What Is Decentralized Finance (DeFi)?
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What Is Decentralized Finance (DeFi)?

What Is Decentralized Finance (DeFi)?

Intermediate
Na-publish Dec 16, 2019Na-update May 22, 2024
11m

Key Takeaways

  • DeFi lets users access crypto financial services with just a wallet and some crypto. Decentralized applications (DApps) enable lending, liquidity provision, swaps, staking, and more across many blockchains.

  • While Ethereum was DeFi's original home, most blockchains with smart contract capabilities now host DeFi DApps, including layer-2 solutions like Arbitrum and Optimism. Smart contracts are essential to the services DeFi offers, which include staking, investing, lending, harvesting, and more.

  • DeFi allows people to optimize yield, join decentralized marketplaces, access banking services, and engage in quick borrowing and lending. However, DeFi isn't without its risks; you should always do careful research before taking risks.

Introduction

Entering the world of decentralized finance (DeFi) can be exciting but also confusing. After some time HODLing, it's common to wonder how you can squeeze extra gains out of your portfolio. However, there's a lot to unpack when it comes to DeFi.

When used responsibly, DeFi DApps and projects can become powerful tools. But if you jump in too soon, it's easy to become overwhelmed and make unwise investment decisions. The best way to get involved is to learn the risks and find what's suitable for you. With this in mind, let's explore the basics you'll need when starting your DeFi journey.

What Is Decentralized Finance (DeFi)?

Decentralized finance refers to an ecosystem of financial applications built on blockchain networks. More specifically, DeFi aims to create an open-source, permissionless, and transparent financial service ecosystem that is available to everyone and operates without any central authority. Users maintain complete control over their assets and interact with this ecosystem through peer-to-peer (P2P), decentralized applications (DApps).

DeFi's core benefit is enabling easy access to financial services, especially for those isolated from the traditional financial system. Another advantage is the modular framework it’s built upon, with interoperable DeFi applications on public blockchains. These have the potential to create entirely new financial markets, products, and services.

Main Advantages of DeFi

Traditional finance relies on institutions such as banks to act as intermediaries and courts to provide arbitration. DeFi applications don’t need any intermediaries or arbitrators. The code specifies the resolution of every possible dispute, and users maintain control over their funds at all times. This automation reduces costs and allows for a more frictionless financial system.

As these new financial services are deployed on blockchains, single points of failure are eliminated. Data is recorded on the blockchain and spread across thousands of nodes, making censorship or the potential shutdown of a service a complicated undertaking.

Another significant advantage of such an open ecosystem is the ease of access for individuals who otherwise wouldn't have access to any financial services. Since the traditional financial system relies on intermediaries making a profit, their services are typically absent from low-income communities. However, with DeFi, costs are significantly reduced, and low-income individuals can also benefit from a broader range of financial services.

Potential Use Cases for DeFi

Borrowing and lending

Open lending protocols are among the most popular application types in the DeFi ecosystem. Open, decentralized borrowing and lending have many advantages over the traditional credit system, including instant transaction settlement, no credit checks, and the ability to collateralize digital assets.

Since these lending services are built on public blockchains, they minimize trust requirements and provide cryptographic verification. Lending marketplaces on the blockchain reduce counterparty risk and make borrowing and lending cheaper, faster, and available to more people.

Monetary banking services

As DeFi applications are financial applications by definition, monetary banking services are an obvious use case. These can include the issuance of stablecoins, mortgages, and insurance.

As the blockchain industry matures, there's an increased focus on creating stablecoins. These are crypto assets usually pegged to real-world assets and are easily digitally transferable. As cryptocurrency prices can fluctuate rapidly, decentralized stablecoins could be adopted for everyday use as digital currencies not issued or monitored by a central authority.

With smart contracts, underwriting and legal fees for mortgages could be reduced significantly. Insurance on the blockchain could eliminate intermediaries and allow the distribution of risk between many participants, potentially resulting in lower premiums with the same quality of service.

Decentralized marketplaces

Some of the most popular DeFi applications are decentralized exchanges (DEXs), such as Uniswap and PancakeSwap. These platforms allow users to trade digital assets without needing a trusted intermediary to hold their funds. Trades are made directly between user wallets with the help of smart contracts. 

Some exchanges, known as Automated Market Makers (AMMs), use liquidity pools to facilitate trading without needing a direct counterparty to match your trade. Since they require less maintenance and managing, decentralized exchanges typically have lower trading fees than centralized exchanges.

Blockchain technology may also be used to issue and allow ownership of a wide range of conventional financial instruments. These applications would work in a decentralized way that cuts out custodians and eliminates single points of failure.

Yield optimization

DeFi DApps can be used to automate and optimize the compound yield gained from staking, reward pools, and other interest-bearing products. This is sometimes referred to as yield farming.

For example, you might receive regular rewards from Bitcoin mining, delegating BNB, or providing liquidity. A smart contract can take your rewards, purchase more of the underlying asset, and reinvest it. This process will compound your interest, often significantly raising your returns.

Using a smart contract saves time and optimizes compounding. Your funds are usually pooled with other users’, meaning gas fees are shared across all members of the yield-optimizing smart contract.

Smart Contracts' Role in DeFi

Most existing and potential applications of decentralized finance involve creating and executing smart contracts. While a usual contract uses legal terminology to specify the terms of the relationship between the entities entering the contract, a smart contract uses computer code.

Since their terms are written in computer code, smart contracts can enforce those terms in an automated manner. This enables reliable execution and automation of many business processes that currently require manual supervision.

Using smart contracts is faster, easier, and reduces the risk for both parties. However, smart contracts also introduce new types of risks. As computer code is prone to bugs and vulnerabilities, the value and confidential information locked in smart contracts are at risk.

Challenges Faced by DeFi

Poor performance

Blockchains are inherently slower than their centralized counterparts, affecting the applications built on them. Developers of DeFi applications need to take these limitations into account and optimize their products accordingly. Layer-2 solutions like Arbitrum and Optimism are addressing these issues by offering faster and cheaper transactions.

High risk of user error

DeFi applications transfer the responsibility from intermediaries to the user. This can be a negative aspect for many. Designing products that minimize the risk of user error is a tough challenge when the products are deployed on top of immutable blockchains.

Bad user experience

Using DeFi applications currently requires extra effort on the user's part. For DeFi applications to become a core element of the global financial system, they must provide a tangible benefit that incentivizes users to switch from the traditional system. Recent improvements in user interfaces and educational resources are helping to mitigate this issue.

Cluttered ecosystem

Finding the most suitable application for a specific use case can be daunting, and users must be able to find the best choices. The challenge is not only building the applications but also thinking about how they fit into the broader DeFi ecosystem. 

Risks of DeFi

While the DeFi world can offer appealing APYs, it is not without risks. Even though they are decentralized, you are essentially consuming financial services, and some of the risks are familiar:

Counterparty risk

If you take part in crypto loans or any other kind of lending, you’re at risk of the counterparty not repaying their debt.

Regulatory risk

The legality of certain services and projects can be difficult to ascertain. If you are invested in a smart contract that is subsequently shut down due to regulatory problems, then your funds can be at risk. Recent actions and guidelines from global regulators are influencing the development and adoption of DeFi.

Token risk

The assets you hold have different risk levels affected by their liquidity, trustworthiness, token smart contract security, and associated project and team. As the DeFi space has many low market-cap tokens, token risk can be particularly high.

Software risk

Code vulnerabilities can undermine the security of smart contracts you’re invested in. Your wallet could also be compromised due to connecting to DeFi DApps and giving them certain permissions. Security practices, such as multi-signature wallets and insurance funds, are emerging to address these risks.

Impermanent loss

If you’re staking in liquidity pools, divergences away from the price ratio you entered at will cause you to lose some tokens deposited in the pool if you withdraw.

Accessing DeFi Projects

Ethereum has long been the traditional home of DeFi. However, many blockchains now have healthy DeFi ecosystems. Networks with smart contract capabilities like BNB Chain, Solana, Polkadot, Avalanche, and newer layer-2 solutions on Ethereum are popular choices.

Finding projects and DeFi protocols requires research. Online forums, messengers, and websites can help you learn about new opportunities. However, be extremely cautious with any information you find. Always double-check the safety of any project you read or hear about.

What Do I Need to Access DeFi Projects?

To start using DeFi DApps, you'll need:

  • A compatible wallet: A browser extension wallet like MetaMask or a mobile one such as Trust Wallet will do the job. A custodial wallet (one where you don't own the private keys) is less likely to allow you to connect to DApps.

  • Crypto assets: This seems obvious, but you might need a mixture of assets. For example, if you are looking to use Ethereum-based DApps, you will need ETH for gas fees and another token for whatever service you use.

DeFi vs. Traditional Finance (TradFi)

DeFi offers an open financial system to anyone with internet access, contrasting traditional finance, which relies on centralized institutions and regulatory bodies. However, DeFi and traditional finance are increasingly interacting. Banks and financial institutions are beginning to explore DeFi protocols, creating hybrid models that blend the benefits of both systems.

DeFi vs. Centralized Finance (CeFi)

Even in the crypto world, not every financial service is decentralized. For example, staking through a centralized exchange like Binance often requires you to give up custody of your tokens. In this case, you must trust the centralized entity that deals with your funds.

The majority of the services offered will be the same. They likely are done through the same DeFi platforms that a user can access directly. However, CeFi takes away the often complicated nature of managing DeFi investments yourself. You may also have extra guarantees on your deposits.

CeFi is neither worse nor better than DeFi. Its suitability depends on your wants and needs. While you may sacrifice some control in CeFi, you often receive stronger guarantees and offload some responsibility for handling assets and executing transactions.

What Is the Difference Between DeFi and Open Banking?

Open banking is a banking system where third-party financial service providers are given secure access to financial data through APIs. This enables the networking of accounts and data between banks and non-bank financial institutions. Essentially, it allows for new products and services within the traditional financial system. 

DeFi, however, proposes an entirely new financial system that is independent of the current infrastructure. DeFi is sometimes also referred to as open finance.

For example, open banking could allow the management of all traditional financial instruments in one application by securely drawing data from several banks and institutions. 

Decentralized finance, on the other hand, could allow the management of entirely new financial instruments and new ways of interacting with them.

Closing Thoughts

DeFi has quickly created a self-sustaining ecosystem of value that attracts capital, developers, and new products. While DeFi promises to revolutionize the financial sector, it is still an emerging field. The future of DeFi lies in ongoing technological advancements, regulatory developments, and increasing mainstream adoption. For sustainable growth, continuous innovation is essential to address the limitations and risks associated with DeFi.

Further Reading


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