What is Decentralized Finance?

Learn everything there is to know about decentralized finance and how it is used!

Decentralized finance (DeFi) refers to financial services executed on public blockchains like Ethereum and Solana.

Primarily, DeFi challenges the centralized financial system, offering the same products (e.g. borrowing, lending, deposits) in a decentralized manner.

DeFi is peer-to-peer (meaning that all transactions are made directly, not through a third party), pseudonymous, and open to all those who don’t want to be a part of the current financial system.

In this article, we’ll dive deep into how DeFi works, what are its benefits and use cases. Enjoy!

How Does Decentralized Finance Work?

DeFi uses a system of security protocols, hardware, and software to facilitate P2P transactions and eliminate intermediaries like banks and other financial companies.

The two main technologies working to make DeFi a thing are blockchains and decentralized applications, or dApps. Let’s take a look at their role:

Blockchain

A blockchain is a secure, distributed ledger where transactions are recorded in blocks.

Once verified, each block is closed, encrypted, and linked to the next one, forming a chain. This structure ensures data integrity, as altering a block would affect the entire chain, making it tamper-proof.

DeFi was made possible after the creation of Ethereum, the first major platform to support smart contracts. Vitalik Buterin, the creator of Ethereum, stated:

Blockchain is not just about cryptocurrencies; it has the potential to revolutionize many industries.

The quote was taken from Ethereum’s whitepaper, in which Vitalik stated that although Bitcoin revolutionized the ability for people to transfer value (cryptocurrency), blockchains can recreate the whole financial sector.

Decentralized Apps

Decentralized applications, or dApps, are software programs that run on a blockchain network instead of centralized servers. Unlike traditional applications, dApps operate on decentralized, peer-to-peer networks, ensuring transparency, security, and resistance to censorship.

In DeFi, dApps play a crucial role by enabling a wide range of financial services without intermediaries like banks or brokers. They facilitate lending, borrowing, trading, and earning interest on assets.

For instance, MakerDAO allows users to lend their assets to others and earn interest, while borrowers can secure loans without a traditional bank.

These applications rely on smart contracts — self-executing agreements coded on the blockchain — to automate and enforce transactions. This automation reduces the need for trust between parties and minimizes transaction costs.

By providing decentralized, secure, and efficient financial services, dApps are revolutionizing the traditional financial system and driving the growth of the DeFi ecosystem.

What are The Benefits of Decentralized Finance?

Decentralized finance offers five main advantages over traditional finance. Let’s review them:

• Transparent: All transactions are publicly visible, providing a level of transparency rarely seen in private corporations.
• Open: No application or account setup is needed; simply create a wallet to gain access.
• Flexible: Users can transfer their assets anytime without needing permission, waiting for long transfers, or paying high fees.
• Pseudonymous: No personal information, such as name or email address, is required.
• Fast: Interest rates and rewards update quickly, often every 15 seconds, and can be much higher than those offered by traditional financial institutions.

Why is Decentralized Finance Important Now?

DeFi offers a digital alternative to traditional financial systems like Wall Street — and that makes it crucial for hundreds of millions of people worldwide.

It allows anyone with an internet connection to access financial services, breaking down barriers set by conventional banks and financial institutions.

With DeFi, users can lend, borrow, trade, and earn interest on their assets without needing a bank. This democratizes finance, giving people more control over their money. There’s no need for a credit check or approval from a bank. One can simply use a digital wallet to interact with various financial services on the blockchain.

DeFi also empowers individuals by reducing the influence of banks and other intermediaries.

In the traditional system, banks hold significant power, deciding who gets loans or access to certain financial products. DeFi shifts this power to the users, making financial services more inclusive and accessible.

Decentralized Finance Use Cases

DeFi has already proved itself as a powerful tool with hundreds of REAL use-cases.

Let’s take a look at some of the most important ones:

Decentralized Exchanges

Decentralized exchanges, or DEXs, are some of the biggest protocols in DeFi and crypto right now.

Exchanges like Uniswap and Raydium handle billions of dollars in trading volume and are slowly approaching the numbers shown by centralized exchanges like Binance and Bybit.

DEXs work just like any other dApp. To start trading, a user must simply connect a crypto wallet with enough cryptocurrency to trade with.

However, in comparison to a CEX, DEXs work entirely differently. Instead of an order book, DEXs use a liquidity pool that derives the price of an asset from the amount of locked assets in its smart contract.

Lending and Borrowing

Lending and borrowing is the largest sector in DeFi by total value locked, with more than $51B worth of assets locked.

Protocols like Aave and Compound work just like a normal bank would, with a small nuance.

All lending and borrowing are made through smart contracts, which means that all transactions are secured by extensive lines of code.

At the time of writing, Aave is the biggest lender in DeFi, with more than $20B in TVL and $9B in borrowed assets across 12 chains.

Yield Farming

Yield farming, also known as liquidity mining, allows token holders to lend their digital assets and earn interest. It is attractive because the interest rates are higher than traditional savings options.

Yield farmers use liquidity pools to earn additional yield and then reinvest it into other pools for more rewards. Platforms like MakerDAO are popular for yield farming, offering a Maker Vault where digital assets are locked as collateral.

Yearn.Finance, a newer decentralized platform, algorithmically finds profitable trades to optimize lending opportunities for token holders.

Closing Thoughts

To sum everything up, DeFi is a peer-to-peer alternative for traditional finance run by banks and other Wall Street institutions.

While the biggest sectors in DeFi are still lending, yield farming and trading, DeFi also offers insurance, market indexes, and much more.