What is Decentralized Finance [DeFi]?
Often referred to as DeFi, Decentralized Finance a distributed, blockchain-based and inclusive financial system.
Decentralized finance (also known as DeFi) is for sure one of the most valuable achievements of the crypto era. But what does decentralized finance mean?
In this article you’ll find out what decentralized finance is, how it works, the improvements it introduced — compared to the traditional financial system, and its countless use cases.
What Does DeFi Mean?
Decentralized Finance — as the name suggests — is a financial system where no central authority is needed.
Differently from centralized systems, DeFi users have full control over their financial instruments.
To be a part of the centralized financial system, people need to trust third parties.
Think about your bank account: every time you make a transaction you need to verify it with your bank and get their approval. Your bank has access to your funds and account.
In decentralized finance, no one but you has access to your funds: you can use DeFi platforms just by connecting your wallet and approving your transactions. You are the ONLY one who can make decisions concerning your account.
This means that this innovative mechanism solves one of the main problems of the traditional financial space — the need for trust.
DeFi solved the problem by eliminating trust: you maintain sole responsibility over your financial assets.
But is it possible to make a decentralized system work?
Decentralized Finance (DeFi) vs. Traditional finance
Even if blockchain technology relies on distribution and decentralization, there are parts of the crypto space that are very similar to traditional finance — namely, centralized exchanges.
So, it is useful to highlight the main differences between DeFi and the traditional financial system not only to understand why cryptocurrencies and their technology are so different from fiat currencies, but also to fully understand different systems within the same industry.
Decentralized finance brought many improvements to the traditional financial system, especially when it comes to financial inclusion.
Here are some of the most relevant differences between DeFi and traditional finance:
- DeFi is trustless and transparent: as we said, each transaction is performed thanks to smart contracts, so every single operation is directly recorded on the blockchain. Thanks to blockchain explorers, anyone with an internet connection can verify what’s happening on the blockchain. For example, when you make a transaction using the Ethereum network, you can find it on a block explorer like Etherscan. Despite this, you can still benefit from anonymity, since the accounts you find are just a string of numbers and letters that represent the public address of an account. This, and the fact that smart contracts don’t execute if their rules are not met, make the whole system trustless — for instance, you don’t need to worry about your counterparty’s delays in payments. That’s how DeFi managed to eliminate intermediaries: you’re in full control of your assets.
- DeFi is inclusive: as long as you have an internet connection, you can have access to DeFi platforms, DeFi trading, DeFi services. In a few words, you can get access to financial services and accounts even if you don’t have a good credit score or history. If we think of the number of people who don’t have access to financial services around the world, and to what this implies, it’s safe to assess that DeFi gives real opportunities to people.
- DeFi usually allows for faster transactions than CeFi: depending on the blockchain, your transactions can be finalized in seconds or minutes — and if you’re willing to pay higher fees, you can get even faster transactions in most cases.
An Introduction to Smart Contracts
Smart contracts can be traced back to Nick Szabo, a cryptographer who had this idea at the beginning of the nineties.
The kind of contracts ideated by Szabo — who later on created Bit Gold — were “smart” because they didn’t need any third party to be executed. Once again, trust was the main issue to address.
Smart contracts are just strings of code that run on a network controlled by many computers — or nodes: that’s why we say that the system created on top of these contracts is decentralized, or distributed, because it is managed by many people rather than one single head.
Smart contracts became successful thanks to Ethereum: more than Bitcoin, the Ethereum project is based on a flexible system, whose infrastructure is made of a high-level programming language.
It’s Turing complete, meaning that you can use its programming language to code anything and to solve any computational problem, and this makes the network particularly flexible and feasible to program anything.
The whole crypto space is trustless in the sense that any crypto transaction is recorded directly on blockchains and is peer-to-peer, but it’s important to point out that while CEXs (centralized exchanges) gather all their users transactions and manage them thanks to a centralized database, DeFi fully respect people’s autonomy: users don’t need third parties because everything is carried out by smart contracts. They are created by developers who use codes to set specific rules: if these rules aren’t met, the contract is not executed.
Each contract runs on the blockchain, so it’s executed automatically, and its fuel is represented by cryptocurrencies — that is, you need cryptos to pay fees and execute each transaction.
In very simple terms, a smart contract is like any traditional contract, but it is “smart” because:
- It’s automated — if the conditions you set are met the contract will produce the required outcome;
- It doesn’t execute if conditions aren’t met;
- It runs on blockchains — so it’s immutable and secure;
- It doesn’t require any third parties and avoids delays.
Developers just need to write the code to set rules and use a decentralized wallet to pay fees in order to send the contract to the blockchain.
To better understand all the implications of this innovative system, let’s make a comparison between DeFi and traditional finance.
Decentralized Finance — Use Cases
After covering the main features of decentralized finance, it’s useful to analyze the main use cases and services offered by DeFi.
Trading
Decentralized trading protocols are undoubtedly one of the most used services offered by DeFi.
Decentralized trading needs further clarifications. In theory, the whole crypto space should be decentralized, because its goal is to make a difference compared to traditional finance. But in reality, also in the crypto space there are platforms that are more similar to traditional financial institutions — that’s why we need to distinguish centralized exchanges (CEXs) from decentralized exchanges (DEXs).
Centralized exchanges — like Binance — are more similar to traditional banks: there is a central authority that sets rules and fees to pay also for the service offered by the platform, and generally you don’t have the keys to your wallets, because you entrust them to the platform.
If this can have advantages — regulatory compliance, support in case of problems with your assets — it’s also true that this kind of exchange can be a barrier for all those people who don’t have the necessary documents and financial instruments to complete verification procedures.
On the other hand, DeFi trading platforms are extremely inclusive — for DEXs, such as Curve, PancakeSwap and KyberSwap, you don’t need to sign up or verify your account, so you don’t need any bank account or proof of address, and this allows anyone to benefit from financial services, since a decentralized swap just needs a DeFi wallet and an internet connection. This verification process is also known as KYC (Know Your Customer).
Borrowing
DeFi lending and borrowing don’t require any intermediaries.
A platform like Aave, for instance, allows lenders to lend their crypto assets to earn interest, while borrowers can use them to ideally make a profit before repaying the loan.
This kind of service is used for many purposes: borrowers can take a loan to increase their capital and invest, or they can take loans to profit from arbitrage opportunities.
In any case, DeFi borrowing and lending are peer-to-peer services, or they are possible thanks to DeFi liquidity pools, where users can provide liquidity that will be used by borrowers.
This kind of service is extremely useful if you compare how hard and costly it is to take a loan by using traditional financial institutions.
Passive Income Opportunities
Lending your cryptos is not the only passive income opportunity offered by the DeFi space.
When we talk about passive income we’re not implying that your investments will for sure be successful — remember that any possible string of income is made up of cryptocurrencies and that they can lose value.
In general, you should always evaluate a project and understand if it’s reliable and if it fits your needs.
This being said, crypto traders and investors often choose another possible source of passive income — staking. Staking is related to those crypto projects that use proof-of-stake blockchains — simply put, those projects reward users just for hodling their cryptos, since this favors the decentralization of the blockchain and a lower supply of their tokens, allowing for a possible increase in price. Also KyberSwap enables users to stake their tokens.
Building
The so-called dApps — decentralized applications — prove that smart contracts can be used to code basically anything. This kind of application runs on blockchain, and — being a part of the DeFi space — they’re completely decentralized — you don’t find any central authority, but a network that manages the blockchain used to build the application.
From a design point of view, it’s hard to tell a dApp from a traditional application, but there are some key features that make it possible to distinguish them:
- dApps are safer, in the sense that it’s pretty hard to hack a blockchain;
- They’re always active and you can’t find points of failure;
- As we mentioned, they’re distributed — even if this is an advantage in terms of security, this also means that they’re harder to update;
- They have an economic system fuelled by cryptocurrencies.
dApps are maybe the best way to prove that blockchain technology is not only about crypto trading and investing: they brought cryptos to the real world, allowing for the creation of complete businesses. The most popular network that allows the creation of dApps is Ethereum.
Benefits of DeFi
Decentralized finance has both pros and cons.
Having full control over your financial assets means that you have more responsibilities: no one can recover your keys if you lose them, and you should take your time to understand how DeFi works — a strong knowledge is always fundamental.
Even if we listed many of the benefits of DeFi throughout the article, let’s recap what decentralized finance has to offer:
- Inclusiveness — this is the first and more relevant benefit of DeFi. According to the latest World Bank’s Global Findex report, around 1.7 billion adults around the world are unbanked people. This means no access to all those products and services that require some financial statement — in many cases, even the possibility to get a job is included. While CeFi still requires this kind of documentation, DeFi eliminated this barrier.
- To further encourage inclusivity, many DeFi projects use DAOs: Decentralized Autonomous Organizations are groups made up of people who can participate in the governance of a crypto project just by holding tokens. Also in this case, the management of the project is distributed, there are no leaders.
- Lower costs: as we said many times, decentralization means no central authorities or third parties. This means that DeFi mainly works on a peer-to-peer basis, allowing for lower costs — since it simply cuts the middleman.
- More use cases: as we said, you can do basically anything with DeFi. From trading to starting a business, the system is flexible enough to support any kind of economic and financial operation — and it constantly improves itself to support more opportunities, further reduce costs and include even more people.
- Full control over your finances — does this imply more responsibilities? Yes, but it also means that no one can tell you that you don’t own your money and your financial assets — and this seems quite a good trade-off.
Final Thoughts
Decentralized finance (DeFi) allows anyone to get access to financial instruments and to have full control over their financial lives.
The blockchain technology managed to give people a trustless system: the DeFi system works using smart contracts, contracts able to auto-execute themselves when all conditions are met, and its full transparency allows everyone to check what’s happening on the blockchain. All this made it possible to create a financial system that doesn’t need users to trust any third party.
All this can seem overwhelming, but the fact remains that the DeFi space is developing tools and applications that allow a larger share of the global population to have access to financial services.
Decentralized finance is constantly improving itself to better meet users’ needs: if you want to stay on top of the developments in the DeFi space, follow our How To DeFi 101 series to get all the info you need.
