What is Decentralized Finance (DeFi)?
Decentralized Finance (“DeFi”) is the idea that traditional financial service offerings such as banks, markets, and other investment services can be recreated or improved upon using applications created on the blockchain.
DeFi is an ecosystem of blockchain-based financial instruments designed in a decentralized way:
outside of companies’ and governments’ regulation
running on smart contracts
There is no reliance on centralized authorities, and stakeholders come together to build a permissionless ecosystem. The idea driving the majority of the industry players is to open financial services to everyone by creating a permissionless ecosystem.
DeFi recreates traditional financial services — i.e., lending & borrowing, trading, and even insurance — tailored for storing, earning, or transferring digital assets. Decentralized applications (dApps) can come in varying degrees of decentralization, simplicity, and security, providing users with flexible options.
DeFi has some unique traits making it a phenomenon in finance. Many platforms have some or all of these characteristics:
- No third parties. DApps rely on smart contracts instead of the humans responsible for operations. DeFi products need no intermediaries to process transactions. No mediator has control over or access to your assets as the majority of DeFi platforms are non-custodial.
- Governed by users. When it comes to governance, DeFi is also unique since it moves towards decentralization and should eventually be based on the crowd’s wisdom. By holding the governance tokens, users can take part in voting on platform governance decisions.
- Easy to enter. Thanks to the permissionless nature of DeFi, anyone can start using the platforms without the need to disclose personal information and applications for access. All you need is to connect the wallet to the platform and start lending, borrowing, or trading. Your account is not tied directly to your real-life identity as the platform, and other users only know your wallet number (no name/age/country mentioned). However, some wallets do have KYC/ AML requirements, and therefore DeFi does not guarantee anonymity if these wallets were used.
- Community driven. In the DeFi space, communities are crucial aspects of each project as they help create value through usage and organic marketing. With many DeFi applications and protocols being open source, community developers can add features and build new apps. Projects can be “forked” to launch tweaked versions of the original product.
- Truly Global. The products are not customized for specific countries and are developed so that a person from Europe and a person from Asia will have the same experience and access to features.
The DeFi industry is often classified into different layers, starting with the base layers (infrastructure and blockchain protocols), the assets, and other frameworks, before reaching the consumer layer on top, with which most users interact. Whereas the ICO trend of 2017 seemed more about competing for base-layer blockchain protocols vying to be the next-Ethereum killer, the 2020 DeFi trend seems more about connecting as many existing protocols and assets as possible with a focus on collaboration cross-chain applications. This offers the advantage of specialization, as specific projects can focus on niche use cases, technologies, or markets, after which they can be integrated into multiple platforms for more rapid growth.
Risks and security
DeFi is rapidly developing, but not all projects entering the space have passed through comprehensive security audits and formal verification. Therefore, all users must understand the risks involved with DeFi as bugs, exploits, thefts, and loss of funds through user error are not uncommon in this space. Always exercise best practices with wallet and private key management while investing responsibly to avoid severe losses. Furthermore, many analysts regard some of the protocols and investment practices as entering an investment ‘bubble’ where tokens could quickly devalue in a changing market environment. The purpose of this guide is to encourage responsible use of DeFi platforms rather than mere speculation on future token value.