Decentralized Finance, also known as DeFi, uses cryptocurrency and blockchain technology to manage financial transactions. DeFi aims to democratize finance by replacing old, centralized institutions with peer-to-peer relationships that can provide a full range of financial services, from everyday banking, loans, and mortgages, to complex contracts and asset purchases.
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Today, almost every aspect of banking, lending, and trading is managed by a centralized system backed by government agencies. Consumers must deal with a series of financial intermediaries to access everything from car loans and mortgages to stock and bond transactions.
In the US, regulators such as the Federal Reserve and the Securities and Exchange Commission (SEC) set the rules for the world of central financial institutions and stock exchanges, and Congress modifies the rules over time.
As a result, there are few channels for consumers to access financial services directly. They cannot bypass intermediaries such as banks, stock exchanges, and lenders, who earn a percentage of every financial and banking transaction for their own profit.
DeFi challenges this centralized financial system by essentially disempowering middlemen and empowering everyday people through peer-to-peer exchanges.
This can be done like this, today, you can put your savings into a savings account and earn 0.50% interest on your money. The bank then turns around and lends that money to another customer at 3% interest and keeps 2.5% as profit. With DeFi, people lend their savings directly to others, reducing the 2.5% profit loss and earning the full 3% return on their money.
You might be thinking, “Yeah, but I already do that when I send money to my friends with PayPal, Venmo, or CashApp.” But you don’t. You still have to have a debit card or bank account linked to these apps to send the money, so these peer-to-peer transfers to friends still rely on central financial intermediaries to go through.
Blockchain and cryptocurrency are the key technologies that enable decentralized finance.
When you make a transaction in your account, your banking history is recorded on a private ledger owned and managed by a major financial institution. Blockchain is a decentralized, distributed public ledger where financial transactions are recorded in computer code.
When we say that blockchain is distributed, it means that all people using a DeFi application have the same copy of the public ledger, which records every transaction in encrypted code. This secures the system by providing users with anonymity, as well as payment verification and a record of asset ownership that is (almost) impossible to change by illegal and malicious activity.
When we say that the blockchain is decentralized, it means that there is no middleman managing the system. Transactions are verified and recorded by people using the identical blockchain, through a process of solving complex mathematical problems and adding new transaction blocks to the chain.
Proponents of DeFi argue that decentralized blockchain makes financial transactions secure and more transparent than the private opaque systems used in centralized finance.
DeFI taps into a wide variety of simple and complex financial transactions. It is powered by decentralized applications called “DApps” or other programs called “protocols”. DApps and protocols handle transactions in the two main cryptocurrencies, Bitcoin (BTC) and Ethereum (ETH).
While Bitcoin is the most popular cryptocurrency, Ethereum is much more versatile for a wider variety of uses, which means that a large number of DApps and protocols use Ethereum-based code.
Here are some of the ways DApps and protocols are already being used:
- Traditional financial transactions. Everything from payments, securities and insurance, to lending is already happening with DeFi.
- Decentralized exchanges (DEXs). Currently, most cryptocurrency investors use centralized exchanges such as Coinbase or Binance. DEXs facilitate peer-to-peer transactions and allow users to be in control of their money .
- E-wallets. DeFi developers create digital wallets that can operate independently of larger cryptocurrency exchanges and give users access to anything they want, from cryptocurrencies to blockchain-based games.
- Stablecoins. While cryptocurrencies are highly volatile, stablecoins try to stabilize their prices in a number of ways.
- Yield harvesting. Also called the “rocket fuel” of crypto, DeFi allows speculators to lend cryptocurrencies and potentially make big profits when said coins they lend to the respective DeFi lending platforms have great lending yields.
- Non-fungible tokens (NFTs). NFTs create digital assets from normally non-tradable assets, such as videos of slam dunks or the first tweet on Twitter. NFTs make these previously untradable assets tradable.
- Flash loans. These are cryptocurrency loans that borrow and repay funds in the same transaction. Does it look weird? Here’s how it works: Borrowers have the ability to make money by entering into a contract encoded on the Ethereum blockchain – no lawyers needed – that borrows money, executes a transaction, and immediately repays the loan. If the transaction cannot be executed or does not make a profit, the money is automatically returned to the lender. If there is a profit, then you keep it, minus any fees. Think of flash loans as decentralized arbitrage.
The DeFi market measures its traction by measuring what’s called locked value, which measures how much money you’re currently using in different DeFi protocols. Right now (July 2021), the total locked value is almost $53 billion.
DeFi is an emerging phenomenon that also brings many risks. As a new innovation, decentralized finance has not been sufficiently tested in long-term or widespread use. In addition, national authorities are looking more closely at these applications, with the aim of establishing some operating regulations. Some other risks in a DeFi are:
- There is no user protection. DeFi has developed in the absence of rules and regulations. But it also means that users may have little recourse if a transaction doesn’t go right. In centralized finance, for example, the Federal Deposit Insurance Corp. (FDIC) compensates account holders for up to $250,000 per account, per institution, if a bank fails. In addition, banks are required by law to maintain a certain amount of their capital as a reserve, to maintain stability, and to cash out your money to you whenever you need it. There is no similar protection in DeFi.
- Hacking. While a blockchain can be nearly impossible to modify by malicious action, other aspects of DeFi are at high risk of being hacked, which can lead to theft or loss of money. All possible uses of decentralized finance are based on software systems that are vulnerable to hackers.
- Collateralization. Collateral is a thing of value used to guarantee a loan. When you get a mortgage, for example, the loan is secured by the home you’re buying. Almost all DeFi lending transactions require collateral equal to at least 100% of the loan value, if not more. These requirements greatly limit who is eligible for many types of DeFi loans.
- Private Key Requirements. With DeFi and cryptocurrency, you need to secure the wallets used to store your assets. Wallets are protected with private keys, which are long, unique codes known only to the owner of the wallet. If you lose a private key, you lose access to your funds – there is no way to recover a lost private key.