DeFi 101: What is decentralised finance and how does it work?

Blockchain terminology can be confusing at first, especially for new users.

Decentralized finance, cryptocurrency, immutable ledger — what does it all mean?

Decentralised finance (DeFi) is an umbrella term for blockchain-based financial applications and services that aim to operate without traditional intermediaries. DeFi can increase access to certain financial services, but it can also involve a steep learning curve and material risks.

This article defines core terms, explains how DeFi works, and outlines common technologies and use cases.
 

Decentralised finance (DeFi) refers to financial services delivered through smart contracts and blockchain networks, often reducing reliance on traditional intermediaries (such as banks or brokers). 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).
 

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 is a type of distributed ledger where transactions are recorded in blocks that are linked together cryptographically. 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. Many nodes keep copies of the ledger, creating a record that is designed to be tamper-resistant, although no system is risk-free. DeFi exists on multiple public blockchains. Ethereum is one of the largest DeFi ecosystems, but other networks also support DeFi applications.

The term “DeFi” became popular within the Ethereum ecosystem. MakerDAO is an early Ethereum-based protocol associated with Dai, a value-referenced crypto asset.  A significant share of DeFi activity occurs on Ethereum, although activity varies by chain and changes over time.
 

One of the biggest advantages of DeFi is in the name itself — decentralization. Decentralisation can reduce reliance on a single intermediary, and in non-custodial setups users control the private keys used to access and move assets. 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 the 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: Many blockchains are designed to be tamper-resistant and publicly auditable. However, reversals and corrections can occur in limited circumstances depending on the network and application. 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.

Though there are many advantages to DeFi, the technology is not without risks. A major risk is market volatility, which can affect crypto assets used in DeFi applications. Crypto markets can be volatile and price moves can affect DeFi positions, collateral values, and outcomes in smart-contract-based applications.

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: Many DeFi protocols are open source. While transparency supports review, bugs or design flaws can still be exploited and lead to losses. In the worst-case scenario, this can lead to major digital asset thefts.
• 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 means users should be cautious about scams (including rug pulls) and understand protocol risks before using DeFi applications.