DeFi Explained: A Beginner's Guide to Decentralized Finance

The Beginner’s Guide to Decentralized Finance

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If you’re diving deep into the world of cryptocurrency, you have probably heard the term “DeFi” used to describe a variety of new protocols and assets. 

First, it’s important to acknowledge DeFi is a newer term just now coming into wider use. This means that DeFi, short for decentralized finance, doesn’t have a strict definition. Rather, it is attempting to describe what a certain class of cryptocurrencies is now striving to achieve. 

That said, DeFi cryptocurrencies can be said to have emerging commonalities. 

Most DeFi projects are software protocols that run on top of another cryptocurrency – commonly Ethereum or Cosmos – and that use a combination of that protocol’s crypto asset (as well as their own and maybe others) as a means to automate a financial service.

A great example of this in practice is the cryptocurrency DAI. 

Put simply, DAI allows users to “lock” cryptocurrency in a smart contract running on the Ethereum blockchain, where the funds are used as collateral to generate new assets that power its lending service.

DeFi projects like DAI can also incorporate what’s called a “governance token,” a crypto asset that may allow users to influence project direction or generate earnings from the service.

Proponents of DeFi cryptocurrencies argue that this means they serve as “capital assets” similar to stocks and bonds. So, whereas Bitcoin may serve as a pure money or store of value, these new crypto assets aim to provide exposure to the value of the service provided.

Note: The above represents our best effort to summarize the state of the industry’s cutting-edge. 

As always, you should exercise scrutiny when analyzing projects and protocols, and this may count doubly so for projects operating at the emerging edges of the technology.
 

What do DeFi protocols do?

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As DeFi protocols become more numerous, it’s beneficial to understand the different classes of problems these projects are attempting to solve.  

The purpose of this section is to classify the various categories that popular projects fall under, which might be helpful when building and diversifying your crypto portfolio. 

Lending and Borrowing

DeFi cryptocurrencies focusing on lending may allow users to take out a loan with software, removing the need for a trusted third party. 

Powered by code instead of paper contracts, these projects might automate the maintenance margins and interest rates required in lending. Among other things, this allows for automatic liquidation should balances fall below specified collateral ratio. 

While each lending protocol has different nuances, they all act in similar ways. For example, there are typically two types of users: those lending their tokens to the protocol and providing liquidity to it, and those borrowing it. 

Someone wishing to lend cryptocurrencies would send those tokens to an address controlled by the protocol, earning interest based on the amount lent.

Borrowers, on the other hand, post collateral in the form of a cryptocurrency. They are then allowed to borrow cryptocurrencies as a percentage of the posted value.

Should the protocols work as intended, users can easily borrow cryptocurrencies, and holders can earn a return on their assets. 

Examples of lending protocols are Aave, Compound, yEarn. 

Decentralized Exchanges

Decentralized exchanges (DEXs) may allow users to exchange crypto assets without the need for a mediator, allowing for the true peer-to-peer trading of cryptocurrencies.

The protocol's users are typically able to instantly convert cryptocurrencies without needing to access an order book. Instead, the conversion rate might be built into the network.

The idea is that DEXs can provide access to trading pairs, even when the volume of the underlying asset may be too small for larger exchanges.  

Another major benefit of a DEX is that user funds are not held by centralized parties. Instead, they are held in personal wallets, increasing the privacy of those using DEXs. 

Examples of decentralized exchanges are Uniswap, 0x and Kyber Network. 

Derivatives

Derivatives markets are where buyers and sellers exchange contracts based on the expected future value of an asset. These assets can be anything from cryptocurrencies to future event outcomes to real-world stocks and bonds. 

In protocols like Synthetix, users can trade real world assets such as stocks, currencies and precious metals in the form of tokens on Ethereum. 

On other protocols, such as Augur or Gnosis, users wager on the outcome of events. With Augur, users can create and exchange “shares” representing a portion of the value of outcomes like election results or sports results. 

Lastly, protocols like dYdX offer users the possibility to trade margin tokens, allowing traders exposure to leverage short or long positions in various markets. 

Kraken's Crypto Guides

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•  What is Bitcoin? (BTC)
•  What is Ethereum? (ETH)
•  What is Bitcoin Cash? (BCH)
•  What is Litecoin? (LTC)
•  What is Chainlink? (LINK)
•  What is EOSIO? (EOS)
•  What is Stellar? (XLM)
•  What is Cardano? (ADA)
•  What is Monero? (XMR)
•  What is Dash? (DASH)
•  What is Ethereum Classic? (ETC)
•  What is Zcash? (ZEC)
•  What is Basic Attention Token? (BAT)
•  What is Algorand? (ALGO)
•  What is Waves? (WAVES)
•  What is OmiseGo? (OMG)
•  What is Dogecoin? (DOGE)
•  What is Tether? (USDT)
•  What is Dai? (DAI)
•  What is Tezos? (XTZ)
•  What is Cosmos? (ATOM)
•  What is Augur? (REP)