What is DeFi? - Understanding Decentralized Finance
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Last Updated: November 7, 2022

What is DeFi? - Understanding Decentralized Finance

Cryptocurrency has been around since 2009, with some even claiming it started in the 90s. But even with as long-established a phenomenon as crypto, there are still inventions emerging that turn the crypto world upside down. One of these inventions is DeFi or decentralized finance. In this article, you’ll find a short DeFi guide.

What Is DeFi?

DeFi is the biggest and most life-changing invention in the crypto world. 

DeFi, a shorthand for decentralized finance, is a financial system that has eliminated the need for third-party intermediaries, including banks. The invention of DeFi has enabled peer-to-peer transactions that are programmatically executed through smart contracts - pieces of code set up in the blockchain, meaning that users are directly connected without any interference from an intermediary.

What Is a Smart Contract?

A smart contract is a thing that makes it possible to create DeFi apps (dApps) on the blockchain. A smart contract is a transaction protocol - a computer program that automatically executes transactions by tying together relevant events to the agreement.

How Does DeFi Differ From Traditional Financial Services?

To understand DeFi and how it works, it is best to see how DeFi differs from traditional financial services or centralized finance.

Centralized vs Decentralized

Centralized finance (sometimes shortened as CeFi) revolves around third-party governance. In centralized finance, your money is kept by banks or other intermediary financial corporations. Third parties facilitate every financial movement between parties and charges gees every step of the way.

For example, this is how a transaction looks like in centralized finance: you purchase a bottle of water using a credit card. The charge goes from the retailer to the retailer's bank. The bank then forwards the card details to the credit card network which clears the charge and requests a payment from your bank. Your bank approves the charge, sending the approval to the network. The network then forwards the approval to the acquiring bank and back to the merchant. The payment is done.

Keep in mind that every member of this chain receives payment for the services. All the financial transactions made in centralized finance cost money, some transactions can take days to approve, and if you're traveling, you may not be allowed to use bank services.

Decentralized finance eliminates the need for third parties by allowing people and businesses to make transactions through peer-to-peer network technology. You can lend, trade, and sell from anywhere you have an internet connection. It can be done by using software that records and verifies transactions in distributed financial databases which collect data from all users and verifies it via a consensus mechanism.

Although DeFi takes control away from third-party governance, it doesn’t provide anonymity. Your transactions aren’t linked to your identity, however, they are still traceable.

Problems With Traditional Finance

Centralized finance currently has these unsolved problems:

  • Centralized finance isn't open for everyone - some people don't have access to get a bank account or use financial services.
  • Financial institutions can block you from getting paid.
  • Lack of access to use financial services can keep people from getting employed.
  • Trading hours are limited to business hours.
  • Money transfers can take long, usually days, because of manual processes.
  • Centralized financial institutions can close down markets at will.
  • There's a monthly fee for financial services - institutions take their cut.

A Comparison

To better understand how decentralized finance differs from traditional one, here’s a short comparison:

DeFiTraditional finance (CeFi)
Your money is in your possession.Your money is held by third-party companies.
You have control over your money - where it goes and how it’s spent.You have to trust companies not to mismanage your money.
Transfers take minutes.Transfers take days.
Financial activity is pseudonymous.Financial activity is tightly connected to your identity.
Open to anyone.You must apply to use financial services and you may not be granted access.
No limited trading hours, markets are open 24/7.Trading hours are limited to business hours.
Transparent - anyone can check the data and see how the system works.Financial institutions keep all the data in closed books - you can’t ask to see their loan history.

How Does DeFi Work?

Decentralized finance operates under blockchain technology. Blockchain is a shared and secured ledger, a database of sorts, that is recording transactions and tracking assets. 

In the blockchain, all the transactions are recorded in blocks. The transactions are then verified by other users - verifiers. If verifiers agree on a transaction, the block that stores the data is closed and encrypted. Some information about this block is also stored within the next created block.

This way, the blocks are chained together (thus, the name "blockchain"). There is no way to alter the blockchain since the information is linked between blocks and the information in the previous block cannot be changed without altering the other blocks. This concept is what provides security to the blockchain.

Peer-to-Peer Transactions

One of the bases of DeFi - peer-to-peer (P2P) financial transactions. A P2P transaction is an agreement between two parties to exchange assets without a third party involved.

If you wanted to get a loan in traditional finance, you would have to go to the bank and apply for one. If you were approved of a loan, apart from paying interest, you'd also be paying service fees for using the lender's services.

Now with peer-to-peer lending, you would use DeFi applications (dApps) to apply for a loan. The algorithm then would match you with other users that meet your loan needs. You would then agree to the terms of the lender. The consensus mechanism would verify the transaction and you would then receive the loan.

Your transaction will be recorded on the blockchain, and the lender will begin collecting the payments from you at the agreed time periods. These transactions will follow the same process on the blockchain.

Peer-to-peer lending doesn't mean there won't be any interest and fees, however, you can choose from many more options that are suitable for you.

What Are The Benefits of DeFi?

DeFi has provided many benefits to the way finance works, including the following:

  • It is completely open for anyone. You don't need to apply anywhere, all you need to get access is to create a wallet.
  • It's pseudonymous. You don't need to provide any personal information, such as your name or email address.
  • It's absolutely flexible. You can move your funds anywhere and at any time. You won't have to ask for permission from the bank or wait a long time for a transaction to go through.
  • It's transparent, meaning everyone involved can see all of the transactions.
  • It's way more accessible than traditional banks. You may get a loan or insurance without a credit score.

What Are The Downsides of DeFi?

However, DeFi doesn't come without drawbacks. Here is a list of the biggest DeFi downsides:

  • It's still quite new and experimental. Since DeFi is still a new thing that is constantly updated, user experience can still be rough and there is be a lack of consumer protection.
  • It's vulnerable to bugs. Since with DeFi, everything is in code, there is always a risk of bugs or other vulnerabilities.
  • There's a possibility of high volatility and risk. Depending on which applications you're going to use, your investment can experience volatility - cryptocurrency prices are constantly changing and there is no way to predict when the price will crash.
  • You have to keep track of everything yourself. Since there is no third-party governance, you have to keep your own records for tax purposes and if you forget your password, there is nobody to remind you.

What Are The Uses of DeFi?

DeFi has been a major shift in the way finance is being performed. Here are the biggest ways DeFi is applied:

Coins

Under the DeFi model there are blockchains popping up every day and every one of them usually creates their own coins as an incentive for people to use their platform. The most popular DeFi based coins include Ether (ETH), Solana (SOL), and Cardano (ADA).

Stablecoins

In the crypto world price fluctuation is pretty common, so volatility is one of the main risks. As a solution, there are stablecoins - their value is fixed to the value of a corresponding traditional currency, meaning there is less fluctuation in price.

Tokens

Tokens are similar to coins, however, they are created on already existing blockchains. For example, the Ethereum blockchain has one native coin - Ether, but UniSwap or Compound tokens are cryptocurrencies created on the Ethereum blockchain. 

Wallets

Many crypto transactions still used third-party governance to conduct transactions, and crypto wallet providers held the wallet key instead of the owner. DeFi wallets, such as MetaMask or Coinbase, lets you keep possession of your crypto. Keep in mind - you are responsible for the access key to the wallet, so if you lose the key (a password), there is no way to be given a new one.

Liquidity and Staking

Liquidity mining is the process of storing the digital assets in a liquidity pool so other users had the liquidity to make trades in that particular cryptocurrency. For that, you'll receive interest on your investment and provide liquidity to the platform.

Staking is the process of participation in a proof-of-stake ecosystem. It's a way of validating blockchain transactions and earning benefits for doing so. The amount of benefits is determined by the amount of staked (locked) currency by the person.

Trading, Borrowing, Lending, and Saving

DeFi works on smart contracts that let you trade, borrow, and lend your crypto without any intermediaries, meaning there is a lot less risk. If a borrower doesn't meet their obligations, the lender can take back the funds. Also, DeFi savings accounts are similar to traditional ones just offer much higher interest rates.

The Future of DeFi

Decentralized finance is still developing, it's just taking its first steps. Naturally, it still has some unresolved issues. For starters, it is unregulated, so there occasionally occur some mishaps, infrastructural issues, or scams. However, there are already steps taken so that DeFi could have some lawful regulations and still be independent of third parties. 

DeFi is still constantly developing and changing for the better. While it's only a start, there are definitely big opportunities in DeFi's future.

DeFi has been a wind of change in the crypto and financial worlds, providing many new possibilities. While it’s still quite new, it already has been applied in many ways, from crypto wallets to liquidity pools. And, there are definitely more uses of DeFi coming along the way. DeFi has also brought a lot of benefits to the user - eliminating the need for intermediaries, it made crypto trading way easier. Now that you know what is decentralized finance, you can make use of its benefits too.