The 9 Fundamental Components of a DeFi Ecosystem

DeFi can’t be simplified to just yield farming, stablecoins, or decentralized exchanges (DEXs). Its definition is as decentralized as the many components that form the DeFi landscape. 

And as new projects appear, DeFi’s definition becomes broader and more vague.

So let’s boil down the components that are truly essential to DeFi.

Quick Takes:

• The DeFi ecosystem has at least five essential components, including stablecoins. Without stablecoins, DeFi services would be more limited.
• Developed ecosystems tend to outgrow even the most efficient ones. They attract new developers with a large community and dApp selection.
• For successful adoption, DeFi networks don’t just need to be functional; they also need to be convenient. The ideal DeFi ecosystem is Ethereum compatible, features secure blockchain bridges, and is equipped with other cross-chain tools like oracles.

How DeFi Works

Decentralized Finance (DeFi) is a category of blockchain-based platforms with financial use cases. The goal is to eventually offer as many or more services as traditional finance, except without private ownership, asset custody, or ID verification requirements.

This financial ecosystem would allow anyone worldwide to access or provide DeFi services, whether it’s liquidity for DEXs, stability for stablecoins, or loans for collateral-based borrowing. 

This is possible because the DeFi system doesn’t require users to trust each other to guarantee security. No one directly controls a platform (in theory), and you don’t have to trust anyone with your coins, since there’s no central entity.

Instead, DeFi platforms leverage public blockchains that enable on-chain computing—better known as smart contracts. 

Ethereum was the first network to develop Turing-complete, autonomous programs. This expanded the utility of smart contracts beyond simply validating transactions. As a result, Ethereum became the first and largest DeFi ecosystem.

Developers can combine smart contracts with traditional software to create decentralized applications (dApps), which follow the same DeFi principles. 

Almost every dApp uses DeFi tools because of how essential they are for the overall blockchain ecosystem.

What’s So Special About the Defi Ecosystem?

Digital payments expanded when the Internet shifted from Web 1.0 (read-only) to Web 2.0 (read-write). 

This introduced the current online ecommerce landscape and sped up Internet adoption. Information became decentralized, but payments weren’t yet.

That’s what DeFi does. It ushers in a new era that makes finance and ecommerce more accessible, allowing them to reach broader markets. 

There are dApps for social media, gaming, real estate, healthcare, governance, supply-chain management, and just about anything else you can think of.

The Top 9 Essential DeFi Features

Despite the variety of DeFi projects in the landscape today, a few key features are essential for any true DeFi project.

Here are 10 core DeFi elements, ranked from most to least essential.

#1 Functional Smart Contracts

Smart contracts alone might not define the DeFi ecosystem, but they’re essential for every dApp to work. Without these programs, crypto finance would need some sort of central company to manage user requests. DeFi wouldn’t be possible.

While smart contracts had long existed on Bitcoin, they were not Turing complete. This made their functions limited. 

When Ethereum arrived, however, the DeFi landscape really took off. Comparing smart contracts in these two ecosystems is like comparing a pocket calculator to a smartphone.

Bitcoin was strictly designed for its purpose as a store of value. Turing completeness would complicate its security with unintended uses, especially with looping functions. 

Fortunately, Ethereum and all compatible blockchains (BnB, Polygon, PulseChain, etc.) can limit those loops by using tokens as gas fees, as well as the proof-of-stake (PoS) consensus model to incentivize good behavior among validators.

#2 Web3 Wallets

Web3 wallets get their name due to the fact that you can access (almost) any dApp using the same wallet. 

Instead of registering or logging into every Web3 project, they are like having one “account” for the entire network. There’s no need for verification because these wallets are permissionless and self-custodial.

Web3 wallets are different from traditional non-custodial ones because they’re dApps and only work with compatible blockchains.

Let’s use Metamask and Exodus as an example:

Since the Metamask dApp is EVM compatible, it supports Ethereum, PulseChain, Optimism, and all tokens ever created in these ecosystems.

Exodus wallet, on the other hand, is not a dApp. This means that it can’t connect to, say, Uniswap. This also makes its token selection limited.

Web3 also allows developers to create exclusive wallets for smart contracts. So when you interact with DEXs or liquidity pools, your tokens go from one non-custodial wallet to another. These follow different conditions to automatically return your tokens, such as timers and withdrawal requests. 

Developers can also reduce token supply with so-called burn addresses. They enable sending crypto to a smart-contract wallet without admin keys.

User tokens kept in those wallets are called TVL or total-value-locked.

Some DeFi developers keep admin keys for governance, code upgrades, and security emergencies. One decentralized way to achieve this is through multi-signature wallets like Gnosis Safe. Here, every action needs approval from all (or most) members.

For example, when you use a 5-member wallet, sending crypto requires 4 of 5 confirmations.

#3 Liquidity Pools

If all cryptocurrency were in user wallets, DeFi would be very limited. It would be a peer-to-peer (P2P) marketplace like NFTs. Since there is not always someone willing to buy or sell, both traders and newer platforms would be limited.

That’s why DeFi needs liquidity. But how do you store crypto without trusting specific users?
This is achieved through smart contract wallets funded by platform users. These “liquidity providers” (LPs) can add different tokens and proportions to this “pool,” which the contract offers to anyone looking to swap these tokens. 

Liquidity providers also earn fee revenue from traders. This increases with your contribution percentage and the trading volume of the platform. Exchanges use hundreds of pools as a way to replace traditional order books and market makers.

Not only does DeFi have more liquidity, but today’s pools are more efficient both for DEXs and LPs. Providers can add liquidity for specific price ranges, choose different ratios other than 50-50, and join single-token pools.

#4 Decentralized Exchanges (DEXs)

DEXs are a major reason why DeFi took off in 2020. For most crypto investors, exchanges are the most important tool. 

Not all crypto holders use liquidity pools or lending protocols, but almost everyone is familiar with CEXs and DEXs.

The risks of custodial centralized exchanges have long been clear. Around 2018, the first decentralized exchanges (DEXs) came out, allowing traders to maintain control of their own funds while accessing thousands of tokens. 

DEXs let you instantly trade any token from that network, even if there are no buyers or sellers available.

DEXs leverage liquidity pools, arbitrage trading, and AMMs to guarantee liquidity for most tokens:

• Traders unbalance the number of pool tokens.
• Automated Market Makers (AMMs) adjust both token prices to rebalance the pool proportion. It sells the surplus token at a discount and buys the deficient one at a premium from arbitrageurs.
• Arbitrageurs trade across platforms to profit from those deviations and rebalance the pool

There’s an inverse relationship between DEXs and liquidity pools. Deep liquidity means less revenue for new providers but better rates for traders, and bad rates might mean that there’s a high-yield pool that needs LPs. That’s why DEXs and pools often use the same platform (such as with Uniswap, PancakeSwap, SushiSwap, and so on.)

#5 Fully-Backed Stablecoins

Without reliable stablecoins, DeFi liquidity is like a game of musical chairs. Everything works smoothly until crypto markets come to a sudden halt. 

Along with black swan events, the DeFi TVL can plummet by several billion just as quickly.

Stablecoins are the non-fiat alternative for traders to get in and out of crypto. 

Users can get stablecoins to enter markets quicker while avoiding custodial wallets. It also helps the TVL, because DeFi dApps (for staking, LP providing, lending, etc.) also accept stablecoins.

There’s no question about the utility of stablecoins, but not all stablecoins are backed in the same way. 

So far, these methods of backing a stablecoin have proved most effective:

• Decentralized stablecoins (like DAI) that mix both stablecoins and crypto reserves.
• Algorithmic stablecoins (like LUSD and USDL) which offer reliable redemption and liquidation systems.

Fully-backed stablecoins lead to better lending protocols.

#6 Lending Protocols

A big “problem” in crypto is the hold-and-hope mentality. It limits the utility of any cryptocurrency. 

Lending protocols help free up idle crypto that would otherwise be collecting dust for years.

The risk of lending isn’t that different from holding (market volatility), except with more benefits. Lenders earn interest and rewards for collateral. Borrowers access more crypto without credit scores, sometimes with low collateral, no repayment schedules, and 0% interest.

Today’s best protocols have added features like:

• Leveraged lending, to increase interest revenue.
• Stablecoin loans, to avoid market exposure and liquidation risks
• Liquid staking. Staking is a form of network security that involves locking (or lending) tokens for interest rewards. Liquid means you receive equivalent tokens, which you can use on other dApps or trade on behalf of your actual tokens. 

Lending protocols are the last truly essential DeFi component. The next four features on this list can enhance dApp features, but are not always needed.

#7 Decentralized Oracles

Due to the nature of decentralized networks, dApps are limited in terms of the data they can interact with.
Without “oracles,” they’d be limited to the DeFi ecosystem. But with oracles, DeFi applications can access off-chain, real world information like:

• Weather and energy consumption data for supply-chain networks.
• Internet-of-Things (IoT) device data for insurance protocols.
• Social media data for verification.
• Sports and games data for betting.
• On-chain information from other blockchains

Oracles are considered “layer zero”. This means that they don’t belong to specific blockchains. The most important properties of an oracle are the same as with blockchains: accurate consensus and lots of nodes.

#8 Cross-Chain Communication

One shortcut to DeFi ecosystems is cross-chain bridges. 

Interoperability allows users to convert tokens and transfer data between blockchains. That includes contracts and features from external dApps.

Simply put, developers save time and money by building on established networks. Ethereum has hundreds of dApps that you can import, integrate, combine, or repurpose. 

Cross-chain enables these features, without requiring you to build on Ethereum.

You can build on PulseChain, for instance, and import dApps from other chains like Ethereum, Arbitrum, Polygon, and more.
Alternatively, you can build on Fantom and import from Ethereum, BnB Chain, and Avalanche all at once.

This feature allows small DeFi ecosystems to be almost as functional as bigger ones.

But cross-chain tech is experimental, raising concerns about safety for regular use. 

#9 Data Sourcing Tools

Having thousands of DeFi tools can be too much of a good thing. 

Ethereum has hundreds of inactive dApps with no product-market fit, so most of the volume/TVL goes to the same big few dApps.
But popular doesn’t mean best. 

Thankfully, there are sourcing tools that allow us to compare countless dApps in no time.

• DEX aggregators find the best rates for specific token swaps.
• Yield farming optimizers automatically switch your investment to the dApp with the highest annual percentage yield (APY).

Emerging DeFi Components to Watch

Many of the ten DeFi components today didn’t exist before 2020. 

It’s likely, then, that we could discover new ones soon. 

Here are up-and-coming DeFi components worth paying attention to:

• Insurance protocols:  These are platforms that send crypto to users who pay a premium for protection from issues like failed transactions, smart contract errors, and platform exploits.
• NFT marketplaces: These P2P platforms allow users to create NFT assets at no cost, set their prices, and buy from other collections. NFTs have gained DeFi functionality, such as fractional ownership or NFT staking for token yields.
• Privacy tools: Even with the lack of identity, there can be even less privacy in public blockchains than in traditional banking. Privacy dApps like Tornado Cash (TORN) or Brave (BAT) can better shield your transactions.
• Advanced trading functions: DEXs don’t yet provide other common tools that CEX traders use to manage risk. However, some DEXs and aggregators are increasingly supporting long-awaited features like limit orders.

As the DeFi landscape continues to grow and develop, it’s possible that the fundamental components of DeFi will evolve in new ways as well. 

Still, throughout these evolutions, key features like fairness, transparency, autonomy, and decentralization will always be core to the purpose of the DeFi landscape.