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Understanding DeFi

Decentralized Finance, also known as DeFi, is a broad term for innovative financial services built on public blockchains, like Stellar. DeFi offers greater accessibility, efficiency, and transparency, redefining the boundaries of traditional finance and paving the way for a more inclusive and decentralized financial future.

Overview

What is Decentralized Finance (DeFi)?

Much has been written about DeFi to date. At its core, DeFi represents a transformative shift in how financial services and transactions operate. Today, financial services rely on trusted institutions that act as intermediaries to guarantee transactions. This has led to a number of pain points for both users and providers of financial services; the reliance on intermediaries can make transactions more costly and mean transactions often lack transparency. Additionally, relying on these institutions can create an imbalance of power as users must rely on them to hold and transact their money on their behalf. And lastly, reliance on institutions can make access to financial services difficult, as billions of people still do not have access to bank accounts. As the name DeFi implies, Decentralized Finance reduces reliance on intermediaries to democratize access to financial services. DeFi leverages blockchain technology powered by immutable public ledgers, dApps, cryptocurrencies, digital assets, and smart contracts to enable financial services without the need for intermediaries.

DeFi Explained

How Does DeFi work?

To understand how Decentralized Finance works and its many use cases, it is important first to explain some of the key components that power DeFi services.

Blockchain

Implementing blockchain technology and smart contracts is central to DeFi's functionality and success. A blockchain is a distributed ledger recording all transactions across a network of computers, making it virtually impossible to alter or hack. This technology ensures the immutability and transparency of financial transactions. You can read more about blockchain basics in our overview here.

Cryptocurrencies

Sometimes referred to as “Tokens” or “Digital Assets,” cryptocurrencies are digital or virtual tokens that use cryptography for secure financial transactions, control the creation of new units, and act as utilities to verify the transfer of assets on a blockchain network. Tokenization is the process of representing real world assets (RWAs) or financial products as digital assets on a blockchain. Among the diverse spectrum of cryptocurrencies, Stablecoins holds a unique position; they are pegged to more stable assets like fiat currencies or gold, aiming to combat the inherent volatility of cryptocurrencies like Bitcoin or Ethereum. This category of digital tokens provides benefits such as faster transactions and reduced fees, with a stable value, making them a go-to choice for digital transactions and a bridge between traditional finance and the emerging DeFi landscape.

Decentralized Exchanges (DEXs)

A Decentralized Exchange (DEX) is a pivotal component in the DeFi landscape, offering a platform for trading cryptocurrencies without the need for a central authority. Unlike traditional exchanges, DEXs operate on blockchain technology, ensuring transparency, security, and immutability of transactions. These platforms are powered by smart contracts, which facilitate, verify, and enforce the negotiation or performance of a trade autonomously, without any intermediaries. Users of DEXs retain full control over their funds, as trades are executed directly between users' wallets through an automated process. This peer-to-peer mode of operation reduces the risk of theft and hacking and provides privacy and censorship resistance. DEXs often utilize liquidity pools to enable trading, where users can supply their assets to the pool and earn transaction fees or other rewards in return. This model promotes a self-sustaining liquidity framework, empowering users to trade assets in a decentralized, trustless environment.

Smart Contracts

On top of this infrastructure, DeFi utilizes smart contracts — self-executing contracts with the terms of the agreement directly written into code. These contracts automatically enforce and execute the terms of an agreement based on predefined rules without the need for intermediaries. Smart contracts execute automatically when predefined terms and conditions are met without the need for intermediaries. Smart contracts can operate independently, but many decentralized applications (Dapps) implement several contracts that work together to achieve certain functionalities.

Dapps

Decentralized Applications, also known as dapps, are applications that operate on a blockchain network. Unlike traditional applications, which run on centralized servers, dApps function on a distributed ledger. They are powered by smart contracts, which allow them to operate more autonomously and transparently, with the rules of interaction embedded directly into the code. dApps enable various financial services, including lending, borrowing, and trading, without a centralized authority.

Liquidity Pools

Leveraging these technologies, DeFi offers innovative financial instruments, such as liquidity pools, where users pool their resources to provide liquidity for trading pairs on decentralized exchanges, earning incentives in the process. Swap functionality enabled by token swap daaps to facilitate efficient asset exchange and Automated Market Makers (AMMs) to provide liquidity for various digital assets. As the DeFi protocol that powers decentralized exchanges, an AMM provides the necessary liquidity to enable swaps and exchanges across currencies and between users directly, without intermediaries like centralized exchanges or financial institutions. In addition to liquidity pools consisting of two or more assets to swap between, AMMs include multiple pricing curve options to support different types of assets and tokenized pool deposits, which are transferable and depositable into other smart contracts.

Lending & Borrowing

Traditional lending, facilitated by banks, constitutes a fundamental pillar of the financial system. Lenders provide funds to borrowers with the expectation that the borrowed amount will be repaid, often with additional interest, in return for the immediate availability of capital. DeFi markets, unlike traditional banks or centralized platforms, let users access borrowing and lending without having to jump through as many potentially disqualifying hoops. Because decentralized lending and borrowing markets leverage blockchain technology and smart contracts, no intermediaries oversee their operations.

Benefits

What are the Advantages of DeFi?

DeFi, and blockchain-based technology in general, offer a number of advantages that can improve upon existing financial services.

Speed & Cost

Smart contracts are digital and automated, which streamlines processes and saves time and money. Without the need for intermediaries, there’s no…

Transparency

In DeFi, every transaction is recorded on a public blockchain, ensuring complete transparency. This visibility allows users to audit and verify…

Accessibility

By reducing intermediaries, DeFi platforms are inherently inclusive, offering financial services to anyone with an internet connection and lowering…

Immutability

By leveraging blockchain technology, DeFi ensures that once a transaction is recorded, it cannot be altered or deleted. This permanence secures the…

Challenges

What are the Risks and Challenges of DeFi?

Despite its significant benefits, DeFi also comes with its set of risks and challenges. As an emerging technology, DeFi platforms and protocols are often untested at scale, leading to potential vulnerabilities in smart contracts that can be exploited. Moreover, the user experience in DeFi can require a highly complex curve for new users. Additionally, blockchain's anonymous and global nature can pose challenges in ensuring compliance with global regulatory standards, making it a contentious point for widespread adoption. Understanding and mitigating these risks is crucial for the maturity and long-term success of Decentralized Finance.

The Stellar Opportunity

What is DeFi on Stellar?

Soroban is the Stellar network’s native smart contracts platform. It is a Rust-based smart contracts platform that offers a batteries-included developer experience designed for scale and reliable access to financial rails via Stellar. The Stellar ecosystem has developed a robust network of wallets, digital assets, and global on and off-ramps, enabling applications and use cases built on Stellar to connect to real-world financial services. With Soroban’s capabilities, DeFi developers and application builders can more easily tap into existing high-quality assets and access these on and off-ramps. Soroban's comprehensive ecosystem and integration with the Stellar network make it an ideal platform for building and deploying DeFi applications while providing users with financial access and opportunities that would otherwise remain unavailable.

Next Steps

Get Started with DeFi on Stellar

Interested to learn more or build your own DeFi application on Stellar? Join the conversation in the Stellar discord or explore the resources below to learn more about DeFi, how to start building smart contracts with Soroban, and explore funding opportunities with programs like the Stellar Community Fund (SCF).

Soroban Smart Contracts Overview

A developer-friendly, Rust-based smart contracts platform designed for scale and sensibility. Soroban seamlessly integrates with and works alongside…

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Stellar Community Fund

The Stellar Community Fund draws on community input to support developers and startups building on the Stellar network and Soroban.

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Smart Contract Basics

Smart Contracts

Smart contracts are self executing programs run on the blockchain network. Learn about the history, concept and applications of this technology.

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Smart Contract Building Blocks

Smart Contracts

Smart contracts are self executing programs run on the blockchain network. Learn about the history, concept and applications of this technology.

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