What is DeFi?
DeFi is short for “decentralized finance,” which refers to a new financial industry within Web3.
DeFi protocols offer users all the financial services you’d expect from a bank or brokerage house, except there are no centralized authorities. This includes allowing users to deposit funds for interest, borrowing and lending, and more. Instead of relying on bankers or brokers to verify transactions, dApps (decentralized applications) in DeFi use smart contracts. First introduced on Ethereum (ETH), smart contracts are blockchain-based programs that can automatically fulfill commands when specific criteria are met.
DeFi also doesn’t ask users for KYC (know-your-customer) information. Instead, these protocols recognize users by their unique crypto wallet addresses. If you want to use a DeFi dApp, all you need is to connect your crypto wallet to take advantage of various services.
For example, if you’re a DeFi user and want to take out a loan from the Aave borrowing and lending protocol, you’d first deposit crypto collateral into a smart contract and receive borrowed funds in your wallet. The smart contract will automatically charge interest payments and monitor the value of your margin balance. Once you pay off your loan on Aave, the smart contract will automatically release your collateral back into your wallet.
In addition to decentralized crypto lending services, DeFi includes decentralized exchanges (DEXs) like Uniswap and decentralized crypto staking pools like Lido Finance.
Currently, DeFi is most active on the Ethereum blockchain, but many competing smart contract blockchains have DeFi dApps. Whether it’s “Ethereum killer” chains like Solana or an Ethereum layer-2 solution like Polygon, it’s becoming easier to find DeFi protocols across Web3.
What are DeFi tokens?
DeFi tokens are cryptocurrencies that are associated with specific DeFi projects. Often, these tokens serve a specific use case within each DeFi protocol’s ecosystem, which technically makes them a form of “utility token.”
Unlike coins or security tokens, utility tokens should have a clear function in their respective protocols. In the case of DeFi tokens, these cryptocurrencies typically have a purpose within their associated dApp.
Typically, DeFi developers launch these cryptocurrencies on top of whatever blockchain they build their dApp on. Since most of the activity in DeFi is on the Ethereum blockchain, most DeFi tokens follow Ethereum’s ERC-20 token standard.
What are the uses of DeFi tokens?
Every DeFi dApp has a different reason for issuing DeFi tokens. However, most of these cryptocurrencies have the following three use cases:
1. Liquidity pool rewards
DeFi tokens often serve as an incentive to attract more users to their platform. Specifically, these DeFi tokens are used as rewards for users who lock their crypto in a dApp’s liquidity pools.
Since DeFi is “decentralized,” it can’t take advantage of centralized market makers or banks to supply liquidity. Instead, DEXs and crypto lending platforms need to rely on funds from the Web3 community. If you have a compatible wallet, you can add liquidity to a DeFi protocol by depositing crypto into a liquidity pool. These liquidity pools run on smart contracts, allowing DeFi users to make trustless peer-to-peer transactions.
Since locking crypto in a liquidity pool carries many risks, developers incentivize liquidity providers with token rewards. After locking your crypto in a DeFi dApp’s liquidity pool, you’ll receive token rewards in the protocol’s native cryptocurrency.
The Ethereum-based lending dApp Compound was the first to introduce a DeFi token reward with its COMP token in 2020. Since then, prominent dApps like Uniswap, Aave, and PancakeSwap have been offering DeFi tokens as rewards to liquidity providers.
2. Governance tokens
Many DeFi dApps add voting privileges to their DeFi tokens to promote decentralized blockchain governance. In many cases, users who hold DeFi tokens can have a say in the future direction of a project. If crypto holders can vote on improvement proposals with their DeFi tokens, these cryptos are technically “governance tokens.”
While every dApp has a unique governance system, most grant users one vote per token. Usually, you can see a list of upcoming proposals on a DeFi platform’s governance portal. If you hold DeFi tokens, you can “stake” as many tokens as you want in a smart contract during the voting period. Once voting closes, the smart contract will tally the votes and release the results.
For example, the DeFi protocol Maker DAO issued a governance token called MKR. Users who hold MKR routinely vote on adjustments to the collateral requirements and interest rates for borrowing Maker’s DAI stablecoin.
3. Additional DeFi services
Having aDeFi token isn’t necessary to interact with most DeFi dApps. As long as you have an associated wallet and the blockchain’s native cryptocurrency, most DeFi protocols will allow you to use their services.
However, there are cases where DeFi tokens can give users access to additional features. In addition to voting rights, most DeFi protocols allow users to deposit their tokens in liquidity pools for crypto rewards. Some DeFi dApps allow users to stake their DeFi tokens for extra benefits.
For example, Aave has a unique “Safety Module” that rewards depositors with staking rewards called “Safety Incentives.” To earn these rewards, you must stake the protocol’s AAVE tokens. The Aave team created this module to serve as a backup source of funding in the event of a security breach. As a depositor, you should know that the company can lose up to 30% of its staked AAVE if it deems this elimination necessary.
Where can users buy DeFi tokens?
Crypto investors already involved in DeFi typically earn DeFi tokens for locking crypto in a liquidity pool. Most DEXs and crypto lending sites offer DeFi tokens as rewards to liquidity providers. However, there are other ways crypto investors can add DeFi tokens to their portfolios.
The simplest way to access DeFi tokens is to purchase them on a reputable centralized crypto exchange (CEX). While CEXs may not carry cryptos from small DeFi projects, it’s getting easier to find large-cap DeFi tokens on many trading platforms. Crypto companies like Binance and Coinbase now offer easy access to dozens of DeFi tokens. There are even a few brokerage apps like Robinhood that now provide access to tokens like Uniswap’s UNI.
It’s also possible to buy DeFi tokens on many decentralized exchanges (DEXs). Since DEXs are already within the DeFi ecosystem, they have plenty of DeFi tokens available for trading. DEXs like Uniswap, SushiSwap, and PancakeSwap are a few high-profile DEXs with dozens of DeFi tokens.
Some exchanges offer access to multiple DeFi tokens via the DeFi Pulse Index (DPI). This weighted fund by Index Cooperative tracks all major DeFi tokens to give investors price exposure to the entire DeFi ecosystem.
Lastly, it’s possible to get DeFi tokens for free in crypto airdrops. Interestingly, some of today’s top DeFi tokens started as airdrops to early adopters. Most notably, Uniswap released its UNI token as an airdrop in 2020 to users who previously used the DEX. While airdrops are common in DeFi, it’s always a best practice to do plenty of research. There are many scam crypto projects that market DeFi token airdrops.
Examples of DeFi tokens
The list of DeFi tokens is growing every day. Indeed, most coin price aggregator sites like CoinMarketCap have pages dedicated solely to DeFi tokens. Although dozens of DeFi tokens hold prominent positions in the crypto ecosystem, here are a few that dominate the Web3 ecosystem (at the time of writing):
- Uniswap’s UNI: Uniswap was the first automated market maker (AMM) DEX on Ethereum, and it remains the largest DEX in DeFi. The Uniswap team released its UNI token as an airdrop to users and liquidity providers in 2020. UNI uses the ERC-20 token standard and serves as Uniswap’s governance token.
- Aave’s AAVE: Originally called ETHLend, Aave is a major crypto lending dApp on Ethereum. The AAVE cryptocurrency has many use cases, including governance, rewards, and better interest rates for borrowed crypto funds.
- Lido Finance’s LDO: Lido Finance is a decentralized staking pool provider that works with multiple proof-of-stake (PoS) blockchains. You can deposit a PoS crypto like ETH or DOT onto Lido Finance to earn interest. Lido’s LDO cryptocurrency is primarily used as a governance token in the Lido DAO.
At Worldcoin, we’re excited about the many liberating financial opportunities that DeFi offers Web3 users, although you should remember that DeFi is still in its experimental phase. There are many bugs, hacks, and scams you need to be aware of. To learn more about how to safely use DeFi dApps, subscribe to our blog.