What is DeFi? Decentralized Finance Explained

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Crypto and blockchain are new decentralized finance (DeFi) technologies that push the boundaries of finance and aim to disrupt the current financial system. In simple terms, DeFi involves ways to transfer funds and transact without the use of a centralized intermediary. 

What is Decentralized Finance (DeFi)?

DeFi is a broad term that encompasses projects that use blockchain technology to help users transact. The key difference between DeFi and centralized finance is that DeFi does not have a centralized intermediary as part of its transaction process. For example, if you send your friend money via a wire transfer, the funds have to go through a bank. The bank may charge fees or hold the funds for some time, creating inefficiencies. However, DeFi allows users to send funds directly to another person, a process called peer-to-peer transacting. 

DeFi is possible through the use of smart contracts, which typically replace the need for trust with the use of collateral. By requiring collateral, parties are incentivized to behave properly without anyone watching over them. Smart contracts hold collateral in escrow and can handle defaults and successes automatically for negligible cost. 

Smart contracts are stored and executed on a blockchain for safekeeping. Since these blockchains are decentralized, no one entity can control the financial functions that are executed on-chain. 

Why is DeFi Important?

The current banking and financial system has some flaws, particularly as it relates to inefficiency. Other issues include a lack of transparency, lack of standardization across borders and human error. While the current system works for many, crypto enthusiasts see room for improvement. 

That’s where DeFi comes in. By allowing for full transparency and standardization and removing the human decision-making aspect, DeFi could solve many of the problems seen with the current financial system. 

DeFi uses the blockchain to operate. The blockchain is an unchangeable ledger that stores all the information of transactions on the blockchain. It is viewable by anyone and standardized. For example, all users on the Ethereum chain can transact with any other user on the Ethereum network, facing the same rules and abilities.

These factors could lead to massive improvements in the banking sector if executed and used correctly.

How Decentralized Finance Works

Traditional financial services employ thousands of people, incurring huge expenses to offer products and services. Banks also need to rely on the legal system to handle disputes. DeFi replaces employees and the legal system with smart contracts on the blockchain, drastically reducing operating expenses to provide products many deem superior to traditional bank counterparts. 

These smart contracts use rules to automate tasks. For example, one potential use is in the insurance industry. Smart contracts could be used to automate claims, allowing for faster payouts and a better customer experience. 

DeFi Applications

Now that you have a basic understanding of DeFi and how it works, let’s take a look at some of the ways it is being used today.

Decentralized Exchanges (DEXs)

Decentralized exchanges (DEXs) allow the permissionless exchange of cryptocurrencies. DEXs use one of two methods to make a market: order books or liquidity pools.

The order book method of exchange has been used by centralized finance (CeFi) for a long time. An order book provides the exchange of assets so long there is supply and demand at the same price point. This type of structure pairs buyers and sellers of each asset, and an investor can buy or sell an asset at the highest bid or lowest asking price. On a DEX, funds are exchanged directly between counterparties, eliminating the need for funds to go through a centralized institution.

For liquidity pools, let’s take a look at an example. Uniswap runs on the Ethereum blockchain and facilitates the exchange of Ethereum-based tokens for a small fee. Uniswap offers users the ability to exchange Ethereum-based cryptocurrencies instantly by tapping into its smart contract liquidity pools. These liquidity pools are funded by other users who earn exchange fees for providing this liquidity.

Stablecoins

A stablecoin is a cryptocurrency whose value is tied to another asset, most commonly the U.S. dollar. Let’s look at the two biggest stablecoins, USDT and USDC.

• Tether: Tether was launched in 2014 and is the biggest stablecoin by market cap. Tether issues one of its USDT tokens for each dollar staked. USDT is not issued by smart contracts, but the central Tether is in charge of making sure each Tether is properly backed. It’s important to note that the Tether team was under investigation by the New York Attorney General for issuing more Tether than USD backing it, but the investigation was settled in 2021. 
• USD Coin: USD Coin (USDC) was created by Coinbase in response to the issues arising within Tether. Unlike Tether, USDC is voluntarily regulated by U.S. financial institutions. Coinbase has never supported Tether exchange on its platform, and now it aims to capitalize on Tether’s legal issues.  

Lending Platforms

Decentralized lending can offer higher interest rates than centralized lending with better security and anonymity.

For the protocol to work, borrowers must offer collateral greater than the amount they borrow into the loan smart contract. The smart contract safely holds collateral throughout the term of the loan, replacing the need for a trusted intermediary. 

Should the borrower default, the lender receives their funds back, and the smart contract will automatically settle the dispute.

With this level of over-collateralization, projects can offer over 10% APY for certain stablecoin loans without know-your-customer (KYC) requirements, which would be nearly impossible in traditional finance.

How to Make Money From DeFi?

Other ways to use DeFi to earn rewards and make money exist.

• Staking: Some blockchains use staking to help secure and process transactions. This process involves giving some tokens as collateral in exchange for the right to verify transactions and receive rewards.
• Airdrops: Some projects reward early adopters of projects by giving them tokens for free, in an event called an airdrop. While they can be hard to find, these can be lucrative.
• NFTs: Non-fungible tokens (NFTs) are a relatively recent phenomenon in the crypto world and present a unique investment opportunity. Investors can buy and sell NFTs to potentially earn a profit.

Benefits of DeFi

• Security: Without human interference and public information, DeFi applications can benefit from the added security allowed by blockchain.
• Rewards: Through over-collateralization and peer-to-peer transactions, crypto users can earn large rewards and pay smaller fees than with traditional banks. 
• Accessibility: Since DeFi allows for cross-border transactions, virtually anyone with a device and an internet connection can access the projects.
• Efficiency: Without an intermediary to slow down processes, transactions can occur much faster and with lower fees, which could ultimately make banking and finance more efficient. 

Downsides of DeFi

• Lack of regulation: DeFi is new, so regulators are still gathering information and trying to parse out what regulation could look like.
• Phishing scams: While DeFi is mostly used for good reasons, there are also a handful of people who look to make money by scamming others. These scams usually involve using deceitful practices to gain access to wallets and then send the funds to themselves. Without regulation, there is often nothing you can do to get your funds back.

DeFi: Finance for the Future

New technologies have continually pushed the frontiers of what is possible, allowing people to become more efficient and connected. While there is much debate, some see DeFi as potentially changing the way people transact daily. Through the use of novel technologies, it could benefit society. Only time will tell if these potential benefits will be realized.

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