The Definition of Decentralized Finance (DeFi)
The definition of DeFi
Decentralized finance (DeFi) refers to a wide range of software protocols and tools that give people the power to perform financial transactions––trading, borrowing, lending, and more––without third parties like banks, exchanges, or brokerages.
More than that, DeFi marks a shift from trusting centralized institutions to trusting decentralized, code-based, peer-to-peer networks.
The benefits of DeFi
DeFi offers many benefits in comparison to TradFi (traditional finance, such as banks). DeFi is:
- Inclusive. Crypto and blockchain technologies are open to anyone with an Internet connection, giving financial power to traditionally marginalized groups.
- Permissionless. Crypto networks don’t require approval from centralized institutions to participate, so most people can enjoy unrestricted access.
- Transparent. Crypto networks rely on public blockchains, where transaction data can be viewed by anyone and is immutable, meaning it can’t be changed or tampered with.
- Secure. To interact with DeFi, you’ll need to use a non-custodial wallet, this means you retain control of your private keys and crypto assets and don’t have to put your trust in a centralized entity.
- Fast. While bank transactions settle within 3–5 days, crypto transactions settle in a matter of minutes or hours, increasing how fast money changes hands throughout the financial system.
- Censorship resistant. Because crypto transactions happen on decentralized networks, they can’t be censored or stopped by a single entity. This can protect crypto users from fraudulent activity, government overreach, and more.
- Programmable. Tasks that would traditionally require a human can be automated using crypto smart contracts. This opens up new possibilities for financial products and services and lowers the chances of human error.
The risks of DeFi
With great power comes great responsibility. Risks in DeFi include:
- Loss of crypto keys. As with all crypto custody, if you lose your keys, you can lose access to your crypto funds.
- Actions are irreversible. The user is ultimately responsible for what they do. When you click send on a cryptocurrency transaction, it can’t be undone.
- Phishing scams. Hackers are prevalent in all areas of the internet, misleading emails and messages can trick you into sharing your crypto keys and ultimately finances.
- Unclear regulation. Regulations around DeFi aren’t crystal clear yet, so there’s a risk that crypto assets could be subject to stricter regulations in the future.
- Coding bugs and errors. Smart contracts are code, and code can have vulnerabilities that hackers can exploit. This is called smart contract risk.
How DeFi works
In the current traditional financial system, when you want to open a bank account or take out a loan, you have to go through a centralized institution like a bank.
If the bank can verify your identity, they’ll let you open an account.
If they can establish your creditworthiness, they can decide to grant you a loan.
In both cases, the bank calls the shots.
If you lack proper identification or aren’t “creditworthy” in the opinion of the institution, they can restrict your access to those services or deny you altogether.
DeFi replaces the bank with a series of decentralized applications (dApps) powered by smart contracts.
The definition of a dApp
A dApp is a decentralized application. While standard web applications — like Twitter — run on systems owned by a single organization, in the crypto world, dApps operate on public blockchain networks, which are open-source, and therefore not controlled by one single authority.
DApps work on their own and usually consist of multiple smart contracts.
What is a smart contract?
Smart contracts are computer programs that can automatically execute the terms of an agreement — a loan, a trade, a purchase, and other transactions — when certain conditions are met without the approval of a third party.
Smart contracts follow “if/when…then…” statements written into code on a blockchain, making them self-executing. If a certain event occurs, the smart contract activates and completes the next action in the agreement.
Smart contracts pull in information through DeFi components called oracles that provide data from the real world to blockchains.
For example, say you choose to take out a loan from a decentralized lending platform like Maker. The platform issues you a loan in the form of token Dai, its stablecoin, and puts your crypto collateral (say, Ethereum) into a smart contract.
The terms of the loan — the interest rate, the length of the loan, and so on — are programmed into the smart contract. If you don’t repay the loan in Dai by the due date, the smart contract sells your ETH to repay the debt plus interest.
On the other hand, if you do repay the loan on time, the smart contract releases your ETH back to you.
In traditional finance, all these steps would be completed by a human bank teller or loan officer — and they would probably take days or weeks.
With DeFi and smart contracts, everything happens near-instantly and without any intermediaries.
Step-by-step example of DeFi
Getting a crypto-backed loan through Aave
Aave, a decentralized lending and borrowing platform, is one of the most popular DeFi protocols in existence today. On the platform, you can use crypto as collateral and receive a loan without even giving your name or email address.
If you already own ether (ETH) in your crypto wallet, you can borrow stablecoins and other cryptos against it easily.
- First, connect your Blockchain.com wallet to Aave via WalletConnect: Click “Connect Wallet” then “WalletConnect” then scan the QR code from your Blockchain.com Wallet mobile app and accept the connection.
2. Next, deposit ETH onto the Aave platform. This ETH serves as collateral for loan, or the asset you will borrow against. On Aave, you can deposit over a dozen different cryptos as collateral.
3. With your ETH deposited, the smart contract will let you borrow up to 60% of its value in stablecoins like USD Tether (USDT), USD Coin (USDC), and other cryptocurrencies.
4. As long as your loan stays below 60% of your collateral’s value, Aave will keep your loan open and charge interest. If your loan’s value goes over the 60% threshold, the smart contract will automatically sell, or liquidate, your crypto to repay the loan.
5. Finally, the user can end the loan by repaying the amount of the loan plus interest. As soon as that transaction clears, the user can pull all their collateral off of the Aave platform.
The only fees you pay throughout the process are ones to support the Ethereum network. The Aave platform doesn’t charge any other fees or put you through a frustrating approval process.
Examples of DeFi
The crypto community is still experimenting with different ways to use DeFi protocols. Some popular applications include:
Decentralized exchanges (DEXes)
These are marketplaces where you can buy and sell crypto assets without entrusting your funds to a centralized exchange. The most popular decentralized exchange is Uniswap.
On this platform, you can exchange between thousands of cryptos with a few clicks.
Lending and borrowing platforms
These are platforms where you can lend or borrow crypto assets, using cryptocurrency as collateral. One of the most popular lending and borrowing platforms is Aave.
Compliance and Know-Your-Transaction (KYT) tools
These are tools that help crypto businesses meet compliance requirements, such as anti-money laundering (AML) and countering-the-financing-of-terrorism (CFT) regulations. Chainalysis KYT is a popular example of a compliance tool.
Can anyone be denied access to DeFi?
No — crypto networks are permissionless, meaning anyone with an Internet connection can use them. This is one of crypto’s defining characteristics.
Is DeFi trustworthy?
In crypto, users rely on code to be the banker, broker, and lender. With open source software, anybody can inspect it and verify that it works as intended.
That said, smart contracts are only as good as their code. There have been a few high-profile hacks in the DeFi space that have lost users millions of dollars. It’s critical to do your own research before using any crypto product or service.
How do prices stay current in DeFi if no one manages them?
To make sure that crypto prices are accurate on the blockchain, DeFi protocols use what are called oracles. You can think of oracles as “crypto price feeds” that provide real-time data about crypto prices to the blockchain.
For example, an oracle might tell a crypto network what the price of Ethereum or Bitcoin is at any given moment to establish the basis for a loan. This is yet another example of a DeFi component replacing what a third party would do — and potentially charge for — in the traditional system.
By using crypto networks and smart contracts instead of centralized intermediaries, DeFi protocols can offer financial services that are available to anyone with an Internet connection — 24 hours a day, 7 days a week.