Financial services have always depended on intermediation and middlemen. Banks, exchanges and others ensure that money flows smoothly and securely, under the watchful eye of various government agencies. Decentralized Finance (DeFi) offers a new, alternative infrastructure in which financial transactions can take place directly between users, without the need for a central party to regulate, direct or control everything. DeFi reduces costs and makes access to financial services more efficient and inclusive.

The possibilities are enormous and DeFi continues to develop at lightning speed. At the same time, this growth brings new challenges, such as usability and integration with existing financial systems.

This article explores the main concepts and applications of DeFi and shows how it can shape the future of payments and investing. Several places include links to articles we previously posted, where the concept cited is discussed in more detail.

Key concepts within DeFi

To better understand DeFi, let's first look at some core concepts. Indeed, DeFi is an umbrella term for several technologies that hook into each other and together make this ecosystem possible.

Blockchain - the basis of DeFi

We'll start with the basics: blockchain. A blockchain is a decentralized, public and digital registry in which transactions are immutably recorded by miners or validators (special users of the blockchain). This ensures transparency and security within DeFi, as anyone can independently verify transactions. Ethereum is the most widely used blockchain for DeFi because Ethereum is built for smart contract functionality (see below), while networks such as Solana and Avalanche offer faster and cheaper alternatives. The choice of blockchain determines the cost, speed and security of DeFi applications.

Read more about it in this article: Blockchains.

Smart Contracts - the workhorses of DeFi

Atop the foundation of blockchain we find smart contracts. Smart contracts are self-executing programs on the blockchain that automatically handle financial transactions and processes once predetermined conditions are met. When a smart contract is written by a developer and published on the blockchain, it can in fact continue to perform its functions autonomously within the program's framework. The computer program (“contract”) has thus actually become smart (“smart”). Within DeFi, we see that the classic counterparty is often essentially a smart contract and thus interacted with.

Read more in this article about: Smart Contracts.

Liquidity Pools - the engine of DeFi

One of the most common applications of smart contract technology within DeFi is the liquidity pool. A liquidity pool is a digital money pool into which users deposit crypto to provide liquidity to a market, the rules of which are defined in a smart contract. This is similar to how exchange houses hold different currencies to always facilitate a transaction. For each transaction that uses the liquidity in the liquidity pool, a fee is paid to the providers of the liquidity (such as Poolder).

Read more about in this article: Liquidity Pools.

Gas - the lubricant of DeFi

However, nothing goes for nothing, not even in DeFi! Every transaction on a blockchain costs gas fees paid for by crypto. Gas fees are the fees paid to have user transactions processed by miners or validators in a blockchain. The amount of these fees depends on the network pressure (on the blockchain) and the complexity of the transaction. Ethereum, for example, is known for high gas fees during peak hours, while related blockchains to Ethereum, such as Arbitrum and Optimism, and alternative blockchains such as Solana, offer cheaper options.

Stablecoins - the backbone of DeFi

Because cryptocurrencies such as Bitcoin and Ethereum can fluctuate significantly in value, stablecoins play a crucial role within DeFi. These digital tokens are linked to traditional currencies, such as the U.S. dollar, providing stability in an otherwise volatile market. Well-known examples are USDT (Tether) and USDC, both of which are linked 1-to-1 to the dollar.

That peg is guaranteed by the fact that the issuers of these stablecoins hold collateral in liquid government bonds and cash. Thus, with Tether, you can basically exchange one USDT for one U.S. dollar at any time because Tether keeps those dollars or equivalent reserves in reserve.

Read more about it in this article: Stablecoins.

Total Value Locked - the value of a protocol.

The Total Value Locked (TVL) shows how much power is locked into a DeFi protocol, usually in the form of crypto housed in smart contracts. It is an important measure of a platform's size, reliability and popularity. The higher the TVL, the more users are willing to entrust their money to the protocol.

You can compare it to the amount of assets on a stock exchange: the bigger the pot, the more attractive to traders and investors. A high TVL provides more liquidity and thus more efficient trading, while a falling TVL is often a sign of declining trust or usage.

DeFi is open financial innovation

Having briefly considered the key concepts of DeFi, we turn our gaze to the promise and some existing applications of DeFi. DeFi opens the door to an open financial system in which anyone, regardless of location or background, can participate. By breaking down the barriers of traditional financial institutions, DeFi makes experimentation and innovation easier. New products and services can emerge faster without the constraints of expensive infrastructure or strict entry requirements. This leads to more efficient and flexible financial services with less friction. DeFi creates an ecosystem in which financial flows can move more freely and smartly. In fact, anyone with a smartphone can join!

Read our article on __DeFi & Sustainability __where we further discuss DeFi's impact on financial empowerment.

Following are some examples of current applications of DeFi technology.

Trading without intermediaries

Within DeFi, it is common to buy and sell cryptocurrencies on a fully automated platform. On a so-called Decentralized Exchange (a “DEX,” such as Uniswap or Raydium), you can trade crypto without a centralized counterparty such as Bitvavo or Coinbase. The DEX uses liquidity pools and smart contracts that can be called by users from their wallet. Because transactions are recorded directly on a blockchain, the central counterparty is not needed. After all, the blockchain can be trusted to accurately store and display transaction history.

Read more about in this article: what is a Decentralized Exchange?

Borrowing money without a bank

Why go to a bank when you can borrow and lend directly within DeFi? With DeFi platforms like Aave or Compound, you can use your crypto as collateral to take out a loan, or actually earn interest by lending out your assets. It works like a mutual loan between individuals, but fully automated and transparent thanks to smart contracts.

Generating passive income

DeFi allows users to earn interest on their crypto assets. This is similar to how you get interest on a savings account, but with potentially higher returns as well as risks. The technology behind DeFi allows parties like Poolder to make these services more efficient and accessible. By deploying smart strategies and advanced tools, Poolder makes it easy to participate in investing via liquidity pools, without Poolder's clients needing in-depth technical knowledge themselves.

Challenges and developments within DeFi

We have now dwelled on the key concepts and opportunities of DeFi, but as with any impactful new technology, DeFi also has its challenges. DeFi is still evolving, and as the ecosystem grows, improvements are constantly being made to make the technology more secure, efficient and user-friendly. Below we discuss some of the key developments and concerns.

Security of smart contracts

DeFi runs entirely on code, and that means mistakes can have major consequences. Just as traditional software can be vulnerable to bugs and hacks, DeFi protocols must be continuously tested and improved. Because an error in a smart contract is immutable once it is on the blockchain, protocols such as Uniswap, Aave and Curve have enlisted teams of auditors to check their code. An entire industry has sprung up around smart contract auditing, with companies like Peckshield and Trail of Bits helping platforms improve their security. Still, the do-your-own-research (DYOR) mentality remains crucial: in DeFi, your money is really your own responsibility.

Liquidity

Liquidity is the lifeblood of any financial system, and so is DeFi. When too many users suddenly withdraw their funds, a protocol can drop in value (the “TVL” decreases!); a phenomenon similar to a bank run in traditional finance. When liquidity dries up, trading becomes more expensive and less efficient, which can cause users to drop out. Protocols such as Balancer and Curve respond to this by offering smart incentives, such as higher rewards for liquidity providers. Attracting and maintaining liquidity remains one of the biggest challenges for DeFi platforms and will determine their long-term success.

Regulation and compliance

DeFi was built to be globally accessible, but that doesn't mean it is beyond the reach of legislation. Regulators are looking more and more seriously at the impact of DeFi and are developing legislation to protect users and ensure financial stability. In Europe, MiCAR (Markets in Crypto-Assets Regulation) is one of the first comprehensive laws targeting crypto markets. While some in the industry see regulation as a threat, it may also help to gain wider acceptance by institutional parties and traditional investors. How DeFi and regulation will relate to each other is one of the big questions for the coming years.

Want to know more? Read our article on: MiCAR: Europe's New Crypto Law.

In the end

The future of DeFi

DeFi is growing fast and gaining attention from traditional financial parties. Banks, asset managers and funds are exploring how to deploy or integrate blockchain technology into their services. At the same time, new players are emerging that are fully committed to this digital infrastructure.

Poolder deliberately chooses the latter route and is leading the way by managing the assets of its funds entirely within DeFi as well as using it to generate returns. This shows how DeFi is not only a meaningful alternative, but also a way to make the financial system more efficient and innovative.

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