Blog Post

Introduction to DeFi – the Future of Finance

May 14, 2024

Welcome to AnChain University's blog series on DeFi (Decentralized Finance). 

This ecosystem is reshaping the financial landscape by leveraging blockchain technology to decentralize services traditionally controlled by central institutions such as banks, brokers, and exchanges.

What is DeFi?

Decentralized Finance, commonly known as DeFi, is an innovative ecosystem of financial technology that leverages blockchain networks to eliminate the need for traditional financial intermediaries. DeFi allows direct access to a myriad of financial services including lending, borrowing, and trading, all facilitated through smart contracts executed primarily on networks like Ethereum.

Uniswap Smart Contract Analysis on AnChain.AI SCREEN™

Key Attributes of DeFi

  • No Intermediaries: DeFi removes the need for middlemen, facilitating direct financial interactions through peer-to-peer services.
  • Interoperability: Various DeFi applications can work together, creating a cohesive ecosystem. This integration allows for complex financial operations that can be tailored to specific needs.
  • Open Source Nature: Most DeFi projects are open source, allowing anyone to view, verify, and contribute to the code, fostering an innovative, transparent, and collaborative environment.

Understanding DeFi in layers

  • Blockchain: Contains the transaction history and state of accounts. Ethereum is the most common blockchain used in DeFi.
  • Assets: Includes ETH and the other tokens involved in transactions.
  • Protocols: Components of DeFi protocols include smart contracts, oracles, tokens, DApps, decentralized exchanges, lending platforms, yield farming, and more. Learn more about DeFi.
  • User Interface: the user interfaces for accessing and managing protocols.

Core Components of the DeFi Ecosystem

DeFi is an open-source movement made up of an ecosystem of protocols, applications, and innovations.

  • Stablecoins: Stablecoins are cryptocurrencies that are designed to maintain a stable value, typically pegged to a fiat currency such as the US dollar or euro. Stablecoins are often used as a medium of exchange in DeFi applications, as they provide a way to transfer value without being subject to the price volatility of other cryptocurrencies. Examples include USDC, DAI, and USDT (Tether).
  • Decentralized Exchanges (DEXs): Platforms like Uniswap function purely through smart contracts, enabling users to swap cryptocurrencies without needing an intermediary and without extensive identity checks, making DeFi accessible and preserving user privacy. This might change soon.
  • Lending and Borrowing Platforms: Platforms like Aave, Compound, and Maker allow users to lend or borrow digital assets directly from other users, without the need for traditional financial institutions. These platforms use smart contracts to automate transactions.

Learn more about Ethereum and Smart Contracts.

Understanding DeFi Risks

DeFi opens new avenues for permissionless and transparent financial services, empowering billions globally. But it also comes with its share of risks and challenges:

  • Flash Loan Exploits: Flash loans are a type of uncollateralized loan provided by DeFi platforms. Hackers can use these loans to exploit price discrepancies between different DeFi platforms, allowing them to make profits without having any funds of their own. For instance, in November 2020, a flash loan exploit allowed hackers to steal $6 million from a DeFi platform called Value DeFi.
  •  Smart Contract Exploits: DeFi platforms use smart contracts to automate transactions and execute code. However, if there are vulnerabilities in the code, it can be exploited by hackers. For example, in February 2021, a hacker exploited a smart contract bug in the DeFi platform Alpha Homora, resulting in a loss of $37 million worth of funds.
  • Oracle Exploits: Oracles are used by DeFi platforms to provide external data to smart contracts. However, if the data provided by oracles is compromised, it can lead to serious issues like price manipulation. For instance, in February 2020, an oracle attack on the DeFi platform bZx resulted in a loss of $630K worth of funds.
  • Social Engineering Attacks: DeFi platforms are also vulnerable to social engineering attacks like phishing scams and impersonation attacks. For example, in February 2021, a user lost $800,000 in cryptocurrency due to a phishing scam that targeted the DeFi platform PancakeSwap.

The Promise of DeFi

Despite its risks, DeFi offers a compelling vision: a more interoperable, borderless financial system. This vision encompasses a world where financial transactions are more transparent, accessible, and equitable. DeFi's reliance on blockchain technology ensures that transactions are secure, transparent, and immutable, offering a robust alternative to traditional financial systems.

As we continue this series, we'll dive deeper into each component of DeFi, exploring how they work, their impact on the financial landscape, and how you can safely interact and innovate within this space. If you want to get a crash course on DeFi, consider enrolling in our latest “Fundamentals of DeFi” course at AnChain University.

Learn more about DeFi in our latest course.