What is DeFi? A guide to the future of finance

• DeFi means: DeFi (decentralized finance) refers to the set of financial applications running on a blockchain network, which eliminates banks and intermediaries from financial transactions.
• Tools: To interact with financial applications, you need web3 wallets (web3/defi wallets), which provide full self-custody over your assets. (What is a Web3 wallet? A guide for beginners)
• Leading projects: The sector is dominated by massive projects and their associated defi tokens, such as Lido, Aave, Uniswap, and MakerDAO. These projects enable borrowing, crypto token trading, stablecoin issuance, and options trading, among other things.
• Portfolio management: To track investments scattered across multiple networks and protocols, it is now essential to use a portfolio manager specialized in DeFi.

The traditional financial system (TradFi) relies on intermediaries – banks, brokers and clearing houses – to process transactions. This system is slow, expensive and inaccessible to many. In contrast, crypto DeFi (cryptocurrency-based decentralized finance) offers an open, global alternative that operates 24/7, is permissionless and runs entirely on public blockchain networks.

But how exactly does this bankless world work, and how can you participate in it?

The Evolution: From Bitcoin to Ethereum

To understand the explosion of decentralized finance (DeFi), we need to look at the evolutionary steps of the technology. It all started with Bitcoin, but the real financial revolution came with another innovation.

🪙Bitcoin (BTC)

Launched in 2009, Bitcoin proved that blockchain technology can be used to securely transact financial transactions without intermediaries (banks). However, the Bitcoin network intentionally uses an extremely simple and rigid system: essentially an immutable, distributed digital ledger (or, we can simply call it a database) that performs a single task: It is able to record that user “A” sent 1 BTC to user “B” and how many Bitcoins A and B have based on these transactions. From a technological point of view, Bitcoin is a huge innovation, but in terms of its functions it is very simple, with its programmability severely limited in order to ensure maximum security. In practice, this means that changes to the Bitcoin code are very rarely approved, and even when they do, they are usually minor.

The Bitcoin system and network are not capable of providing more complex financial services, their only function is the aforementioned BTC transfer from one user to another.

🔗Ethereum (ETH) Innovation

A huge change began in 2015 with the launch of the Ethereum network. Ethereum's creators asked the question: What if the blockchain could not only store simple transactions and balances, but also run any software code?

Developers can write complex programs directly on the network. These programs are called smart contracts. The name smart contract comes from the fact that in traditional systems, for example, when taking out a loan, the customer goes to the bank branch and signs a contract based on which the bank allocates the loan amount, and the contract also contains the loan terms: when and how much money must be repaid, what happens if the customer cannot repay the loan, etc. Ethereum and smart contracts have made it possible for all of this to happen automatically, without human interaction.

✨This is how DeFi was born

The emergence of smart contracts was what exploded the DeFi ecosystem. Developers realized that if a code could move money (tokens) under certain conditions, then a smart contract could take on the role of a bank or an exchange.

• Lending: Instead of a bank clerk approving your loan, a lending protocol automatically locks your deposit (collateral, say ETH or BTC) and immediately disburses you the requested amount in, say, a dollar stablecoin. It's similar to using your property as collateral and the bank disburses the money to your bank account (unsecured loans don't exist on the blockchain).
• Broker services: Instead of a brokerage matching buy and sell orders, a DEX (decentralized exchange) converts your tokens based on a mathematical formula. For example, if you want to buy ETH and you have other crypto tokens in your wallet, you send your tokens to a smart contract, which automatically calculates and allocates you the appropriate amount of ETH.

Ethereum has thus created an open, global, programmable financial infrastructure from mere “digital gold”.

⚙️How to use DeFi services? How Web3 wallets work

In traditional finance (TradFi), you log in to your online bank with an email address and password, and your money and data are managed by a central institution on its own servers. In the world of decentralized finance (DeFi), this model changes fundamentally: there are no registration forms, usernames, or bank tellers.

To interact with smart contracts running on the blockchain, you need a Web3 wallet.

💳What is a Web3 wallet and how does it work?

A Web3 wallet (most often a browser extension or mobile app) is your personal vault on blockchain networks. The most important thing to understand is that a wallet does not physically store your cryptocurrencies. The tokens exist on the blockchain itself. The wallet actually stores the cryptographic private keys that prove to the network that you own those tokens.

This model is called self-custody. You are your own bank, which means maximum freedom, but also maximum responsibility.

The steps of operation in practice:

1. The Seed Phrase: When you create a Web3 wallet, the software generates a password for you consisting of 12 or 24 English words. Whatever happens to your computer, these 12 words will allow you to restore access to your assets anywhere in the world. However, if you lose them or they fall into the hands of unauthorized persons, your money is lost forever. There is no “Forgot password” button and no customer service in crypto.
2. Connecting to dApps: If you want to use a DeFi application (dApp), you simply click on the “Connect Wallet” button on the website (these are completely traditional looking and accessible websites, the only added feature is the ability to connect your wallet. For example: Aave web interface). Your wallet identifies you in the system and you can see your balance instantly on the platform, without any KYC (identity verification).
3. Signing & Gas: When you make a transaction (e.g. deposit USDC into a smart contract), your wallet will pop up and ask you to digitally sign the transaction. This is where you will also have to pay the network usage fee, known as the gas fee.

💡We wrote in detail about how Web3 wallets work in a previous article: What is a Web3 wallet? A guide for beginners

Building blocks of the DeFi ecosystem: the most important categories

DeFi is not a single homogeneous system, but a set of distinct, interconnected financial legos (money legos). In practice, this means that a token issued by one application can be used in another, and then in a third. The largest database that collects DeFi projects and detailed statistics can be found here: DeFillama

It is worth knowing the basic sectors of the ecosystem and their business models:

• 💱Decentralized Exchanges (DEX): These platforms are the core trading hubs of DeFi. Unlike traditional exchanges (order books), most DEXs use what is known as the Automated Market Maker (AMM) model. Here, users (liquidity providers) deposit their tokens into a dedicated smart contract (liquidity pool), and a mathematical algorithm determines the price of each token in the pool. When someone swaps tokens through this pool, the transaction fee is passed on to the users providing the liquidity. (Examples: Uniswap, Curve, PancakeSwap)
• 💰Lending & Borrowing: Decentralized equivalents of traditional bank lending. These protocols allow users to deposit their cryptocurrencies in exchange for interest. Other users can borrow this capital, but only under strict overcollateralization – that is, they must deposit more collateral (e.g., in the form of Ethereum) than they borrow (e.g., in a dollar stablecoin). This eliminates the risk of default. There is no such thing as non-collateralized borrowing in crypto. (Examples: Aave, Compound)
• 🔒Staking and liquid staking: In Proof-of-Stake networks, users stake their tokens to secure the network (Ethereum works on this basis, but Bitcoin, for example, does not). In practice, servers must be operated that validate transactions on the network, ensuring the stability of the network. According to the amount of ETH staked in smart contracts, the server will receive the right to validate a given batch of transactions (block). Then the validator receives the transaction fees paid for the transactions.
  Liquid staking revolutionized this by connecting server operators and ETH owners. The system delivers the staked ETH to the server operators, and ETH owners receive the staked rewards (minus the server operators’ fees). ETH owners also receive a tradable receipt (stETH in the case of Lido) for the staked capital, which can be used in other DeFi projects, such as borrowing.
  Another innovation is re-staking, which allows the same staked capital to be used to secure multiple independent networks (oracles, bridges) at the same time, multiplying the return. (Examples: Lido, EigenLayer, Rocket Pool)
• 💲Stablecoins: The essence of stablecoins is that they try to track the value of a currency or other asset as closely as possible through various mechanisms. At the time of writing, 99%+ of stablecoins track the exchange rate of the US dollar (0.5% are based on the euro, while everything else is negligible). While USDT (Tether) or USDC (Circle) are issued by traditional companies (who hold the dollar collateral in the bank), decentralized stablecoins are issued by smart contracts, backed by a cryptocurrency (such as ETH or BTC). If the value of the collateral drops too much, the code automatically liquidates the position, thus maintaining the exchange rate of $1. Because of this mechanism, most of these projects also act as lending protocols (Examples: MakerDAO/Sky (DAI/USDS), Ethena (USDe), Frax)
• 📉Derivatives, Perpetuals, Options: A space for professional and institutional traders, generating increasing traffic on blockchains. These platforms allow leveraged trading – taking long and short positions – through smart contracts without requiring the user to hand over control of their capital to a central exchange. (Examples: dYdX, Hyperliquid, GMX)
• 📊Yield Aggregators: DeFi asset managers. As interest rates change daily across Aave, Curve, and other protocols, these smart contracts constantly monitor the market, automatically move users' capital to the highest yielding location, and continuously reinvest (auto-compound) the profits earned. (Examples: Yearn Finance, Beefy)
• 🌉Bridges (Cross-Chain Bridges): As more and more blockchains (Bitcoin, Ethereum, Solana, Arbitrum) exist in parallel, the task of bridges is to securely move crypto assets from one network to another, since each network can basically only handle transactions on its own network. Due to their technological complexity, they are also the most vulnerable to hacker attacks. (Examples: Wormhole, Stargate)

🥇Top DeFi tokens and market-leading projects

The maturity of the market is well demonstrated by the Total Value Locked (TVL) in the protocols.

Here are the most defining projects, or dApps (decentralized applications), that form the backbone of the industry:

• Lido (LDO): Lido allows users to stake their Ethereum in exchange for returns, while receiving a tradable derivative token (stETH) that can be used in other DeFi applications.
• Aave (AAVE): The most popular decentralized lending protocol. Users can provide tokens to the system to earn dynamic interest rates or borrow using their own crypto as collateral.
• Uniswap (UNI): The world's largest decentralized exchange (DEX), Uniswap uses an Automated Market Maker (AMM) model, where users can provide liquidity to trading pairs and in return receive a share of transaction fees.
• Sky/MakerDAO (SKY/MKR): The “central bank” of DeFi. They are responsible for overcollateralized lending and the issuance of decentralized stablecoins (DAI/USDS) that form a bridge between the dollar and the crypto world.
• EigenLayer: One recent innovation is the “restaking” narrative. EigenLayer allows users to use already staked ETH to secure multiple networks at once, multiplying the return.

📈Difference between traditional stocks and DeFi project tokens

In the traditional stock market, ownership of a company is a very well-defined concept. This means that when you buy a share on the stock exchange, you become a legally defined owner of the company, which gives you decision-making rights and benefits from the company's profits. There are also differences here, but in almost all cases the ownership relationship is clear. We wrote a detailed article about the companies operating in the crypto field available on the stock exchange here: Crypto stocks: Business models behind the blockchain

However, in the case of DeFi projects, this works completely differently (this also applies to other crypto projects). Although basically here, it is also about a team working on a product, which will have costs (wages and other expenses) and income. If the difference between the two is positive, then the project makes a profit, if negative, a loss. When we buy a token of a crypto project, we really need to look at what rights we get. It is possible that it is just a promise that we will benefit from the profits generated by the project in the future. We may have a say in decision-making through our voting rights provided by the token, but we may not.

In many cases, we can also get other rights by owning a token. For example, on a lending platform, we can potentially receive preferential interest rates when we use the project's product. A frequently used mechanic, for example, in the case of DEXs (decentralized exchanges), is that token holders can decide from week to week what activities to reward with newly created project tokens (in this case, it is a matter of token inflation). In the case of DEXs, the project token holders usually also benefit from the trading fees on the platform, which is equivalent to dividends in traditional terms.

🧠Why is it worth it for a project to reward users of its own smart contracts? Because investors will use the platforms where they can achieve the highest interest rates. This will result in more capital invested in the product and thus more revenue (fees) generated during use. However, the exact distribution of this is left to the token holders.

In the image below you can see the Curve Finance interface, with the largest liquidity pools containing ETH.
- The first column shows what tokens are in the given smart contract (ETH and stETH tokens in the case of the very first pool).
- The "Volume" column shows the trading volume in the recent period, so (looking at the first row) this amount of ETH tokens were exchanged (swapped) for stETH tokens through the given smart contract, or vice-versa.
- The last "TVL" column shows the total value of the tokens in the given smart contract (Total Value Locked).
- The two middle columns (Base vAPY and Rewards tAPR) show that those who provide liquidity to these smart contracts (i.e. place their own capital here) benefit from trading fees (swap fees, Base vAPY column) and from token rewards provided by Curve Finance (percentage value, annualized in the form of CRV tokens).

❓Challenges and risks of DeFi

Decentralized finance (DeFi) offers unprecedented freedom and return potential, but it is important to be aware of the technological and structural limitations. When we remove intermediaries (banks, brokers) from the equation, the responsibility falls 100% on the user.

The DeFi ecosystem currently faces the following main challenges and risks:

📑Smart contract vulnerability

DeFi systems are built on code (smart contracts), not legal contracts. If there is a programming error, logical gap or vulnerability (bug) in the code, malicious actors (hackers) can exploit it and empty liquidity pools in a matter of seconds. Open source is a double-edged sword: anyone can audit it, but hackers can also see the weak points. Since there is no central supervision or state deposit insurance, stolen capital is usually lost forever. It is worth noting here that there has been a shift in this regard compared to the initial state, and in various ways it is usually possible to recover the stolen funds in part or in full. However, there is no guarantee and in many cases the victims do not receive any compensation.

🙍‍♂️Extreme risk of user error

In the TradFi world (traditional banking), financial institutions are lenient towards mistakes. You can recall a wrong transfer and there is a “Forgot Password” button. In DeFi, you are your own bank. If you send a transaction to the wrong address or give an unknown, phishing (scam) smart contract access to your wallet, your money is immediately lost. Likewise, if you lose the recovery key (Seed Phrase) for your wallet, or a malicious actor swindles it from you, your cryptocurrency becomes inaccessible.

⚙️Infrastructural and performance limitations (poor performance & scalability)

Blockchains are inherently slower and less efficient than centralized servers (e.g., Visa’s network or Binance’s internal database). Networks sacrifice speed in the name of decentralization. While Ethereum has made significant progress in this area and Layer 2 scaling solutions have improved the situation, networks can still become overloaded and gas fees can skyrocket during times of extreme market volatility.

🗄️Chaotic and cluttered ecosystem

DeFi is innovating at an extremely fast pace, which has made the market incredibly fragmented. Countless different blockchains (Ethereum, Solana, Base, Arbitrum) and thousands of decentralized applications (dApps) on them are competing for capital. As an investor, finding the safest and most profitable platform requires a lot of research. Users often have to use 4-5 different bridges and wallets to move their capital from one place to another.

🔣Initial user experience (bad UX)

While fintech hybrids (e.g. Revolut, Robinhood) have done a lot to simplify interfaces, using “hardcore” DeFi is still daunting for traditional investors. Token approval, manual setting of network fees, and the required technological knowledge are all friction points that hinder mass retail adoption. Serious progress is also being made in this direction, primarily in relation to account abstraction, which makes a number of convenient features available to make it easier to get started in this world.

👁️Risk management and transparency

The above risks – especially opacity and smart contract risks – can be mitigated by using the right strategy and tools. While proper diversification is key for stocks and other assets, it is absolutely critical for DeFi projects.

Apart from proper prior research, smart contract risks can only be reduced by diversification. The goal is to prevent the loss of all your assets due to a hidden flaw in a smart contract. This means that you are forced to hold your assets in countless places and in several different tokens (tokens are mostly smart contracts themselves, so they carry their own risks, even if this risk is lower than in the case of complex smart contracts). However, tracking a properly diversified portfolio is not trivial, and for this you will definitely need a portfolio tracker where you can see your exposure to each token or project. It doesn't hurt to be able to track the value of your rewards as well.

We can help you with this with our portfolio tracker specialized in DeFi projects, where you can track the contents of multiple web3 wallets at once, along with your stocks and ETFs, providing full coverage for your financial portfolio.

💡DeFi is a risky area, but with the right strategy and the right professional tools, these risks become manageable. Try our Portfolio Tracker: iO Charts Portfolio Manager

Frequently Asked Questions (FAQ)

1. What is the biggest difference between DeFi and traditional banks?

In traditional banks, a central institution controls your money, approves transactions, and sets interest rates. In DeFi (decentralized finance), the rules are enforced by public, immutable smart contracts (code) on the blockchain, without intermediaries, 24 hours a day.

2. Are DeFi tokens and protocols secure?

Although the codes of leading protocols (like Aave or Uniswap) are constantly audited by cybersecurity firms, DeFi carries risks. Due to technological (hacker) attacks and the high volatility of defi tokens, it is important to only invest as much money as you can afford to lose.

3. Which is the best DeFi wallet for beginners?

For Ethereum and its associated networks (EVM), we can recommend Rabby wallet and MetaMask. If you want to move around the Solana ecosystem, Phantom is the most user-friendly option. These web3 wallets can be downloaded for free as browser extensions or mobile apps.

4. How can I earn passive income with crypto DeFi?

There are several ways: you can stake your existing cryptocurrencies to secure the network (e.g. Lido), lend your stablecoins on lending protocols (e.g. Aave), or provide liquidity on decentralized exchanges (e.g. Curve) for a share of transaction fees.

5. Why do I need a dedicated DeFi portfolio manager?

As your investments grow, your assets can easily be scattered across multiple blockchains and protocols. A portfolio management software automatically aggregates data from different defi wallets, showing you your accumulated rewards, saving you from the hassle of opaque and error-prone manual (Excel) administration. It also helps you never forget a previous position where you may have invested significant money.

Legal and liability statement (aka. disclaimer): My articles contain personal opinions, I write them solely for my own entertainment and that of my readers. The articles published here do NOT in any way exhaust the scope of investment advice. I have never intended, do not intend, and am unlikely to provide such in the future. What is written here is for informational purposes only and should NOT be construed as an offer. The expression of opinion is NOT in any way considered a guarantee to sell or buy financial instruments. You are SOLELY responsible for the decisions you make, and no one else, including me, assumes the risk.