What Is DeFi and How Does It Work?

Decentralized finance (DeFi) is one of the most exciting modern applications of blockchain technology. Learn more about its importance and how it differs from traditional finance.

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Nicole Sanders
Principal Software Engineer, Blockchain Expert

The decentralized nature of cryptocurrency has always been one of its primary selling points, but it wasn’t until the launch of Ethereum that more advanced applications of decentralization became prevalent. 

These new applications laid the groundwork for the evolution of a system known as decentralized finance (DeFi). 

What is DeFi?

DeFi is an anonymous system that completes traditional financial transactions without any use of, or interference from, an intermediary or governing body. Instead of using a neutral third party, DeFi uses an application through blockchain technology, also known as DeFi protocol, to connect users directly; its products and smart contracts maintain fulfillment of these agreements. While it’s possible to build DeFi apps on other blockchains, Ethereum is the most popular and accessible in 2021.

The popularity of DeFi rapidly expanded in 2020 and 2021. The value of assets attached to DeFi contracts, known as total value locked, increased from roughly $697 million at the beginning of 2020 to more than $85 billion in August 2021 according to Defi Pulse.

What is a smart contract?

Smart contracts make it possible for users to create DeFi apps on top of the blockchain; they’re transactional protocols or computer programs that automatically execute when relevant events tied to the agreement take place. Ethereum is closely related to DeFi because it was coded with smart contracts in mind.

Why is DeFi important?

A societal transition away from traditional finance toward DeFi would constitute a fundamental shift in the ways we interact with forms of currency.

There are often dozens of third parties involved in your finances. We store fiat currency with financial institutions. We go through traditional banks and exchanges to digitally transfer fiat currency to friends and family. These processes can be time consuming, and potentially expensive to utilize as they often involve transaction fees.

DeFi doesn’t have the vulnerabilities or inconveniences we tend to assume are necessary.

How does DeFi differ from traditional finance?

Traditional finance is highly regulated, and there’s often a frequent amount of fees. While we obviously have a greater familiarity with traditional finance, DeFi offers: 

  • Much higher levels of autonomy with transactions; no permissions are needed to conduct transactions and deals can be structured without waiting periods
  • Better transparency into transactions and fees
  • Greater trust in the technology itself as opposed to intermediaries like banking institutions

However, these perks don’t come without potential risk. DeFi is still new territory, and it’s also less private since transactions are visible on the public decentralized blockchain.

What are DeFi applications?

Decentralized finance already includes dozens of different financial applications, and more will inevitably develop in the years to come. After all, the only limit to what DeFi could accomplish is how well the smart contract is crafted.

People even use contracts to create prediction markets where users can make wagers on things like sporting events and election results. Polymarket is one example of a prediction market. 

Some of the most significant modern DeFi services and decentralized applications are: 

  • Coins
  • Stablecoins
  • Tokens
  • Wallets
  • Liquidity, mining, and staking
  • Trading 
  • Borrowing, lending, and saving

Coins

As blockchains pop up that can be utilized in the DeFi space, they usually create their own coins to incentivize people to use the platform. 

Some of the most popular coins are:

  • Ether (ETH)
  • Cardano (ADA)
  • Solana (SOL)
  • Polkadot (DOT)

Stablecoins

Volatility is the primary risk of most cryptocurrencies as price fluctuations are common.

Stablecoins are the most popular solution to volatility in the current DeFi ecosystem. Their value is fixed to the value of an underlying asset, such as fiat currency or other exchange-traded commodities; as a result, the value of the stablecoin is unlikely to drop below the value of the asset it’s tied to, and there’s less fluctuation in the stablecoin’s value. 

Tokens

DeFi tokens are an asset similar to coins. They can also be a type of cryptocurrency, however, tokens are created on a pre-existing blockchain.

For example, Ethereum’s coin is Ether, while tokens like UniSwap and Compound are non-native cryptocurrencies constructed on the Ethereum blockchain.

They can come in many different variations, like payment tokens, governance tokens, and utility tokens.

What are NFTs?

Non-fungible tokens (NFTs) are a unique type of token that represent something of value like a song, piece of art, or video. They’re a synthetic asset—a derivative that takes its value from an underlying asset and tokenizes the relationship instead of using a contract. NFTs are a way to demonstrate ownership via the blockchain.

They don’t prevent other people from viewing or accessing the underlying object of the NFT, but no one else can make copies of the NFT itself. NFTs allow creators to set up royalties whenever someone sells their art.

To learn more about the potential tax implications of NFTs, please read our guide

Wallets

Many crypto transactions still fall under the centralized finance umbrella because the average crypto exchange is centralized and uses a third party to conduct transactions. You’ll know you’re dealing with a centralized exchange if you buy your first digital asset and the crypto wallet holds the key instead of you.

Conversely, DeFi wallets like MetaMask Wallet and Coinbase Wallet are non-custodial. You retain possession of your crypto, but you’re responsible for the private keys that let you access the wallet.

Be aware, on a DeFi wallet, if you lose the keys, you can’t request a new one like you would a new password from a centralized wallet.

Liquidity mining

DeFi mining, or liquidity mining, shouldn't be confused with the more popular proof-of-work mining. 

Liquidity mining involves pairing your digital assets—either coins or tokens, like ETH and DAI— and storing them in a liquidity pool, so other DeFi users have the liquidity to facilitate trades between the two. You'll receive a return for your investment, and give other platform users the liquidity necessary to complete their transactions.

Yield farming

Chasing returns by bouncing between pools is known as yield farming. Some yield farmers can generate large returns, which you can examine on sites like CoinGecko.

Staking

Staking is a way to participate in the consensus algorithm in a proof-of-stake ecosystem, similar to how miners create new blocks in a proof-of-work system. Both are ways of validating a blockchain, but staking assigns mining power based on ownership stake—the percentage of coin an owner acquires—and requires far less computational energy than proof-of-work.

Trading

DeFi trading apps let users engage in crypto investment trading without the use of a centralized exchange. Currently, much of cryptocurrency trading is centralized, just like stock trading. Coinbase, Binance, and Kraken are all centralized exchanges.

A decentralized exchange is a crypto market that relies solely on smart-contract and blockchain technology to execute trades, which lets users buy and sell with each other directly.

Borrowing, lending, and saving

Smart contracts can be created to let you borrow and lend your cryptocurrency without the use of an intermediary, which sidesteps a lot of the risks involved in traditional lending.

For example, if a borrower doesn’t meet their obligations in a flash loan, their lender can take their funds back. Therefore, collateral is unnecessary in many DeFi lending situations.

DeFi saving accounts function similarly to traditional savings accounts, but offer much higher interest rates. You can watch interest accrue in real-time, but it usually pays out daily, weekly, or monthly depending on the platform.

What are the tax implications of DeFi?

You must report your income from DeFi transactions on your tax returns and pay the appropriate taxes.

You can generate two types of taxable income: ordinary income and capital gains. For example, earning crypto through a DeFi exchange for services rendered is ordinary income. Trading one crypto for another through a DeFi exchange could be a capital gains tax event and generate a capital gain if the proceeds exceed the cost basis.

For more information about filing digital asset taxes, we have a checklist to get you started, and more detailed information in our Complete Guide to Cryptocurrency Taxes

How TaxBit can help

TaxBit recognizes the need to support your DeFi activity, and each day we're actively working on expanding DeFi support to popular blockchains.

The initial version of our DeFi support allows you to sync in any transfers, trades, and approvals you’ve made on a DeFi platform involving ERC-20 tokens on the Ethereum network, or BEP-20 tokens on the Binance Smart Chain network.

Ready to try out the updates for yourself? Create an account or login to start.

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