Decentralized Finance (DeFi) is one of the essential blockchain technology innovations, and many believe it will overtake the traditional finance world. DeFi uses cryptocurrencies that can be programmed through smart contracts to build exchanges, lending and borrowing platforms, insurance and staking services, etc., without centralized authorities and intermediaries.
With over $13 billion worth of value locked in Ethereum smart contracts, the DeFi ecosystem has launched a wide range of integrated protocols and financial instruments. The various types of decentralized applications, DApps, are usually programmed on Ethereum and enable you to buy, sell, trade, stake to earn passive income, and lend and borrow cryptocurrencies on a decentralized network.
In this article, we’re diving deep into DeFi protocols, how they work, and how to choose a DeFi app to earn a yield on your crypto. So, join us to learn about the top DeFi protocols to lend or stake your tokens to earn more rewards.
Let’s get right to it!
What Is Decentralized Finance?
Decentralized Finance (DeFi) is an umbrella term for a collection of financial products which rely on smart contracts and blockchain technology to facilitate peer-to-peer (P2P) financial services. It refers to the shift from traditional, centralized financial systems to a peer-to-peer finance paradigm, giving people complete control of their money.
DeFi redefines traditional financial services such as lending, trading, staking cryptocurrency, investment, payment, insurance, etc., by disrupting the role of intermediaries and enabling permissionless, decentralized, and borderless services such as staking, efficient stablecoin trading, decentralized lending or Yield Farming, DEX (Decentralized exchanges), DeFi insurance, liquidity mining, etc.
To get an in-depth understanding of the DeFi system and how to make the most of the DeFi sector, read our detailed guide “What Is DeFi.”
The DeFi ecosystem has evolved over time into a vast network of integrated financial instruments and protocols. Most DeFi protocols are usually programmed on Ethereum to write smart contracts and derive the rules on how the decentralized financial services will work.
What Are DeFi Protocols?
DeFi protocols are customized autonomous programs developed to overcome challenges in the traditional banking business. For example, more than half of the world’s population lacks access to a bank account, which DeFi protocols aim to change.
The best DeFi protocols have grown exponentially in the last two years, and the total value locked in DeFi assets surpassed the $176.33 billion threshold in 2021, making it quite a promising year for DeFi companies. Several projects have received funding in the hundreds of millions of dollars, and the industry has over $56 billion in locked assets.
The advancement of DeFi protocols allows for introducing new financial services and products, catering to the many different needs of users, including various notable tokens and projects. Startups in this space also find potential as the value of DeFi protocols rises dramatically.
In addition to financial solutions, these protocols generate liquidity between several blockchains and create on-chain assets such as stocks and shares to boost cryptocurrency adoption.
Advantages of DeFi Protocols
A DeFi protocol is described as a set of rules or standards that regulate certain tasks or activities. For industry players, DeFi protocols include a set of norms and principles aligned with real-world organizations.
DeFi protocols are designed to enhance financial security and transparency, boost liquidity and development opportunities, and support an integrated and standardized economic system.
Some of the advantages of DeFi protocols include:
Programmability
Smart contracts are highly programmable and enable the development of new financial instruments and digital assets.
Permissionless
In contrast to traditional finance, DeFi is characterized as open and permissionless, i.e., anyone with a crypto wallet and an Internet connection, regardless of location, can use DApps built on Ethereum.
Immutability
The decentralized design ensures tamper-proof data coordination while also improving security and audibility.
Transparency
As Ethereum addresses are encrypted and pseudo-anonymous keys, every transaction on the Ethereum network is broadcast to other users and validated by them. This level of transparency concerning transaction data not only makes extensive data analysis possible but also ensures network activity is visible to any user. In addition, Ethereum and the DeFi protocols operating on it are also built with open-source code that anyone can read, audit, and build upon.
Interoperable
DeFi protocols and DApps are built to be interoperable due to Ethereum’s composable software stack. Product teams and developers can build on top of existing protocols, customize interfaces, and integrate third-party apps. For these reasons, DeFi protocols have been dubbed “money Legos.”
Self-Custody
DeFi market participants always maintain ownership of their assets and control over their data by using Web3 wallets such as MetaMask to interact with permissionless financial apps and protocols.
How Does a DeFi Protocol Work?
DeFi protocols are enabled by blockchain technology, a decentralized and secure database for recording transactions without needing a third party to validate transactions. The blockchain consists of a continuous chain of immutable records made of data blocks linked together. Each computer in the network maintains a copy of the ledger to avoid a single point of failure. A new block is added in sequential order and is permanent and tamperproof.
Blockchain also uses a computational process called consensus to validate blocks before they can be added to the chain. Each block provides details of a transaction that has been validated by other users. When these verifiers reach an agreement on a transaction, the block is closed and encrypted; a new partnership is formed, containing information about the previous block.
Each succeeding block’s information is linked to form the blockchain, so it’s difficult to update information in prior blocks without impacting subsequent ones. This approach ensures that a blockchain cannot be altered, adding to its high level of security.
For example, a peer-to-peer lending and borrowing protocol will link you with peers who satisfy your lending requirements. The loan will subsequently be processed when the terms of the lender are agreed upon; however, you won’t get your loan until the consensus process verifies them. At the agreed-upon intervals, the lender can begin collecting payments from you – the payment you make using a DApp, is recorded on the blockchain, and the funds are eventually transferred to the lender.
Decentralized Finance Applications
Decentralized financial protocols, ranging from DAOs to synthetic assets, have opened new economic activity and opportunities for individuals worldwide. The extensive list of use cases highlighted below demonstrates that DeFi is much more than an emerging ecosystem of projects. Instead, it’s a comprehensive and integrated endeavor to build a parallel financial system on Ethereum that competes with centralized services in terms of accessibility, resilience, and transparency.
DAOs
A DAO is a decentralized autonomous organization that cooperates under transparent rules encoded on the Ethereum blockchain, eliminating the need for a centralized administrative institution. Several prominent DeFi protocols, like Maker and Compound, have established DAOs to collect funds, run financial operations, and provide decentralized governance to the community.
Asset Management
With DeFi protocols, you’re in charge of your own crypto assets and control your data in the DeFi space. Crypto wallets such as MetaMask, the CoinStats Wallet, Gnosis Safe, and Argent enable you to engage with DApps to accomplish anything from buying, trading and transferring crypto to earning interest on your digital assets in a simple and safe manner. Non-custodial wallets store your seed phrase, passwords, and private keys locally on your device so that only you can access your accounts and data.
DEXs
Decentralized exchanges (DEXs) are cryptocurrency exchanges that operate without a central authority, enabling users to transact peer-to-peer while maintaining control over their funds. DEXs reduce the risk involved in trading, such as hacking and theft and the possibility of price manipulation, because crypto assets are never under the exchange’s control.
DEXs also provide token projects with liquidity without any listing fees, unlike centralized exchanges. A few years ago, projects would spend millions of dollars to have their tokens listed on a centralized exchange.
Lending and Borrowing
Peer-to-peer lending and borrowing protocols are among the most extensively used applications in the DeFi ecosystem. For example, Compound is an algorithmic, autonomous interest rate protocol that connects with and underlies several DeFi platforms, including Argent, PoolTogether, and Dharma.
Compound allows users to earn interest on crypto deposited into the Compound’s liquidity pool. You will immediately start earning interest when you deposit money into the pool. The interest rates vary since they are based on supply and demand.
The Compound smart contract matches borrowers and lenders automatically and calculates interest rates based on the ratio of borrowed to supplied assets. Compound is a clear illustration of the DeFi space’s exponential opportunity: as more products integrate the Compound protocol, more crypto assets will be able to earn interest even when idle.
Trading
DeFi trading ranges from futures to margin trading to token swaps and is facilitated across an ever-growing, interconnected network of exchanges, liquidity pools, and marketplaces. Crypto traders on decentralized exchanges benefit from lower exchange fees, faster transaction settlement, and complete custody of their assets.
Payments
Peer-to-peer payment is arguably the cornerstone of DeFi and the entire blockchain ecosystem. Blockchain technology allows users to exchange cryptocurrencies safely and directly with one another, eliminating the need for intermediaries. DeFi payment systems help large financial institutions optimize market infrastructure and better serve wholesale and retail clients while establishing a more open economic system for underbanked and unbanked communities.
Staking
Once the Ethereum network transitions to a Proof-of-Stake consensus algorithm with Ethereum 2.0, investors can stake their ETH to validate transactions and receive staking rewards. Staking is similar to investing in an interest-bearing savings account. Many investors can’t meet the minimum requirement to stake in Ethereum 2.0, so they can join a staking pool to become a liquidity provider and verify transactions to earn interest (reward). Staking rewards are dynamic and change relative to the staked token, the number of tokens staked, and the staking period. In short, the more crypto a user puts at stake, the higher the chances of earning transaction fee rewards.
Note that you may also have to pay gas fees to stake your tokens, and most exchanges ask for a commission in exchange for staking services.
Synthetic Assets
Synthetic assets, like stablecoins, are crypto assets that give exposure to other assets, such as gold, fiat currencies, and cryptocurrencies. Tokens locked within Ethereum-based smart contracts with built-in agreements and incentive mechanisms serve as collateral for these assets. The Synthetix protocol, for example, employs a collateralization ratio of 750%, which helps the network absorb price shocks.
Best DeFi Protocols
The total value locked in the DeFi assets was $56.8 billion as of September 2022. This is one of the principal reasons for learning more about the best DeFi protocols and their capabilities.
DeFi protocols are designed for specific use cases in the financial sector, notably for borrowing and lending applications. At the same time, it’s vital to remember that the DeFi ecosystem is still in its early stages, and many initiatives contain significant risk considerations.
Let’s get straight to the list of DeFi protocols that will help you discover more about the DeFi world.
1. Compound
Compound is one of the most popular yield-farming protocols and the second-largest DeFi project regarding locked-in funds. It’s an algorithmic money market protocol built on the Ethereum blockchain that makes it possible to borrow money and earn interest by lending. Moreover, Compound requires collateral to function correctly. COMP is the protocol’s native token that users can earn by lending or borrowing assets. COMP token holders govern the protocol and vote for implementing any changes.
2. AAVE
Aave is one of the most well-known and leading lending protocols in the DeFi market. It uses its native token AAVE for protocol security while allowing users to participate in protocol governance. To earn AAVE rewards, users can stake their tokens using the safety module.
The Aave protocol creates ERC20-compliant aTokens for the supplier at a 1:1 ratio of the asset used as collateral. You can borrow against most assets, and the collateral ratio and threshold vary depending on the underlying asset. An algorithm decides the interest rates depending on supply and demand.
3. Sushiswap
Sushiswap is an Automated Market Maker (AMM) and lending protocol that uses the SUSHI governance token. Liquidity providers can earn the SUSHI token by providing liquidity to certain pairs on Sushiswap. Users might stake SUSHI tokens by using the Omaske bar to earn protocol fees and issue protocols.
4. Uniswap
Uniswap is one of the essential DeFi protocols and the most important decentralized exchange in the DeFi space. Users can earn the native token UNI by providing liquidity to certain pools. In September 2020, Uniswap introduced a scheme called “Universal Basic Income,” offering 15% of its supply to previous users.
5. Kyber Network
The Kyber Network is among the leading decentralized exchanges that can capture value via native tokens. Kyber Network Crystals, or KNC, are the native tokens on the Kyber Network. Users can use their KNC tokens to vote and delegate on important issues, such as implementing essential governance mechanisms.
6. yEarn
yEarn is also among the best DeFi protocols. It’s an automated liquidity aggregator that offers several options for yield farming. The protocol’s governance is carried out through yEarn’s native token, YFI. In addition to receiving a pro-rata share of protocol fees, users can stake YFI tokens to participate in the protocol’s governance.
7. Maker
Maker, also known as MakerDAO, is a decentralized credit platform built on the Ethereum blockchain. The project has $1.41 billion locked in, making it the most significant project in regard to the US dollar by far. Dai is the stablecoin that supports Maker, tied to the US dollar. The Maker native token, MKR, can be used to vote on protocol choices, stability fees, and other risk parameters through a democratic voting process.
8. Synthetix
Synthetix is a well-known derivatives protocol with its own native token, SNX. This platform is used to create Synths, synthetics representing the value of an asset in the real world, such as commodities, fiat currencies, etc. Synths are staked to at least 750% with SNX tokens. The ratio is called cRatio, and it allows users to earn native inflation and a portion of trading fees.
9. Curve
Curve is a liquidity aggregator for same-peg assets such as Bitcoin wraps and stablecoins. Users can stake the Curve protocol’s native token, CRV, through the Curve DAO to achieve efficient time-weighted governance. In addition, users can earn liquidity multipliers by mining CRV liquidity.
10. Balancer
Balancer is one of the most popular DeFi protocols. The Balancer DeFi system focuses on automated asset management and liquidity, with the possibility of governance via the native token. The native token, BAL, assists in the control of crucial protocol aspects like support assets and protocol fees.
11. Index Cooperative
The Index Cooperative DeFi protocol is a community governance index management mechanism that underpins the DeFi Pulse Index (DPI). The native INDEX governance token helps determine the content of the indexes. It also helps identify the techniques for employing the indexes in meta-governance for associated protocols.
12. Numerai
Numerai is an AI-based hedge fund that developed the Erasure protocol, which helps predict outcomes. Users can stake NMR tokens in the prediction protocol to demonstrate their confidence in the expected results.
13. 0x Protocol
The 0x protocol is included in the list of top DeFi protocols due to its unique characteristics. It’s a DeFi liquidity protocol that can help distribute liquidity across several exchanges. Users can participate in protocol governance using the native token, ZRX. Market Makers can also stake ZRX to earn trading fees.
14. Nexus Mutual
Nexus Mutual is a DeFi platform that allows users to issue NXM tokens in return for ETH deposited in the Capital Pool in exchange for Nexus Mutual tokens. It can help provide optimal defenses against smart contract vulnerabilities. Members can stake in certain contracts to get a specific share of revenue collected from cover purchases. Nexus Mutual also intends to provide pooled staking to allow the allocation of all purchased covers to users who stake their NXM tokens.
15. Ren Protocol
Ren Protocol is another well-known DeFi protocol that acts as an interoperable link for transferring assets to Ethereum. Users can become validators on the network by depositing 100,000 REN as collateral for running a dark node.
16. PieDAO
PieDAO is one of the best DeFi protocols with solid potential. PieDAO performs asset management with the added benefit of automation and access to numerous DeFi indexes. Interestingly, there are now various liquidity mining tools for generating DOUGH, PieDAO’s native token.
17. Project Serum
Project Serum is one of the essential DeFi protocols and the newest entry into the field of DEXs. Project Serum’s distinguishing features include that it’s totally permissionless and wasn’t built on Ethereum.
18. Alpha Finance
Alpha Finance is an intriguing addition to the list of DeFi protocols with novel features. It essentially acts as a yield farming aggregator for Alpha Homora, a platform that lends idle ETH for leveraged farming. Alpha Finance’s most notable feature is redistributing a portion of the dividends to the communal treasury.
19. UMA
UMA can be added to the list of DeFi protocols as another protocol with creative potential. UMA, being a derivatives protocol, facilitates the creation of permissionless synthetic assets. The native token, also known as UMA, helps participate in protocol governance by challenging underlying registries that are not aligned with associated synthetic assets.
20. mStable
mStable is another example of a liquidity aggregator. It has been designed for same-peg tokens such as mASSETS or mUSD. The protocol’s native token, MTA, began with an Initial DEX Offering, and users can stake MTA via the Earn function. Staking the MTA token helps earn protocol fees in addition to MTA inflation.
Final Words
DEXs, liquidity aggregators, and margin trading platforms are all examples of DeFi protocols. DeFi protocols are also used by asset management platforms, lending companies, and financial institutions. DeFi protocols’ numerous use cases in the financial sector can potentially disrupt the established financial sector standards.
Before you get started, it’s important to choose a protocol to earn the highest APY possible. To minimize market volatility, you can invest in a stablecoin like DAI, USDT, or Tether. Moreover, Tether claims that its tokens are entirely backed by cash reserves of the US dollar.
However, DeFi protocols, like any other, have their own hazards and faults, and it’s essential to be watchful while investing in DeFi protocols.
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