A Beginner’s Guide to Decentralized Finance (DeFi)

Decentralized finance (DeFi) is a digital world in which financial transactions are made outside the control of governments and banks. Read on to find out what is DeFi, how it works, and how you can use it.

What Is Decentralized Finance?

Let’s start with a definition of decentralized finance. Decentralized finance (DeFi) is a way to conduct financial transactions without going through conventional channels like banks. It’s a lot like cryptocurrency, where instead of a currency that is issued by governments and managed by banks, it’s issued and traded by independent people – what we call peer-to-peer.

Or, to make it even simpler, think of crypto as a currency that is under no authority and not controlled by any single body. Now imagine being able to lend that currency, borrow that currency, invest that currency, or even buy a house or car with that currency – and doing it all without a bank’s permission, paperwork, wait times or fees.

That’s decentralized finance.

When finance is centralized, it’s because it’s under the authority of central banks, e.g., the United States Federal Reserve, the Bank of England, the European Central Bank, etc. Those central banks ultimately control their countries’ currencies. They determine how much of the currency there should be, and they determine the costs of lending and borrowing the currency. So, when you go to a bank to take out a loan and the bank offers you a certain interest rate, part of that rate is determined by the country’s central bank.

Centralized finance also involves many corporations who take their share of the profits as well, so that almost any financial transaction you make involves many third parties.

Let’s say you want to pay your cable bill with your credit card. When you submit your credit card information, it goes through the payment processor to the merchant acquirer to Visa or Mastercard to the card issuer, and then eventually to the cable company’s bank account. Each one of those parties takes a cut.

But when finance is decentralized, it means that central banks and corporations have no control over it. A financial transaction just involves you and the other party.

Simple, right?

How Does Decentralized Finance Work?

  • Blockchain

DeFi and crypto are both powered by the same technology: blockchain.

Blockchain technology is what makes cryptocurrency and finance decentralized. The data are not stored on any central server. Instead, the data are broken up into pieces, encrypted, and stored in “blocks”, which are hosted on a global, peer-to-peer database. This makes them very hard to hack or tamper with.

The peer-to-peer part is key. It means that each datum is verified by more than one user before it is encrypted and stored.

  • Smart Contracts

DeFi also runs on the type of blockchain technology used by Ethereum, which allows for the creation of “smart contracts”. Smart contracts are digital agreements between two parties which are programmed to honor pre-set conditions. For example, you can bet another user that you’ll pay him a certain amount if Coco the Clown runs for president in the next election. The smart contract is encrypted on blockchain and is available publicly but cannot be altered. If Coco the Clown does indeed run for president, the funds will automatically be transferred, and the smart contract will be closed.

So, let’s say that you want to take out a loan. In the world of DeFi, an algorithm would match you up with another individual who is willing to lend that amount of money. When you both agree on terms, a smart contract would automatically be encrypted and stored on blockchain.

The idea of DeFi is that you can theoretically get that loan with better interest rates, no third-party fees, no approval wait times, no guarantors, and no collateral. Since it’s all stored on blockchain, if you can’t meet the obligations of the loan, the lender, in theory, could just take their funds back. The lender also doesn’t have to wait very long for a payout, because everything is done instantaneously.

Why use DeFi?

Advantages of Decentralized Finance

DeFi has many exciting perks. It’s a new concept, so not everything has been put into practice yet. But here are some advantages of decentralized finance:

  • Transaction times are faster.
  • You don’t need to wait for a bank to approve the transaction.
  • You don’t need to rely on third parties, such as guarantors, brokers, government entities, or even escrow.
  • Without third parties, you don’t have third-party fees.
  • You have more access to financial services since there are less roadblocks and requirements.
  • You have more control over the terms of a transaction.
  • The transaction and funds are more secure – it’s likely easier to hack into a bank than it is to hack into a digital wallet on blockchain.

Advantages of Decentralized Finance

As mentioned, DeFi is a relatively new idea, so there are still a few kinks to be ironed out. For example:

  • There is no authority or regulator to prevent or prosecute financial crimes.
  • There aren’t enough history and data about DeFi transactions to be able to assess financial risk.
  • No regulation also means less consumer protection.
  • If you think cryptocurrency is volatile, imagine how volatile a brand-new concept like DeFi can be.
  • New markets attract new players, and crooks are always among them.

Is DeFi Safe?

There are many things that are safe about DeFi, such as the inherent data security that comes with blockchain technology. Also, the fact that transactions are done with cryptocurrencies and stored in digital wallets means it’s much harder for them to be stolen or compromised because of identity theft. Keep in mind that DeFi not being under the control of governments and banks (for now) brings its own degree of safety as well - remember 2008? You have more control over the terms of your financial transactions and more choices.

On the other hand, having no government or regulatory body involved leaves quite a few vulnerabilities. For one, there are some very smart scammers out there, and there’s no one to turn to if you become their victim. Second, with no anti-money laundering or anti-terrorism regulations, financial crime is a lot more feasible in the DeFi space. Third, there’s no established mechanism to protect consumers, which means you need to be extra vigilant when you transact with unknown individuals.

You also need to remember that DeFi is a very new concept, and with newness comes volatility and risk. Cryptocurrency has its own volatility and can shoot like a rocket or drop like a stone at a tweet from Elon Musk. With DeFi so linked to the crypto world and being so new, it’s not too far off to imagine that it can be very unpredictable.

What’s the Difference Between DeFi vs Traditional Finance?

Here are some key differences between DeFi and traditional (centralized) finance:

  • In DeFi, all financial services are available to you, whereas in traditional finance you need to qualify and be approved for many services (even a bank account).
  • In DeFi, transferring funds is instantaneous, whereas in traditional finance a transfer can take days if not longer.
  • In DeFi, you hold and control your funds, whereas in traditional finance they’re held by a bank or a company and can be used in ways they see fit.
  • In DeFi, markets are open 24/7. In traditional finance, markets have opening and closing times.
  • In DeFI, you have a certain degree of anonymity, whereas in traditional finance your identity is tied to every financial transaction.
  • In DeFi, products are transparent and can be inspected, whereas in traditional finance you can’t really inspect anyone’s “secret sauce”.
  • In DeFi, you can conduct a transaction with anyone who accepts your terms. In traditional finance, you’re usually limited by banks and corporations who set their own terms.
  • DeFi is unregulated, while traditional finance is.
  • DeFi cuts out the middleman, whereas traditional finance usually involves multiple third parties.

What Can You Do with DeFi?

Since DeFi is open source – meaning the programming code is public and available – anyone can program an application to be used in DeFi, just like someone can program an app for a mobile phone. These are called “decentralized apps”, or “dApps”.  These dApps enable you to do different things in DeFi and different ways to profit from DeFi.

By now, you’re probably asking yourself how you can make money with DeFi. Here are some ways you can do that:

  • Store money in digital wallets with higher interest rates
  • Send or receive money anywhere in the world, instantly
  • Borrow or lend money peer-to-peer
  • Crowdfunding
  • Trade cryptocurrencies
  • Trade tokenized stocks, NFTs, funds, and other financial assets
  • Buy insurance

Final Thoughts

DeFi is still in its early stages, so there’s a lot that’s still unknown. But one thing we do know is that DeFi offers a bright financial future given its almost unlimited possibilities, accessibility, and independence.

However, a lot of the downsides listed above need to be worked out before DeFi becomes mainstream and a viable alternative to traditional finance.

Also, generally, governments hate to be kept out of anything, especially if it involves money. It’s why there’s increased talk of regulating cryptocurrencies, which some countries are already doing. Some countries, like China, have gone so far as to ban cryptocurrencies completely. So, it’s only a matter of time until governments and official bodies try to get their fingers in this pie, which could change the market landscape significantly.

FAQs

How do you make money with DeFi?

There are many ways to make money with DeFi, such as trading cryptocurrencies, tokenized stocks, NFTs or other financial assets, borrowing or lending money and crowdfunding.

How much money is locked in DeFi?

DeFi’s total value locked (TVL) is estimated to be over $240 billion.

How big is DeFi?

The DeFi market’s total value locked is over $240 billion, and DeFi currently accounts for almost the entire cryptocurrency market in terms of price changes.

Is DeFi a company?

No, DeFi is more like a “universe” in which companies can operate.

Is DeFi an Ethereum?

No, DeFi is powered by Ethereum’s blockchain technology.

Does DeFi grow?

DeFi is a fast-growing industry, having grown an estimated 335% in just two years.

Gabriel Sherman
Gabriel joined the team at DailyForex in 2020. Gabriel had previously worked as the national sales manager for a payment processing company, where he edited the marketing materials. After obtaining a degree in Communications from the Interdisciplinary Center of Herzliya, Gabriel helped mortgage and insurance brokers and fintech companies become authorized by the Financial Conduct Authority, and edited the company website and documents.

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