What is DeFi and How Does it Work?

DEFI is only possible because of the Turing Complete nature of the Ethereum blockchain. Being Turing Complete simply means that Ethereum is capable of executing any instruction that can be reduced to mathematics. Those mathematical instructions are programmed using a purpose-written language called Solidity to craft Smart Contracts, which automate financial services.

That Smart Contract logic is then delivered through digital applications – dApps – on desktop and mobile devices where end-users can simply connect an Ethereum wallet to access the service.

Ethereum’s brain, known as the EVM – Ethereum Virtual Machine – processes these Smart Contract instructions for a fee. That fee is paid to its network of validators to ensure the validity of transactions without needing any central intermediary like a bank or payment service.

Ethereum’s architecture builds in a set of standards for creating and transferring value in the form of new cryptocurrencies and tokens, which, when combined with Smart Contracts provided the foundation for an entirely new permissionless digital economy we now know as DEFI.

Though using a new operating model DEFI offers familiar financial services:

Saving & Loans – Protocols like Compound use Smart Contracts to algorithmically offer interest on deposits and lend out funds against collateral. Compound alone has over $10bn in Ethereum based assets earning interest.

Decentralised Exchanges – Smart Contracts enable Automated Market Making – automatically providing liquid pools of tradable asset pairs without any central process or oversight. A DEX will incentivise users to provide liquidity (LPs) and then use algorithms to provide constant pricing and balanced liquidity pools.

DEX’s can also offer the same kind of complex derivatives trading offered by centralised exchanges but with much greater freedom, control and access to liquidity. dYdX and Uniswap are two of the most popular decentralised exchanges.

Yield Aggregation – Given the explosive growth in opportunities to generate a return from DEFI protocols, Smart Contract-based services will find the best strategies to optimise return, also known as Yield Farming.