What Is Decentralized Finance (DeFi)?
Decentralized finance (DeFi) is an emerging financial technology based on secure distributed ledgers similar to those used by cryptocurrencies.
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In the U.S., the Federal Reserve and Securities and Exchange Commission (SEC) define the rules for centralized financial institutions like banks and brokerages, which consumers rely on to access capital and financial services directly. DeFi challenges this centralized financial system by empowering individuals with peer-to-peer transactions.
Centralized Finance Today
Today, almost every aspect of banking, lending and trading is managed by centralized systems, operated by governing bodies and gatekeepers. Regular consumers need to deal with a raft of financial middlemen to get access to everything from auto loans and mortgages to trading stocks and bonds.
In India, the regulatory body, the Reserve Bank of India (RBI) set the rules for the world of centralized financial institutions and brokerages.
As a result, there are few paths for consumers to access capital and financial services directly. They cannot bypass middlemen like banks, exchanges and lenders, who earn a percentage of every financial and banking transaction as profit. We all have to pay to play.
The New Way: Decentralized Finance
DeFi challenges this centralized financial system by disempowering middlemen and gatekeepers, and empowering everyday people via peer-to-peer exchanges.
“Decentralized finance is an unbundling of traditional finance,” says Rafael Cosman, CEO and co-founder of TrustToken. “DeFi takes the key elements of the work done by banks, exchanges and insurers today—like lending, borrowing and trading—and puts it in the hands of regular people.”
Here’s how that might play out. Today, you might put your savings in an online savings account and earn a 0.50% interest rate on your money. The bank then turns around and lends that money to another customer at 3% interest and pockets the 2.5% profit. With DeFi, people lend their savings directly to others, cutting out that 2.5% profit loss and earn the full 3% return on their money.
You might think, “Hey, I already do this when I send my friends money with PayPal, Venmo or CashApp.” But you don’t. You still have to have a debit card or bank account linked to those apps to send funds, so these peer-to-peer payments are still reliant on centralized financial middlemen to work.
How Decentralized Finance (DeFi) Works
Through peer-to-peer financial networks, DeFi uses security protocols, connectivity, software, and hardware advancements. This system eliminates intermediaries like banks and other financial service companies. These companies charge businesses and customers for using their services, which are necessary in the current system because it’s the only way to make it work. DeFi uses blockchain technology to reduce the need for these intermediaries.
Blockchain
A blockchain is a distributed and secured database or ledger. In the blockchain, transactions are recorded in blocks and verified through automated processes. If a transaction is verified, the block is closed and encrypted; another block is created with information about the previous block, along with information about newer transactions.
The blocks are “chained” together through the information in each proceeding block, giving it the name blockchain. Information in previous blocks cannot be changed without affecting the following blocks, so there is no way to alter a blockchain. This concept, along with other security protocols, provides the secure nature of a blockchain.
Using applications called wallets that can send information to a blockchain, individuals hold private keys to tokens or cryptocurrencies that act like passwords. These keys give them access to virtual tokens that represent value. Ownership of the tokens is transferred by ‘sending’ an amount to another entity via a wallet, whose wallet, in turn, generates a different private key for them. This secures their ownership of the token, and the blockchain design prevents the transfer from being reversed.
Applications
DeFi applications are designed to communicate with a blockchain, allowing people to use their money for purchases, loans, gifts, trading, or any other way they want without a third party. These applications are programs installed on a device like a personal computer, tablet, or smartphone that make it easier to use. Without the applications, DeFi would still exist, but users would need to be comfortable and familiar with using the command line or terminal in the operating system that runs their device.
DeFi applications provide an interface that automates transactions between users by giving them financial options to choose from. For example, if you want to make a loan to someone and charge them interest, you can select the option on the interface and enter terms like interest or collateral. If you need a loan, you can search for providers, which could range from a bank to an individual who could lend you some cryptocurrency after you agree on terms.
Some applications let you enter parameters for the services you’re looking for and match you with another user. Because the blockchain is a global network, you could give or receive financial services to or from anywhere in the world.
Goals of Decentralized Finance
Peer-to-peer (P2P) financial transactions are one of the core premises behind DeFi, where two parties agree to exchange cryptocurrency for goods or services without a third party involved.
Using DeFi allows for:
- Accessibility: Anyone with an internet connection can access a DeFi platform, and transactions occur without geographic restrictions.
- Low fees and high interest rates: DeFi enables any two parties to negotiate interest rates directly and lend cryptocurrency or money via DeFi networks.
- Security and Transparency: Smart contracts published on a blockchain and records of completed transactions are available for anyone to review but do not reveal your identity. Blockchains are immutable, meaning they cannot be changed.
- Autonomy: DeFi platforms don’t rely on centralized financial institutions. The decentralized nature of DeFi protocols mitigates the need for and costs of administering financial services.
How DeFi is Being Used Now
DeFI is making its way into a wide variety of simple and complex financial transactions. It’s powered by decentralized apps called “dapps,” or other programs called “protocols.” Dapps and protocols handle transactions in the two main cryptocurrencies, Bitcoin (BTC) and Ethereum (ETH).
While Bitcoin is the more popular cryptocurrency, Ethereum is much more adaptable to a wider variety of uses, meaning much of the dapp and protocol landscape uses Ethereum-based code.
Here are some of the ways dapps and protocols are already being used:
- Traditional financial transactions. Anything from payments, trading securities and insurance, to lending and borrowing are already happening with DeFi.
- Decentralized exchanges (DEXs). Right now, most cryptocurrency investors use centralized exchanges like Coinbase. DEXs facilitate peer-to-peer financial transactions and let users retain control over their money.
- E-wallets. DeFi developers are creating digital wallets that can operate independently of the largest cryptocurrency exchanges and give investors access to everything from cryptocurrency to blockchain-based games.
- Stable coins. While cryptocurrencies are notoriously volatile, stable coins attempt to stabilize their values by tying them to non-cryptocurrencies, like the U.S. dollar.
- Yield harvesting. Dubbed the “rocket fuel” of crypto, DeFi makes it possible for speculative investors to lend crypto and potentially reap big rewards when the proprietary coins DeFi borrowing platforms pay them for agreeing to the loan appreciate rapidly.
- Non-fungible tokens (NFTs). NFTs create digital assets out of typically non-tradable assets, like videos of slam dunks or the first tweet on Twitter. NFTs commodify the previously uncommodifiable.
- Flash loans. These are cryptocurrency loans that borrow and repay funds in the same transaction. Sound counterintuitive? Here’s how it works: Borrowers have the potential to make money by entering into a contract encoded on the Ethereum blockchain—no lawyers needed—that borrows funds, executes a transaction and repays the loan instantly. If the transaction can’t be executed, or it’ll be at a loss, the funds automatically go back to the loaner. If you do make a profit, you can pocket it, minus any interest charges or fees. Think of flash loans as decentralized arbitrage.
The DeFi market gauges adoption by measuring what’s called locked value, which calculates how much money is currently working in different DeFi protocols. At present, the total locked value in DeFi protocols is nearly INR 3 trillion.
Adoption of DeFi is powered by the omnipresent nature of blockchain: The same moment a dapp is encoded on the blockchain, it’s globally available. While most centralized financial instruments and technologies roll out slowly over time, governed by the respective rules and regulations of regional economies, dapps exist outside of these rules, increasing their potential reward—and also increasing their risks.
Risks and Downsides of DeFi
DeFi is an emerging phenomenon that comes with many risks. As a recent innovation, decentralized finance has not been stress tested by long or widespread use. In addition, national authorities are taking a harder look at the systems it’s putting in place, with an eye toward regulation. Some of the other risks of DeFi include:
- No consumer protections. DeFi has thrived in the absence of rules and regulations. But this also means users may have little recourse should a transaction go foul. In centralized finance, banks are required by law to hold a certain amount of their capital as reserves, to maintain stability and cash you out of your account any time you need. No similar protections exist in DeFi.
- Hackers are a threat. While a blockchain may be nearly impossible to alter, other aspects of DeFi are at large risk of being hacked, which can lead to funds theft or loss. All of decentralized finance’s potential use cases rely on software systems that are vulnerable to hackers.
- Collateralization. Collateral is a thing of value used to secure a loan. When you get a mortgage, for instance, the loan is collateralized by the home you’re buying. Nearly all DeFi lending transactions require collateral equal to at least 100% of the value of the loan, if not more. These requirements vastly restrict who is eligible for many types of DeFi loans.
- Private key requirements. With DeFi and cryptocurrency, you must secure the wallets used to store your cryptocurrency assets. Wallets are secured with private keys, which are long, unique codes known only to the owner of the wallet. If you lose a private key, you lose access to your funds—there is no way to recover a lost private key.
How to Get Involved with DeFi
If you’d like to learn more about DeFi in a hands-on way, here are a few ways to get started:
Get a Crypto Wallet
“Start by setting up an Ethereum wallet like Metamask, then funding it with Ethereum,” says Cosman. “Self-custody wallets are your ticket to the world of DeFi, but make sure to save your public and private key. Lose these, and you won’t be able to get back into your wallet.”
Trade Digital Assets.
“I recommend trading a small amount of two assets on a decentralized exchange such as Uniswap,” says Doug Schwenk, chairman of Digital Asset Research. “Trying this exercise will help a crypto enthusiast understand the current landscape, but be prepared to lose everything while you’re learning which assets and platforms are best and how to manage risks.”
Look into Stablecoins
“An exciting way to try out DeFi without exposing oneself to the price swings of an underlying asset is to try out TrueFi, which offers competitive returns on stablecoins (AKA dollar-backed tokens, which aren’t subject to price movements),” Cosman says.
The key to any foray into a new financial space is to start slow, stay humble and don’t get ahead of yourself. Keep in mind that digital assets traded in the cryptocurrency and DeFi worlds are fast-moving and there’s significant potential for loss.
What Is an Example of DeFi?
DeFi is an all-inclusive term for any application that uses blockchain and cryptocurrency techniques or technology to offer financial services. Some of these applications can provide anything from basic services like savings accounts to more advances services like providing liquidity to businesses or investors. One of the more notable DeFi service providers is Aave, which is a “decentralized non-custodial liquidity market protocol” that allows anyone to participate as a liquidity supplier or borrower.
Aave lets you stake any of your crypto-assets to earn interest income from users who might borrow your assets.
Decentralized Finance Uses
Decentralized finance, originally conceived of as a way to bring financial services like loans and banking to those who don’t have access to them, has morphed into an industry where you can take part in many different sectors or endeavors. Here are a few of the most popular:
- Decentralized exchanges: The top preference for defi app users is accessing decentralized exchanges. Exchanges like Uniswap and PancakeSwap have apps that let you interact with other cryptocurrency users.
- Liquidity providers: Liquidity is the ability to sell assets quickly, a problem many cryptocurrency users have encountered. Liquidity providers are generally pools where users place funds so exchanges can provide selling opportunities for their users. Uniswap. “How to Add Liquidity to Uniswap V3.”
- Lending/Yield Farming: There are hundreds of defi apps available that provide lending. Generally, they operate the same way as a liquidity pool, where users lock their funds in a pool and let others borrow them, receiving interest on their loans—called yield farming. Many provide flash loans, where no collateral is required from the borrower.
- Gambling/Prediction Markets: Millions of dollars in cryptocurrency are used everyday gambling using defi apps like ZKasino, Horse Racing Slot Keno Roulett, Azuro, and UpvsDown.4 Prediction markets are platforms that let you place bets on the outcome of nearly any event.
- NFTs: The market for non-fungible tokens has cooled somewhat, but they are still popular with niche investors and collectors.
How to Get Involved in DeFi
Becoming involved in decentralized finance might seem intimidating at first, but there are many ways to do so. The first thing you should do if you want to get into DeFi is to research the activities that interest you the most. You’ll need a wallet, but because there are so many to choose from, you’ll need to learn more about them and find the one that appeals to you.
Once you identify your wallet and activity, you can find a reputable exchange that provides the activity you want to get involved in or use, buy some cryptocurrency, and get started.
Concerns About DeFi
Decentralized finance is constantly evolving. It is unregulated, and its ecosystem is vulnerable to faulty programming, hacks, and scams. For example, one of the main ways hackers and thieves steal cryptocurrency is through weaknesses in DeFi applications.
Laws have not yet caught up with advances in technology. Most current laws were crafted based on the idea of separate financial jurisdictions, each with its own set of laws and rules. DeFi’s borderless transaction ability presents essential questions for this type of regulation. For example:
- Who is responsible for investigating a financial crime that occurs across borders, protocols, and DeFi apps?
- Who would enforce the regulations?
- How would they enforce them?
DeFi Hype
Just like other blockchain- and cryptocurrency-related projects, businesses, and activities, decentralized finance is subject to considerable hype and misinformation, hoping to attract users and their money. Cryptocurrency, blockchain, and all technologies associated with them are also subject to extreme price volatility.
Lots of Money in Crypto, But Not as Much as You’d Think
There is a considerable amount of money flowing through cryptocurrency exchanges, but it isn’t nearly as much as you might be led to believe. Most people still use the traditional financial systems we are all used to. For example, only 0.56% of all money is tied up in cryptocurrency and decentralized finance—a very small figure that should encourage you to do your research to learn if using or investing in DeFi apps, platforms, and cryptocurrency is worth it.
Crypto Winters
A crypto-winter is a period where crypto prices continuously move down and then stay down—sometimes tens of thousands of dollars. The last one occurred between 2022 and 2023. Prices had been rising significantly before 2022 as investors turned to anything they could find following the initial outbreak of COVID-19 and the ensuing pandemic. During that time, they discovered Bitcoin was not only holding value; it was increasing as well—but this was most likely due to their own self-fulfilling prophecies and hype as they drove the price increases themselves.
But toward the end of 2022, prices began declining and stayed there. Billions of dollars were lost during this time. During this period, there were no rumors of substance or any regulatory developments (in the U.S.) beyond a perceived campaign of persecution orchestrated by the Securities and Exchange Commission. However, when rumors began circulating about a Spot Bitcoin ETF approval in October 2023, the hyping began again, and prices rose. When the approval of 11 Bitcoin Spot ETFs was announced in January 2024, prices climbed steadily for a few months (supposedly ending the winter) until a sideways market emerged yet again in March 2024.
Is It Worth It?
DeFi might be just what you’re looking for regarding your finances. However, it might not—the decentralized finance industry is still in its infancy and evolving, making it somewhat of a gamble for most people.
The low amount of actual money invested in cryptocurrency and the effects that hype has on prices should make you consider whether investing in decentralized finance is worth it. If you have money you can afford to lose, the space can be very profitable—but the amount of losses can be just as significant.
If you don’t have money to lose and are looking for ways to fund your retirement or grow your portfolio or net worth over time, defi and cryptocurrency should be the last investment you should consider. They are still too new and volatile to risk your future on.
The Future of DeFi
From taking out the middleman to turning basketball clips into digital assets with monetary value, DeFi’s future looks bright. That’s why people like Dan Simerman, head of financial relations at IOTA Foundation, a DeFi research and development group, see both the promise and potential of DeFi as far-reaching, even though it’s still in the infancy of its capabilities.
Investors will soon have more independence, which will allow them to “deploy [assets] in creative ways that seem impossible today,” Simerman says. DeFi also carries big implications for the big data sector as it matures to enable new ways to commodify data, Simerman says.
But for all its promise, DeFi has a long road ahead, especially when it comes to uptake by the general public.
“The promise is there,” says Simerman. “It’s up to us to continue educating people about the potential, but we also need to keep working hard to build the tools that will allow people to see it for themselves.”
Is DeFi a Good Investment?
Investing in DeFi involves purchasing a cryptocurrency that is used in DeFi and is susceptible to hacks. DeFi hacking has been an issue for several years, but according to the blockchain analysts at Chainalysis, the trend dropped significantly in 2023. However, this doesn’t mean it won’t pick back up again. Like all cryptocurrency and blockchain investments, there are significant risks involved.
FAQ about Decentralized Finance (DeFi)
1. What is Decentralized Finance (DeFi)?
Decentralized finance (DeFi) refers to a system of financial applications and services built on blockchain technology that aims to eliminate intermediaries, allowing direct peer-to-peer transactions.
2. How does DeFi work?
DeFi operates using smart contracts on blockchain networks like Ethereum, enabling activities such as lending, borrowing, trading, and earning interest without traditional financial intermediaries.
3. What are some examples of DeFi applications?
Popular DeFi applications include decentralized exchanges (DEXs) like Uniswap, lending platforms like Aave, liquidity pools, yield farming protocols, and more.
4. What are the benefits of DeFi?
DeFi offers benefits such as enhanced financial inclusion, lower transaction fees compared to traditional finance, greater transparency, and the ability to earn higher interest rates on deposits.
5. What are the risks of DeFi?
Risks include smart contract vulnerabilities, potential hacks leading to loss of funds, lack of regulatory oversight, and high volatility in cryptocurrency prices.
Conclusion
Decentralized finance (DeFi) represents a transformative shift in the financial landscape, offering new possibilities for financial services without relying on traditional intermediaries. By leveraging blockchain technology and smart contracts, DeFi provides opportunities for greater financial inclusion, lower transaction costs, and innovative financial products.