DeFi 101: What is Decentralized Finance & How Does It Work?
Part 1: Intro + Pros & Cons
Lately, it seems like a million blockchain buzzwords are being used all over the place.
Decentralized finance, cryptocurrency, immutable ledger — what does it all mean?
Decentralized finance (DeFi) is an umbrella term referring to a network of products, services, and investors that are moving away from traditional finance (TradFi) in favour of a less centralized alternative. DeFi offers greater financial accessibility— albeit with a hefty technological learning curve— that can be enormously beneficial.
It’s time to disperse the mystery surrounding DeFi.
From defining terms to explaining how it works, what technologies it uses, and several of its key use cases, this is your turn-key guide for everything you need to know to get started with Defi.
Keep reading to learn about the new financial system taking the world by storm.
What is Decentralized Finance (DeFi)?
Decentralized finance — or DeFi for short — is an approach to finance that enables peer-to-peer transactions and financial services without the use of a financial intermediary, such as a bank or broker.
The term DeFi is often closely associated with cryptocurrency.
However, DeFi and cryptocurrency are not synonymous. Both DeFi and crypto use blockchain technology (more on that in a moment) to build and support financial services.
When comparing the two, cryptocurrency refers to digital currencies that are built and stored on a specific blockchain, such as Bitcoin or Ethereum. Meanwhile, DeFi is more of an umbrella term used to describe several different kinds of blockchain-based products (digital assets), services (buy/sell) and operations (smart contracts).
Understanding DeFi: What is Blockchain Technology & Which Chains Support DeFi?
To truly understand DeFi, you first need a good understanding of blockchain technology.
For anyone new to the DeFi or blockchain space, learning what blockchain technology is and how it works is crucial for understanding the products and services available to you.
Blockchain technology is a special type of database known as a distributed database (also called a distributed ledger) that stores information in blocks. These blocks, once filled, are linked together using cryptography, forming the blockchain.
Rather than existing on one large, central computing network, blockchains are decentralized and stored in multiple different computer nodes found across a connected network. Each node has a copy of the blockchain ledger, creating a secure record that cannot be tampered with.
Although DeFi can technically exist on any public blockchain, the primary blockchain used for DeFi purposes is the Ethereum blockchain (home to the Ethereum cryptocurrency).
The term “DeFi” was even first coined by Ethereum developers, with the oldest example of a DeFi project on Ethereum being MakerDAO — a protocol developed in 2014 that enables the generation of a decentralized stablecoin called Dai. As such, the majority of DeFi activity currently occurs on Ethereum.
A whole lot more goes into the operation and management of blockchain technology, but these are the basics you need to know in order to gain a better understanding of DeFi and its origins.
The Advantages & Benefits of DeFi
One of the biggest advantages of DeFi is in the name itself — decentralization.
Decentralization allows individuals to maintain total control and authority over their digital assets, be those cryptocurrencies, NFTs, stablecoins, or any other blockchain-based product.
True decentralized products and services should be non-custodial, meaning that there is no third-party helping to store or manage these products or services on behalf of the owner. However, as blockchain has entered further into the mainstream, custodial options have become available wherein a person relies on a third party to assist in the storage and management of their digital assets.
We discuss the risks of custodial solutions more in the next section on the disadvantages of DeFi.
Other key benefits of DeFi include:
- Financial Accessibility: When talking about DeFi accessibility, we generally mean one of two types of accessibility — technological accessibility and financial accessibility. While technological accessibility can be a bit of a hurdle for beginners, the financial accessibility of DeFi is exceptional. Using a DeFi product or service does not require you to own an official bank account with a centralized authority, making it possible for traditionally unbanked populations to gain greater access to financial services.
- Lower Fees: When you store money and other assets in traditional financial accounts, these accounts can be subject to a variety of fees depending on what actions you take, as well as the terms of agreement provided by the issuing financial institution. On the other hand, though there can be transactional fees associated with DeFi, there are much fewer overall fees to pay. This also grants you greater control over what you do with your assets without having to ask a third party for permission or submit time-consuming applications.
- Transparency: Blockchain and DeFi technologies have the characteristic of being immutable, preventing the ledger’s records from being tampered with, reversed, or falsified. Thanks to the nature of cryptography, this allows transactional histories to be fully transparent and public without revealing any personal information about the person who owns a specific asset.
The Disadvantages & Risks of DeFi
Though there are many tremendous advantages to DeFi, the technology is not without risks.
A major risk that all DeFi investors need to be aware of is the market risk associated with blockchain-based assets. Crypto markets are highly volatile and can have a significant impact on the value of other assets that are associated with a specific cryptocurrency.
Here is a breakdown of the additional risks and disadvantages of DeFi:
- Technologically Complex: In the advantages of DeFi section, we discussed the benefit of financial accessibility. Unfortunately, this advantage is somewhat countered by a lack of technological accessibility associated with DeFi. For the average consumer, figuring out how to access DeFi and the Ethereum blockchain can be a challenge, especially if they lack the equipment (secure computer network, digital wallet, etc.).
- Vulnerable to Exploits: DeFi offers an open-source code that allows anyone to view the code. While this makes it possible for all people to participate in DeFi, it also makes it possible for unsavoury characters with tech experience to exploit flaws and errors in the code. In the worst-case scenario, this can lead to major digital asset thefts. For example, in the U.S., the Federal Bureau of Investigation (FBI) reports that upwards of $1.3 billion in crypto was stolen between January to March 2022, largely due to flaws in smart contracts provided on DeFi platforms.
- Lack of Regulation: For many DeFi enthusiasts, the lack of centralized regulation surrounding blockchain is viewed as a positive. However, a lack of regulation also means a lack of consumer protection, which can ultimately lead to scams and other activities that would be deemed criminal in a centralized system. This makes it critically important to be aware of potential scams (like rug pulls) and to always complete thorough due diligence before investing. (DYOR–Do Your Own Resarch.)