What is DeFi? Understanding Decentralized Finance

William Peaster
Aug 31, 2021
|8 minutes read
what is defi legos

DeFi is an abbreviation of decentralized finance, a term for products and services built as open-source financial software on top of blockchain technology that can be pieced together like money legos via shared infrastructure. 

One of the most unique parts of DeFi is its constituent smart contracts, which power everything from programmable digital assets to decentralized applications (DApps). Smart contracts are publicly accessible and highly interoperable. So like Lego pieces, projects in DeFi can easily connect together to create powerful new innovations. 

Accordingly, decentralized finance is exciting because it’s leading to a constant influx of novel opportunities that can financially empower users across the globe in unprecedented ways. DeFi is thus creating an alternative financial system that’s open to everyone and that minimizes one’s need to trust and rely on central authorities. 

Technologies like the internet, cryptography, and blockchain give us the tools to collectively build and control a financial system for the users, by the users. DeFi is the culmination of these tools and the efforts of global communities of early builders and users, all collectively committed to pushing beyond the limits mainstream finance.

Why Ethereum DeFi?

Almost all DeFi applications today are built on the Ethereum blockchain, the world’s most popular programmable blockchain. Ethereum is a network technology that maintains a shared ledger of digital value. Instead of a central authority, the participants that comprise the network control the issuance of ether (ETH), the network’s native cryptocurrency, in a decentralized manner.

Developers can program applications on Ethereum using smart contracts that can create, store, and manage digital assets on the blockchain. Smart contracts come in many varieties, and you can connect them to create different kinds of decentralized applications (DApps). There are smart contract standards like ERC-20 and ERC-721 that provide easy templates for creating tokens and NFTs, respectively.  

Ultimately, smart contracts or agreements are enforced by the Ethereum blockchain, or rather as applications or scripts that run only as programmed on the Ethereum network. You can build complex irreversible agreements without the need for a middle man accordingly!

A brief history of DeFi

DeFi can be traced back to the launch of Bitcoin, the genesis blockchain and cryptocurrency project that creator Satoshi Nakamoto first released to the public in Jan. 2009. 

Bitcoin and its early growth gave birth to a cryptoeconomy filled with projects that were inspired by, and iterated upon, Bitcoin’s design. As innovative and historical as it may be, though, Bitcoin is and has always been straightforward and conservative technically speaking. It does one thing, and that’s serving as digital gold. 

This limitation served as a major inspiration for Ethereum, a blockchain launched by creator Vitalik Buterin and co-founders in July 2015. Ethereum was explicitly designed to power decentralized applications of all kinds, including financial ones like the kind that are exploding in popularity in DeFi today. 

Fast forward to the end of 2017 and MakerDAO, which is widely agreed to be the first true DeFi DApp, launched on Ethereum. A decentralized borrowing protocol, MakerDAO gave users the ability to deposit ETH as collateral and borrow against that crypto in Maker’s US dollar-pegged stablecoin, DAI. 

Since the turning point of MakerDAO’s launch, the decentralized finance ecosystem has blossomed across a variety of teeming sectors, including borrowing protocols like Compound, derivatives protocols like dYdX, trading protocols like Uniswap, and beyond. Blossomed, because the total value locked (TVL) in DeFi — akin to assets under management (AUM) — has now reached as high as +$87B as of May 2021.

DeFi is like smart money legos

With legos, you start out with a bunch of small bricks. It’s up to you how you piece together the lego bricks to build something new. The same is true about smart contracts. 

With each new project, product, or service launched on Ethereum, you have one more money lego in your collection. And by piecing together existing components of DeFi, you can combine, modify, or create powerful new finance tools out of these money legos.

cDAI is a perfect example of money legos in action. Compound is a money market or, in other words, a lending service on Ethereum. When you supply DAI to Compound, you receive cDAI tokens which represent both your DAI in Compound and any interest you’ve earned from lending. 

Since cDAI is a token, you can send, receive, or even use cDAI in other smart contracts. It’s money legos in action: ETH into MakerDAO to mint DAI tokens, DAI being supplied to Compound, cDAI tokens can be used in other DApps!

For example, then you can swap ETH for cDAI on a Decentralized Exchange (DEX) and instantly start earning interest for just holding cDAI. And because you choose how you interact with smart contracts on the blockchain, you can use a DEX aggregator to compare and trade at the best prices across all the popular DEXes, all within seconds.

What can you do with DeFi?

The activities and projects seen in the young decentralized finance ecosystem can be divided into a range of different categories, including the following popular areas of interest. 

Borrowing / Lending

One of the most popular use cases of DeFi is borrowing and lending crypto. In particular, lending is an extremely popular way to earn passive income in DeFi. And while you may think lending to a stranger sounds risky, most loans made in DeFi are secured via smart contracts with more collateral than borrowed value. This reduces the risk for lenders.

Zooming in, MakerDAO remains the most popular lending DApp. It allows you to borrow against ETH with a stablecoin called Dai, a crypto pegged to the USD. Dai provides a permissionless way for token holders to access US dollar liquidity at the cost of an annual interest rate. 

MakerDAO vault screenshot

Maker’s borrowing dashboard, Oasis.

Other notable DeFi borrowing and lending protocols include Aave, Compound, and Liquity.


Decentralized exchanges, or DEXes for short, are smart contracts that allow users to buy, sell, or trade cryptocurrencies or tokens. Because they run on the Ethereum blockchain, these exchanges operate without a central authority. Instead, the smart contracts enforce the rules, execute trades, and securely handle funds when necessary.

Moreover, unlike a centralized exchange there’s often no need to deposit your funds before making your swap. Try trading on a DEX for yourself!


In mainstream finance a derivative is a financial contract between two or more parties, the value of which is determined by the performance of a specific asset. On Ethereum, an endless variety of derivatives can be created and secured via smart contracts without the need for intermediaries. 

Synthetix is another popular DeFi derivatives project, which offers products like iTSLA, a one-stop crypto for shorting Tesla’s stock on the blockchain, or iBTC for easily shorting bitcoin. 


Tokenized assets and asset management is a quickly growing sector of DeFi. Existing financial assets deployed to the blockchain as tokens fit nicely into DeFi protocols, extending their utility. 

Additionally, asset management protocols allow investors to put their money in the hands of smart contracts or fund managers to manage their portfolio. Other asset management protocols, such as Set Protocol, employ automated strategies such as periodic rebalancing following technical indicators and beyond. 

Decentralization may vary

“Decentralization” in DeFi refers to whether tokens and DApps can run totally independently and without administrative interference from anyone via smart contracts.  There are varying degrees of decentralization extent when it comes to DeFi services. Because the truth is, not everything can be or needs to be fully decentralized.

As previously mentioned, stablecoins are popular in DeFi. But, not all stablecoins are as decentralized as DAI. Many of them are actually tokens representing fiat currency deposits. 

For example, for every USDC token, there is 1 USD being held in custody accounts. You can theoretically “tokenize” or create a token to represent any real world asset. This is where things become a little less black and white, because while you can trade, send, and receive these tokens on the blockchain, you cannot completely eliminate the need to physically manage or redeem the real world asset.

In short, there are limitations to the technology and sometimes the lines of DeFi begin to blur. But one thing is clear: DeFi is here to stay.

The rise of yield farming

Yield farming is a newer phenomenon that’s becoming a major trend in decentralized finance.

Young DeFi projects need liquidity in order to blossom and reach their potentials, so these projects have been incentivizing liquidity providers (LPs) by rewarding depositors with token rewards. You earn for providing liquidity and the project gets stronger, so it’s a win-win. 

Yield farming first came to DeFi’s attention in the summer of 2020, when lending protocol Compound launched its liquidity mining program for its COMP governance token. The campaign awarded COMP to Compound users for borrowing and lending through the protocol. Thus liquidity mining, or yield farming, became an immediate sensation in DeFi. 

The idea with liquidity mining is that young and decentralized finance projects like Compound need liquidity and activity to bootstrap themselves. Offering yield farming awards as denominated in crypto rewards quickly proved to be a capable incentive for attracting in droves of early users, expanding the projects communities, and distributing ownership of the protocol among them. 

In less than a year since hitting the scene, then, liquidity mining has become a norm in DeFi, to the point that now most new projects launch with yield farming programs and many large programs have ongoing programs. 

Want to learn more?

We built DeFi Pulse as a way for the community to follow trends in DeFi. Our DeFi Pulse leaderboard tracks the assets and their total value locked into the smart contracts that make up decentralized finance. We’ve compiled even more DeFi resources you can check out into The DeFi List, too. Lastly, follow us on Twitter @DefiPulse or come chat with us on Discord.