What is Decentralized Finance (DeFi) and How Does It Work?

The Future of Banking (Image by author)

Decentralized finance, or DeFi, is a new way of providing financial services without relying on centralized intermediaries. This article will explain what finance is, how it is traditionally done, and how DeFi is different and better.

What is Finance?

Finance is a broad term that covers anything related to the creation, management, and investment of money and financial assets. Financial assets are non-physical assets whose value comes from a contractual claim, such as bank deposits, stocks, bonds, loans, derivatives, etc. We also use many different financial services daily, such as banking, lending, borrowing, insurance, funds, etc. and a financial market is a place where financial assets are traded.

How is Finance Traditionally Done?

Traditionally, we rely on centralized financial institutions providing these services. There are different kinds of financial institutions, depending on their services, such as banks, securities companies, fund management companies, etc. You can find more details in Title 33 of the United States Code. These financial institutions have some common characteristics:

  • They hold custody of customers’ funds and assets. For example, the money in my bank account is controlled by my bank.
  • They act as intermediaries for transactions. For example, if I want to send money to a friend’s bank account, my bank will communicate with his bank and transfer the money between them.
  • They have a lot of power and control over the transactions. For example, they can freeze someone’s account if they suspect illegal activities or charge fees for their services.
  • They are highly regulated and have to follow strict rules and regulations for onboarding and compliance, such as KYC (Know Your Customer), AML (Anti-Money Laundering), and CFT (Combat the Financing of Terrorism).

As a result of how these services are provided, the customers have no privacy from the service providers. For example, my bank knows my real identity and transaction history. However, the customers need more transparency from the service providers. The information and records are kept inside their databases and applications and are not easily accessible or verifiable.

Banking (Image by author)

How is DeFi Different and Better?

DeFi is a new way of providing financial services without relying on centralized intermediaries. DeFi uses smart contracts, programs that run on public blockchain platforms such as Ethereum. Smart contracts can execute complex logic and rules without human intervention or intermediation. DeFi applications are built on top of these smart contracts and offer various kinds of financial services such as lending, borrowing, trading, insurance, funds, and so on.

DeFi has some advantages over traditional finance:

  • It gives users complete control and custody of their funds and assets. For example, I can store my money in a digital wallet that only I can access.
  • It eliminates intermediaries for transactions. For example, I can send money to a friend directly through a peer-to-peer network without involving banks.
  • It reduces the power and control of the service providers over the transactions. For example, no one can freeze my account or charge me fees without my consent.
  • It is open and permissionless. Anyone can access DeFi applications without going through any gatekeepers or regulators.
  • It is transparent and verifiable. All the information and records are stored on the blockchain, which is public and immutable.

DeFi is not without its challenges and risks. Some challenges include scalability, usability, security, interoperability, regulation, education, etc. Some hazards include smart contract bugs or exploits, user errors or mistakes, market volatility or manipulation, etc.

DeFi is still a nascent and evolving field with a lot of potential to transform how we do finance. If you are interested in learning more about DeFi or trying out some DeFi applications, you can check out some of these resources:

  • DeFi Pulse: A website that tracks the total value locked in DeFi applications across different categories.
  • DeFi Llama: A website that tracks the total value locked in DeFi applications across blockchains.
  • DeFi Rate: A website that provides information and reviews on various DeFi applications.
  • DeFi Prime: A website that provides news and analysis on DeFi topics.

How Public Blockchains and Smart Contracts Enable Decentralized Finance (DeFi)

Traditional finance relies on centralized institutions that hold our funds, act as intermediaries, and have much power and control over our transactions. We have to trust them to operate correctly and securely.

In 2008, an anonymous person or group named Satoshi Nakamoto published the Bitcoin white paper. This started a new era for public blockchains. Public blockchains are distributed ledgers that allow nodes that do not trust each other to maintain an immutable ledger.

Bitcoin was the first technology to let user self-custody their money as a digital currency. It created a public and open system that keeps secure and permanent records and transactions. In 2014, Ethereum was proposed as a more advanced system that could run different applications on its platform. Ethereum uses smart contracts, programs that execute complex logic and rules. This enabled a new way of creating and managing money and financial assets, called open, programmable money. This also led to a new type of economic infrastructure called decentralized finance (DeFi).

DeFi is a stack of open, permissionless, and interoperable applications that run on public smart contract platforms. To determine if an application is DeFi, we can use a three-step process that looks at three aspects of decentralization: custody and settlement, transaction execution, and governance. First, we check if users can custody their assets. If not, then the application is not DeFi. If yes, we move to the second step, checking if anyone can censor or stop a transaction. If yes, then the application is not DeFi. If not, we move to the third step, which is to check if the rules and parameters of the application can be changed by one entity or a small group. If yes, then the application is not DeFi. If not, then the application is DeFi.

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Disclaimer: This content is for educational purposes only and should not be considered financial or other advice. Always do your due diligence before investing.

What is Decentralized Finance (DeFi) and How Does It Work? was originally published in The Dark Side on Medium, where people are continuing the conversation by highlighting and responding to this story.

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