Since the beginning of 2020, the entire cryptosphere has been talking about decentralized finance or DeFi .
However, this constantly evolving ecosystem remains a mystery to many novices who have just arrived in the world of cryptocurrencies .
We can date the birth of DeFi to December 2017 , with the birth of the MakerDAO protocol . MakerDAO is a protocol, namely a series of smart contracts, at the origin of the stablecoin DAI. Unlike BTC which is a volatile asset, DAI is a stable currency based on the US dollar rate . 1 DAI is therefore equal to 1 dollar.
The creation of a stable currency, whose issuance is completely decentralized and relies solely on the crypto ecosystem, was the cornerstone of the birth of the DeFi ecosystem.
Indeed, MakerDAO is the first protocol to have introduced the notion of loan in the crypto ecosystem, via its DAI creation mechanism. In short, the DAI creation mechanism is similar to the creation of debts in the manner of a pawnbroker.
Let's remedy this by exploring together what decentralized finance is.
Decentralized finance , or commonly called DeFi for “decentralized finance” , is a separate field of cryptocurrencies which aims to transpose traditional financial services onto the blockchain .
Initially, Bitcoin (BTC) and other cryptocurrencies revolutionized the monetary world by offering a decentralized currency , that is, without a central control body. As a result, Bitcoin offers an alternative currency, outside the control of banks, until now the only queens of the monetary chessboard.
For its part, the decentralized finance ecosystem is based on this cornerstone provided by cryptocurrencies to go much further than money transfer . In fact, DeFi is a set of decentralized financial services .
Decentralized means accessible to all . Indeed, unlike traditional financial services offered by banks, DeFi is open to all, with no minimum investment and without having to have a bank account .
The DeFi ecosystem does not have a specific genesis date. However, if one thing is certain, it is that it has an original blockchain , which is none other than Ethereum (ETH) .
Ethereum has proven to be a perfect blockchain for the birth of DeFi. Indeed, all of DeFi's services would not have been possible without Ethereum's smart contracts . As a reminder, smart contracts are computer programs that automatically execute actions based on certain conditions.
What is DeFi (Decentralized Finance)
Decentralized finance , or commonly called DeFi for “decentralized finance” , is a separate field of cryptocurrencies which aims to transpose traditional financial services onto the blockchain .
Initially, Bitcoin (BTC) and other cryptocurrencies revolutionized the monetary world by offering a decentralized currency , that is, without a central control body. As a result, Bitcoin offers an alternative currency, outside the control of banks, until now the only queens of the monetary chessboard.
For its part, the decentralized finance ecosystem is based on this cornerstone provided by cryptocurrencies to go much further than money transfer . In fact, DeFi is a set of decentralized financial services .
Decentralized means accessible to all . Indeed, unlike traditional financial services offered by banks, DeFi is open to all, with no minimum investment and without having to have a bank account .
The History of DeFi
The DeFi ecosystem does not have a specific genesis date. However, if one thing is certain, it is that it has an original blockchain , which is none other than Ethereum (ETH) .
Ethereum has proven to be a perfect blockchain for the birth of DeFi. Indeed, all of DeFi's services would not have been possible without Ethereum's smart contracts . As a reminder, smart contracts are computer programs that automatically execute actions based on certain conditions.
MakerDAO, the first DeFi protocol
We can date the birth of DeFi to December 2017 , with the birth of the MakerDAO protocol . MakerDAO is a protocol, namely a series of smart contracts, at the origin of the stablecoin DAI. Unlike BTC which is a volatile asset, DAI is a stable currency based on the US dollar rate . 1 DAI is therefore equal to 1 dollar.
The creation of a stable currency, whose issuance is completely decentralized and relies solely on the crypto ecosystem, was the cornerstone of the birth of the DeFi ecosystem.
Indeed, MakerDAO is the first protocol to have introduced the notion of loan in the crypto ecosystem, via its DAI creation mechanism. In short, the DAI creation mechanism is similar to the creation of debts in the manner of a pawnbroker.
As a result, a user can block ETH on the protocol and it will, in exchange, create a value lower than the deposit in DAI. To recover their blocked funds, the user will then have to repay the DAI they have created.
For example, if you deposit 1 ETH worth $4,000 , it is possible to generate 2,600 DAI , or $2,600 . Then, you will be free to do whatever you want with the 2,600 DAI . However, to get your deposited ETH back, it will be necessary to first repay the generated money.
For about a year, MakerDAO was the only protocol that could be related to what would become DeFi. It took until November 2018 and the launch of the Uniswap protocol to really start the dynamic that would lead to the DeFi ecosystem as we know it.
Uniswap is a decentralized exchange platform (DEX). It allows you to convert cryptocurrencies between them in a completely decentralized way. To do this, the platform has introduced the concept of liquidity pool .
Thus, actors called market makers ( or liquidity providers ), have the possibility of depositing assets related to an exchange pair. For example, ETH and DAI. These assets are deposited in a pool, namely a reserve of tokens on a smart contract.
Subsequently, many platforms have taken Uniswap's model to create other decentralized exchange platforms .
The pool concept could then be reused to create other applications replicating many other financial services, such as loans , savings or even insurance .
In the space of 3 years, more and more DeFi protocols have emerged. At the same time, the sum of funds deposited on all of these protocols has continued to increase, finally reaching $256 billion at the time of writing.
In a few years, the excitement around DeFi has continued to grow. Unfortunately, the Ethereum blockchain quickly found itself congested by the multitude of interactions it had to process.
As a result, transaction fees skyrocketed and its DeFi ecosystem proved unusable for most investors as the amount of transaction fees was far too large compared to the returns generated by DeFi.
To solve this problem, many competing blockchains have emerged, with the firm intention of replacing Ethereum.
In order not to disrupt the habits of developers mainly based on Ethereum, these blockchains have, for the most part, implemented the same ecosystem as Ethereum, namely the Ethereum Virtual Machine (EVM). In this way, these blockchains are able to execute the same code and smart contracts as those hosted on Ethereum. These blockchains are called EVM compatible .
Binance Smart Chain (BSC ) was the first to attract DeFi users looking for yields and low transaction fees. Led by protocols such as PancakeSwap , Venus or Autofarm , it quickly became one of the flagship blockchains in the DeFi ecosystem. To date, BSC has over $19 billion in assets deposited across its protocols.
Subsequently, other EVM-compatible blockchains, such as Polygon , Fantom , and Avalanche , emerged. The DeFi ecosystem now has more than fifty different blockchains , according to data compiled by DefiLlama.
DeFi offers many advantages compared to the traditional financial system.
Firstly, its decentralization makes it possible to offer universal access to this ecosystem. Unlike traditional financial services, which require the creation of a bank account, DeFi is accessible to anyone who has an Ethereum address . An action which, we remind you, is completely free .
Secondly, as DeFi is decentralized and has almost no intermediaries, it allows you to obtain returns that are often much more attractive than traditional financial services in which each intermediary will take their share.
As you probably noticed, DeFi has a lexicon all its own. Don’t panic! We’ll explain the main essential terms.
The concept of liquidity pools is central to the DeFi ecosystem. As we have seen with the history of Uniswap, it is this concept that allowed the whole of decentralized finance to see the light of day.
Basically, a liquidity pool is a pool of tokens that are deposited by liquidity providers in exchange for a reward. This liquidity can then be used for various applications.
An example is Uniswap's liquidity pools, which hold both assets of a given trading pair . Liquidity pools are also used by lending and savings protocols. Thus, savers deposit their savings into pools. This money is then made available to borrowers by the protocol. To take out the loan, borrowers must pay fees, which are redistributed to liquidity providers as a reward for participating in the protocol.
Flash Loan is also a concept specific to decentralized finance. These, also called instant loans, are a kind of loan that can be taken out by a user for the duration of a transaction.
Therefore, the loan is granted only on condition that it is repaid in the same transaction . This tool is particularly appreciated by traders practicing arbitrage. This allows access to a large amount of funds to make a trade that will be profitable. If the trade is a loser, then the sum is not lent.
Farming, or yield farming , is a concept that came much later in the history of DeFi.
In short, it involves optimizing deposits across multiple DeFi protocols to maximize the yield on its assets.
In practice, many protocols have emerged to automate this optimization, allowing the user to simply deposit their funds and the protocol takes care of making the most profitable investments.
TVL , or total value locked , is a metric that represents the amount of funds deposited on a DeFi application. To date, Curve is the protocol with the largest TVL with over $19 billion .
As you can see, the DeFi ecosystem is extremely vast. However, it is possible to classify most protocols into several families based on their usefulness.
To do this, they rely on the creation of debt to issue currency. For example, MakerDAO allows you to create DAI in exchange for a deposit in ETH. In fact, MakerDAO creates debt by issuing DAI, knowing that it can be repaid thanks to the blocked ETH if the debt were to be in default.
Among the flagship protocols, we can cite MakerDAO or Liquity .
Decentralized exchanges (DEX) are a second family of decentralized finance protocols. They allow cryptocurrencies to be exchanged between them . A service similar to that offered by platforms such as Binance or Coinbase , but in a decentralized manner.
So, instead of having funds stored and managed by a centralized company, they are managed by a series of smart contracts hosted on a blockchain.
We can notably cite Uniswap , Curve , Balancer and Sushiswap .
Aggregators , on the other hand, are tools connected to a large number of decentralized exchange platforms that allow you to obtain the best rates . Thus, they determine the platform that offers the best rate for a given pair.
1Inch and Paraswap are among the most used DEX aggregators on the market.
The concepts of lending and saving are cornerstones of traditional finance. Therefore, DeFi could not do without such services. This is when many protocols, commonly called lending protocols , emerged.
These latter connect 2 types of actors: savers and borrowers. In practice, savers deposit their savings in liquidity pools. For their part, borrowers can borrow funds from the pool, at a defined rate . The fees collected by the protocol during a loan are redistributed to savers to reward them for participating in the market.
As the DeFi ecosystem grows, it has more and more protocols. Each of these protocols offers more or less attractive returns at any given time. However, transferring funds from protocol to protocol based on rate variations can be extremely tedious and potentially costly in transaction fees.
So, developers wanted to solve this problem by automating the process. This is how the so-called yield farming protocols were born . These allow you to automatically optimize the yield on a given asset by taking advantage of the wide variety of opportunities in the ecosystem.
Once again, this financial product has its DeFi alter ego. Many protocols, such as TokenSet , offer indices. For example, the DPI index (for “DeFi Pulse index” ) allows you to gain exposure to the main DeFi protocols by holding only one token.
As we saw earlier in this article, the DeFi ecosystem is tending to become a multi-chain ecosystem . It has therefore become essential to be able to easily transfer funds from one chain to another.
Bridges allow funds to be sent from one blockchain to another. To do this, funds are sent and locked in a smart contract on chain A, then a representation of the asset will be issued on chain B and sent to the wallet of the user making the transfer. This process is called tokenization .
Unfortunately, not everything is rosy for the DeFi ecosystem. Indeed, the latter is based on a multitude of smart contracts. As a result, due to the open nature of these ecosystems, anyone is able to publish a smart contract and launch their DeFi protocol .
However, not everyone makes the effort to audit their contracts, which leads to attacks of all kinds. In 2021, the DeFi ecosystem witnessed the loss of $680 million during hacks . A bill that could have risen to $1.4 billion , if some hackers had not been remorseful.
To survive over time and strengthen the confidence of both investors and institutions, the DeFi ecosystem has no choice but to redouble its vigilance regarding the security of its various protocols.
For example, if you deposit 1 ETH worth $4,000 , it is possible to generate 2,600 DAI , or $2,600 . Then, you will be free to do whatever you want with the 2,600 DAI . However, to get your deposited ETH back, it will be necessary to first repay the generated money.
Uniswap: the birth of pools
For about a year, MakerDAO was the only protocol that could be related to what would become DeFi. It took until November 2018 and the launch of the Uniswap protocol to really start the dynamic that would lead to the DeFi ecosystem as we know it.
Uniswap is a decentralized exchange platform (DEX). It allows you to convert cryptocurrencies between them in a completely decentralized way. To do this, the platform has introduced the concept of liquidity pool .
Thus, actors called market makers ( or liquidity providers ), have the possibility of depositing assets related to an exchange pair. For example, ETH and DAI. These assets are deposited in a pool, namely a reserve of tokens on a smart contract.
Subsequently, users of the protocol can exchange ETH into DAI, or vice versa, by depositing one asset of the pair into the pool and recovering the same value of the other asset.
In exchange for this conversion, the user pays a fee which is passed on to the liquidity providers to reward them.
In exchange for this conversion, the user pays a fee which is passed on to the liquidity providers to reward them.
After Uniswap
Subsequently, many platforms have taken Uniswap's model to create other decentralized exchange platforms .
The pool concept could then be reused to create other applications replicating many other financial services, such as loans , savings or even insurance .
In the space of 3 years, more and more DeFi protocols have emerged. At the same time, the sum of funds deposited on all of these protocols has continued to increase, finally reaching $256 billion at the time of writing.
DeFi, a multi-chain ecosystem
In a few years, the excitement around DeFi has continued to grow. Unfortunately, the Ethereum blockchain quickly found itself congested by the multitude of interactions it had to process.
As a result, transaction fees skyrocketed and its DeFi ecosystem proved unusable for most investors as the amount of transaction fees was far too large compared to the returns generated by DeFi.
To solve this problem, many competing blockchains have emerged, with the firm intention of replacing Ethereum.
In order not to disrupt the habits of developers mainly based on Ethereum, these blockchains have, for the most part, implemented the same ecosystem as Ethereum, namely the Ethereum Virtual Machine (EVM). In this way, these blockchains are able to execute the same code and smart contracts as those hosted on Ethereum. These blockchains are called EVM compatible .
Binance Smart Chain (BSC ) was the first to attract DeFi users looking for yields and low transaction fees. Led by protocols such as PancakeSwap , Venus or Autofarm , it quickly became one of the flagship blockchains in the DeFi ecosystem. To date, BSC has over $19 billion in assets deposited across its protocols.
Subsequently, other EVM-compatible blockchains, such as Polygon , Fantom , and Avalanche , emerged. The DeFi ecosystem now has more than fifty different blockchains , according to data compiled by DefiLlama.
The Benefits of Decentralized Finance
DeFi offers many advantages compared to the traditional financial system.
Firstly, its decentralization makes it possible to offer universal access to this ecosystem. Unlike traditional financial services, which require the creation of a bank account, DeFi is accessible to anyone who has an Ethereum address . An action which, we remind you, is completely free .
Secondly, as DeFi is decentralized and has almost no intermediaries, it allows you to obtain returns that are often much more attractive than traditional financial services in which each intermediary will take their share.
The DeFi Lexicon
As you probably noticed, DeFi has a lexicon all its own. Don’t panic! We’ll explain the main essential terms.
Liquidity pools: the heart of DeFi
The concept of liquidity pools is central to the DeFi ecosystem. As we have seen with the history of Uniswap, it is this concept that allowed the whole of decentralized finance to see the light of day.
Basically, a liquidity pool is a pool of tokens that are deposited by liquidity providers in exchange for a reward. This liquidity can then be used for various applications.
An example is Uniswap's liquidity pools, which hold both assets of a given trading pair . Liquidity pools are also used by lending and savings protocols. Thus, savers deposit their savings into pools. This money is then made available to borrowers by the protocol. To take out the loan, borrowers must pay fees, which are redistributed to liquidity providers as a reward for participating in the protocol.
Flash loans: short-term loans made by DeFi
Flash Loan is also a concept specific to decentralized finance. These, also called instant loans, are a kind of loan that can be taken out by a user for the duration of a transaction.
Therefore, the loan is granted only on condition that it is repaid in the same transaction . This tool is particularly appreciated by traders practicing arbitrage. This allows access to a large amount of funds to make a trade that will be profitable. If the trade is a loser, then the sum is not lent.
Yield farming: the passive returns of DeFi
Farming, or yield farming , is a concept that came much later in the history of DeFi.
In short, it involves optimizing deposits across multiple DeFi protocols to maximize the yield on its assets.
In practice, many protocols have emerged to automate this optimization, allowing the user to simply deposit their funds and the protocol takes care of making the most profitable investments.
TVL: the market cap of DeFi protocol
TVL , or total value locked , is a metric that represents the amount of funds deposited on a DeFi application. To date, Curve is the protocol with the largest TVL with over $19 billion .
What are the areas of application of DeFi?
As you can see, the DeFi ecosystem is extremely vast. However, it is possible to classify most protocols into several families based on their usefulness.
Money markets
Money markets are protocols whose purpose is to issue a currency : most of the time, a stablecoin.To do this, they rely on the creation of debt to issue currency. For example, MakerDAO allows you to create DAI in exchange for a deposit in ETH. In fact, MakerDAO creates debt by issuing DAI, knowing that it can be repaid thanks to the blocked ETH if the debt were to be in default.
Among the flagship protocols, we can cite MakerDAO or Liquity .
DEXs and Aggregators
Decentralized exchanges (DEX) are a second family of decentralized finance protocols. They allow cryptocurrencies to be exchanged between them . A service similar to that offered by platforms such as Binance or Coinbase , but in a decentralized manner.
So, instead of having funds stored and managed by a centralized company, they are managed by a series of smart contracts hosted on a blockchain.
We can notably cite Uniswap , Curve , Balancer and Sushiswap .
Aggregators , on the other hand, are tools connected to a large number of decentralized exchange platforms that allow you to obtain the best rates . Thus, they determine the platform that offers the best rate for a given pair.
1Inch and Paraswap are among the most used DEX aggregators on the market.
Loan/Savings Protocols
The concepts of lending and saving are cornerstones of traditional finance. Therefore, DeFi could not do without such services. This is when many protocols, commonly called lending protocols , emerged.
These latter connect 2 types of actors: savers and borrowers. In practice, savers deposit their savings in liquidity pools. For their part, borrowers can borrow funds from the pool, at a defined rate . The fees collected by the protocol during a loan are redistributed to savers to reward them for participating in the market.
Yield farming platforms
As the DeFi ecosystem grows, it has more and more protocols. Each of these protocols offers more or less attractive returns at any given time. However, transferring funds from protocol to protocol based on rate variations can be extremely tedious and potentially costly in transaction fees.
So, developers wanted to solve this problem by automating the process. This is how the so-called yield farming protocols were born . These allow you to automatically optimize the yield on a given asset by taking advantage of the wide variety of opportunities in the ecosystem.
The clues
Indices are financial products that are extremely popular with traditional finance investors. They allow exposure to a multitude of different products while holding only one asset. For example, the CAC 40 index tracks the value of the 40 largest French companies .Once again, this financial product has its DeFi alter ego. Many protocols, such as TokenSet , offer indices. For example, the DPI index (for “DeFi Pulse index” ) allows you to gain exposure to the main DeFi protocols by holding only one token.
The bridges
As we saw earlier in this article, the DeFi ecosystem is tending to become a multi-chain ecosystem . It has therefore become essential to be able to easily transfer funds from one chain to another.
Bridges allow funds to be sent from one blockchain to another. To do this, funds are sent and locked in a smart contract on chain A, then a representation of the asset will be issued on chain B and sent to the wallet of the user making the transfer. This process is called tokenization .
Hacks: The Scourge of DeFi
Unfortunately, not everything is rosy for the DeFi ecosystem. Indeed, the latter is based on a multitude of smart contracts. As a result, due to the open nature of these ecosystems, anyone is able to publish a smart contract and launch their DeFi protocol .
However, not everyone makes the effort to audit their contracts, which leads to attacks of all kinds. In 2021, the DeFi ecosystem witnessed the loss of $680 million during hacks . A bill that could have risen to $1.4 billion , if some hackers had not been remorseful.
To survive over time and strengthen the confidence of both investors and institutions, the DeFi ecosystem has no choice but to redouble its vigilance regarding the security of its various protocols.
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