What is DeFi? — The Rise of Decentralized Finance & Cryptocurrency

Take a minute and imagine sending a letter before the Internet.

You’d write the letter, visit a post office, and the lady behind the counter would verify a whole bunch of information to ensure the letter gets to your friend.

With the introduction of the Internet and email, the middleman, aka the lady behind the counter, became obsolete. The letter’s size, stamps, and postal fees no longer limited your possibilities.

Now, replace the postal office with a bank, the letter size with bank account limits, stamps with rules, and mailing fees with banking fees. In short, imagine the banking system becoming obsolete, same as the post office for sending letters.

In simple terms, that’s what DeFi (short for decentralized finance) is trying to accomplish.

Here, you’ll learn what DeFi is, how DeFi uses blockchain technology, and why it’s the most important thing since the Internet.

What is DeFi and How Does it Work?

DeFi is a financial system that eliminates third parties such as banks from financial exchanges by using blockchain technology.

Instead of using an intermediary that controls the financial flow, DeFi uses P2P (peer to peer) to eliminate the limitations of a centralized system without compromising security.

Most of the people who’ve heard of cryptocurrencies, bitcoin, and blockchain, believe that blockchain technology is decentralized by design. But, blockchain is used both for centralized and decentralized systems.

The most prominent examples of DeFi are DEXs (decentralized exchanges) such as Uniswap (DEX on the Ethereum blockchain) that allow users to swap different cryptocurrencies.

DeFi uses DApps (decentralized applications) to operate. Instead of a possibly biased middleman running transactions, an automated program mediates the transactions through smart contracts.

Why is DeFi Important?

Benefits of DeFi:

• You’re in complete control of your money
• A hacker can’t get admin access to your accounts
• DeFi systems such as DEXs can’t be shut down

Complete control means that you can’t wake up one day and realize you can’t access your money because a bank or a government decided to do so.

Furthermore, everybody knows the geographical location and web address of a particular bank. Meaning it’s theoretically possible for someone to rob or hack a bank. If a system is decentralized, there isn’t a single place (physical or digital) a thief can target.

With a centralized system, it’s also possible for the bank to go out of business. In the early summer of 2020, Wirecard, a fintech company based in Germany, filed for insolvency after revealing that almost 2 billion euros were missing due to fraud.

For a month, people using Wirecard services weren’t sure if they’ll see their money ever again. If you weren’t storing your money in a stock, there was a big chance the money was gone forever.

DeFi sounds great, but the system is still evolving, and there are disadvantages you need to know.

Disadvantages of DeFi:

• Scalability
• Interoperability gaps
• Responsibility

By scalability, even the most prominent blockchains such as Ethereum can process fewer transactions in a second than Visa and Mastercard. This can be a hindrance when processing on-chain. But optimistic roll-ups and other off-chain computations can process just as many transactions as Visa etc, and are becoming more prevalent and accessible.

At the moment, there is one primary DeFi network, Ethereum, with a few up and coming players gaining traction, such as Polygon, Solana, BSC, and Tezos. But if you’re using network A, and your friend is using network B, you’d have to take several extra steps to transfer money.

Although the most important, it sounds weird to list responsibility as a disadvantage.

Look at it like this. If you have complete control, it also means you’re entirely responsible for your financial decisions.

The current banking system does have your back in case of fraud or if you forget your PIN. Even in the before-mentioned Wirecard scandal, users were able to get their money in the end thanks to legally mandated insurances.

If someone gets your crypto wallet’s password or seed phrase, your money is gone. If you forget your password, there’s no customer service solution that can help you recover it. Nevertheless, insurance solutions are already built into several DeFi protocols and are quickly becoming a standard.

The current banking system has been perfecting itself for the last 400 years, while DeFi is still young. If the centralized financial system is the 400-year old grandpa, DeFi is a 2-month old baby that’s arguably maturing at warp speed. And as blockchain technology develops, the current disadvantages will become less prominent.

Bottom Line

There’s much more to explore about DeFi and the world of cryptocurrency. While it might sound abstract, keep in mind that every new technology goes through similar phases.

In the initial phase, only the select few can understand what’s going on. However, the more the technology develops, the more accessible it becomes until even your grandparents can wrap their head around blockchain and crypto. At the moment, more and more people are starting to explore the space, including traditional actors. DeFi is also slowly starting to intersect with other sectors of crypto, influencing art nfts, social nfts, and even fashion.

We’re living in a time where we’re bearing witness to something that will shake the world, and most likely for the better. The sooner we start understanding what’s happening, the better.