How does DeFi work?

This chart shows a growth in the popular DeFi exchange Uniswap. The growth in addresses, or number of users is happening even while prices are declining because of the larger bear market.

Like the rest of the crypto world, DeFi can be, well, confusing.

A big part of the reason why it can feel confusing is all the new jargon you have to learn before being able to feel fully comfortable using DeFi apps and products.

Not to mention there are a couple of steps required (like getting some crypto and setting up a DeFi wallet) before you can get up and running.

In this post we’ll break down some of the DeFi jargon and try to get at a basic framework for how DeFi works.

For more info about some of the reasons why DeFi exists and some early use cases, be sure to check out the “What is DeFi?” post.

DeFi as a new kind of financial infrastructure

One way to think about DeFi is as a new kind of financial infrastructure. Traditional banks are like highways with tolls funneling people all in one direction and that have specific controls in place like speed limits and set on and off ramps.

DeFi, on the other hand, is like if everybody got around in a flying car. Right now there are no rules for flying cars (eventually there will likely be rules, guidelines and more standard operating procedure).

The other thing about the DeFi-as-flying-cars example is that people are allowed to go where they want, and fly at the height that they want, and get places in straight lines rather than have to follow predetermined routes.

So DeFi is a new kind of financial infrastructure that allows people to build out different kinds of financial services and products all while allowing the users of the new apps and services to maintain control of their assets in a non-custodial wallet.

Finally, the biggest thing about this new kind of infrastructure is that everyone has access. It doesn't matter your employment status, accredited investor rating, or your credit history. If you have assets then you can use DeFi protocols because they are permissionless.

So how does DeFi work?

DeFi is built on blockchain protocols using smart contracts — all of which is more jargon.

Another way to think about it: DeFi is programmable, like software (the smart contracts), and the software runs on different kinds of operating systems (the protocols).

Instead of using a password or user name to access this software, a DeFi user has a wallet. The wallet holds their funds and has a private key, which is known only to the user, giving a layer of security.

The reason DeFi is so exciting — and infinitely customizable at scale — is that DeFi products and services are built using computer code — they are like zapier (popular marketing automation software) for money. Zapier lets you set up simple work flows to manage things like outreach, customer fulfillment, sending emails when certain triggers happen — and the same kind of automation/bots working on your behalf kind of setup is possible with DeFi.

Major components of DeFi

One way to get your head around how DeFi works is to get a handle on some of the terms and concepts involved:

Protocol

As mentioned above, a protocol is like the operating system for DeFi. The protocol sets the rules as to how DeFi applications can be made and how they function.

The other parts of the DeFi ecosystem, like the application and the wallet all have to be compatible with the underlying protocol or blockchain. Common DeFi protocols are Ethereum, Polygon, and Solana.

Network

One thing that sets DeFi apart from traditional finance is that a network replaces the need for a company or corporation. DeFi projects will only be as strong as their underlying networks.

Currently, most successful DeFi projects are built on Ethereum using the token standard ERC-20 (this is a set of rules for Ethereum-based smart contracts that makes them compatible with other ERC-20 tokens). There are also other kinds of token standards outlining rules for things like non-fungible tokens, or NFTs..

Smart Contract

These are computer programs that are a key piece to the DeFi infrastructure. Smart contracts live on a protocol’s blockchain, making them publicly visible and auditable.

Additionally, smart contracts can be designed to handle a number of functions — and to automate and have them settle on the blockchain, which eliminates the need for centralized hosts or centralized entities.

Oracles

This function was clearly named by someone that likes science fiction. While it sounds fancy, an oracle is little more than a node that ingests data from the real world and makes it usable to a DeFi application.

Oracles might collect financial information from traditional markets or crop and weather reports for an insurance-related application. The value of DeFi oracles is that they are designed to collect and transmit the information necessary to execute a smart contract, but it can be done in a way that is compatible with the other pieces of decentralized infrastructure.

Token

A token is a currency unit that is native to a DeFi app, like UNI is currency created and used by Uniswap, a decentralized exchange. UNI is actually built on Ethereum using a token standard.

Liquidity pool

This is a fancy way of saying a pool of money. One dominant use case for DeFi is lending and borrowing. Via a DeFi app, lenders give their money to a liquidity pool and then other DeFi apps or users can borrow from that liquidity pool.

On the flipside, users will lend to the DeFi pool in order to make money in the form of interest on the assets they lent to the liquidity pool.

There are a number of reasons why companies, projects, and other people might want to access a liquidity pool and one of them is to borrow on margin.

Borrowing on margin basically means borrowing money and collateralizing the loan with other assets — in this case crypto or DeFi tokens.

Borrowing on margin — especially when the collateral is subject to extreme market volatility like crypto — is super risky. A major part of the implosion of the crypto sector in 2022 was due to crypto collateralized loans tanking industry-wide.

DeFi wallet

A key component of the DeFi system is a wallet, which is a place users can securely hold their assets. Most DeFi apps require that users connect a wallet before they can take any kind of actions.

The user-controlled wallet model is also a key component of the emerging web3 space — although not all web3 apps are DeFi or even finance-related.

There are a number of different wallets, but understanding how they work and how to use them securely is a good first step in the entire DeFi process.

Learn by doing

DeFi can feel complex or fuzzy, but the underlying concepts are actually pretty straightforward.

In some cases, navigating the jargon and getting a handle on how to set-up a wallet and start using DeFi apps is the hardest part.