoperability allows users to convert tokens and transfer data among blockchains. That includes contracts and features from external dApps.
Simply put, developers save time and money by building on established networks. Ethereum has hundreds of dApps that you can import, integrate, combine, or repurpose. Cross-chain is like that, except you don’t have to build on Ethereum.
You can build on Pulsechain and import dApps from Pulse, Ethereum, Arbitrum, Polygon… Or build on Fantom and import from Ethereum, BnB Chain, and Avalanche at once. With just a dozen dApps, a tiny DeFi ecosystem can be almost as functional as bigger ones.
But cross-chain tech is experimental and not safe enough yet. Relay chains, bridges, and oracles are all cross-chain solutions.
#9 Governance systems
One successful case of governance is Uniswap v3. This latest version added flexible fees, concentrated liquidity, and other efficiency changes that made it more liquid and profitable. It’s the result of this governance proposal backed with 71M UNI tokens (or votes).
It’s called on-chain governance, and it allows users to suggest changes or new features for core teams to consider. Some dApps create separate governance tokens while others re-use the main one (UNI is also for DEX liquidity providers). The Uniswap Governance app works as a Decentralized Autonomous Organization (DAO), meaning that anyone can buy UNI tokens to submit/vote on proposals.
For more ambiguous decisions, there are informal discussions called off-chain governance. Ethereum follows this system where the core team reviews user proposals (EIPs) after certain stages (Draft, Review, Last Call…).
Governance isn’t always necessary once there’s a final product. In lending and stablecoin-related dApps, users may benefit more from consistent rules than constantly changing them. Not to mention the manipulation risk.
#10 Data Sourcing Tools
Having thousands of DeFi tools can be too much of a good thing. Ethereum has hundreds of inactive dApps with no product-market fit, and most of the volume/TVL goes to the same big few. But popular doesn’t mean best, and now we have sourcing tools to compare countless dApps in no time.
- DEX aggregators find the best rates for specific token swaps
- Yield farming optimizers (e.g., Yearn Finance) automatically switch your investment to the dApp with the highest annual percentage yield (APY)
Other DeFi Components
Many of the ten DeFi components didn’t exist before 2020. What makes you think we won’t discover new ones soon? Here are other DeFi components now in development:
- Insurance protocols: A platform that sends crypto to users who pay a premium for different conditions. E.g. Failed transactions, smart contract errors, platform exploits…
- NFT marketplaces: A P2P platform for users to create NFT assets at no cost, set their prices, and buy from other collections. NFTs have gained DeFi functionality, such as fractional ownership or NFT staking for token yields.
- Privacy tools: Other than the lack of identity, there’s less privacy in public blockchains than in traditional banking. Privacy dApps like Tornado Cash (TORN) or Brave (BAT) can achieve the opposite— if not both identity and history.
- Advanced trading functions: DEXs don’t yet provide other common tools that CEX traders use to manage risk. In 2023, limit orders and perpetuals are more common, but aren’t stop-losses, contracts, or futures contracts.
Decentralized identity: DeFi can greatly benefit from an alternative (maybe with NFTs?) to KYC and AML regulations. Maybe there could be a credit-score equivalent and not rely only on collateral. Or being able to access fiat off-ramps because of its compliance.
