Decentralized finance — also known as DeFi — is at the forefront of much of the innovation happening in the financial world today. Built using blockchain technology it allows consumers to access many of the same services as in the traditional financial system but with more transparency and accessibility.
And as the financial landscape changes, it will create even more services. Using smart contracts and the underlying DeFi architecture, you can borrow money, invest, buy insurance and more.
But how does DeFi actually work? Keep reading to find out the central characteristics of decentralized finance, its uses, and its risks.
What Is DeFi (Decentralized Finance)?
DeFi is an alternative financial system created using blockchain technology. It bypasses middlemen like banks and other financial institutions that serve as gatekeepers.
DeFi allows consumers to do many of the same things as with the traditional financial system but in a more transparent way. It operates primarily using smart contracts, which are automated agreements that self-execute once certain conditions have been met.
How Does DeFi Differ From Traditional Finance?
In many ways, DeFi replicates traditional financial systems. But it relies on technology, not financial institutions, to facilitate transactions.
DeFi allows you to do many of the same activities as with traditional financial system, including:
- Sending money
While DeFi and traditional finance have plenty of the same functions, it all happens entirely differently. Financial institutions and the government run the traditional financial system, while DeFi is run digitally without any central power.
Decentralized finance is generally transparent. Blockchain is based on open-source technology, and anyone can see and audit the code. Consumers know little about what happens behind the scenes of traditional financial institutions.
Another difference between DeFi and the traditional financial system is the lack of permission to both create and participate. In the case of traditional banks, regulations create barriers to entry for new companies. Additionally, because you have to apply and be approved to provide most financial services, few people qualify.
But because DeFi has no such regulations, anyone can join the space and create apps and financial startups. And consumers can take advantage of these services without the risk of being denied entry.
Most traditional financial companies open only during certain times of the day. For example, you can buy and sell stocks only when stock exchanges are open. Consumers can access certain features of their bank accounts only when banks are open. And even during normal business hours, certain activities, such as bank transfers, take days to process.
But DeFi doesn't abide by operating hours. Services are always available, and in most cases, they are nearly instantaneous.
That's not to say there are no advantages to the traditional financial system. The financial industry is heavily regulated. That seems like a burden at times. But it means there are many systems in place to protect consumers from bad actors.
How Is DeFi Built?
Decentralized finance is built on a multi-layered architecture known as a “software stack.” Each layer builds on the others. This creates the system on which all DeFi transactions operate.
Here are the five components of DeFi's architecture:
- Settlement: This first layer forms the foundation that the rest of DeFi builds upon. This layer is made up of the blockchain and its native protocol asset (primarily either Bitcoin or Ethereum).
- Assets: This second layer holds all the cryptocurrencies and other assets of DeFi. This includes NFTs — or non-fungible tokens, explained later in this article.
- Protocol: The standards (protocols) for various tasks and activities make up this layer. Protocols are implemented through smart contracts and are specific to each of the different activities of DeFi, such as crypto exchanges, debt markets and derivatives.
- Application: The application layer allows consumers to easily interact with DeFi. Consumer applications run on the underlying smart contracts and protocols.
- Aggregation: This top layer expands the application layer. In this layer, aggregators bring multiple applications together and facilitate DeFi transactions that require multiple protocols.
What Can You Do With DeFi Today?
As decentralized finance becomes increasingly popular and versatile, the list of things you can do with it continues to grow. Today, it can facilitate many of the same transactions you find in the traditional financial system.
One of the first features that made DeFi attractive is the ability to send money anywhere in the world immediately and affordably. In the traditional financial system, sending money — especially internationally — can be a long and expensive process. But decentralized finance makes it cheap and easy.
Just as you would use a traditional bank to store your money, DeFi allows you to store your own currency using a crypto wallet. And in an even more recent innovation, services like Donut allow consumers to store their cryptocurrency in what is essentially a high-yield savings account. Your money earns interest as long as you keep it in the account.
Borrow and Lend
DeFi makes borrowing and lending easier and more accessible. Borrowing takes place in two different forms. First, there is peer-to-peer lending. Here, one individual borrows from another. The other type of lending is pool based. With this, multiple lenders pool their money, which borrowers can then borrow.
Unlike borrowing in the traditional financial system, borrowing with DeFi doesn't require you to disclose your identity or be subject to a credit check. But you still provide collateral to ensure the lender is made whole if you don't repay your loan.
DeFi also works well for those who may have a hard time borrowing in a traditional setting. And it allows others to earn a higher return on their cryptocurrency by lending it out.
One of the very cornerstones of DeFi — and what many people know it for — is the ability to buy and sell cryptocurrencies. Centralized crypto exchanges act similarly to traditional stock trading platforms. There's a central power, and you must disclose your identity and deposit assets, often by connecting your bank account. But outside the crypto exchanges, anyone can trade directly with another person without disclosing their identity or depositing funds. Smart contracts facilitate trades, which can take place 24/7.
Cryptocurrencies aren't the only things you can trade on DeFi. Innovators have created tokenized versions of more traditional assets.
You can purchase tokenized versions of traditional stocks, exchange-traded funds (ETFs) and other financial assets.
For example, you could buy a tokenized version of Tesla stock. You wouldn't actually own a share of Tesla, but you would own a token that tracks the performance of a share of Tesla.
Or buy (and sell) NFTs, digital assets that represent real assets. Think of an NFT as a tokenized version of the asset it represents, like how you can buy a tokenized version of Tesla stock. There are NFTs for art, music and more.
Just like you can use the traditional financial system to crowdfund for your ideas, you can use decentralized finance to do the same. Because blockchain technology (and DeFi) is built for transparency, funders can see how their contributions are moving through the system and being used.
Another feature of DeFi is the ability to buy insurance. According to Ethereum's website, DeFi insurance is more affordable, automated, transparent and quicker to pay out. Types of insurance coverages in the works by the company Etherisc provide protection for flight delays, hurricanes, crypto wallet theft, death or illness, and more.
Ethereum and DeFi
Bitcoin and its blockchain technology were the first on the market. But since then, other digital currencies have been created with improved blockchain technology. Ethereum, the second-largest cryptocurrency in terms of market capitalization, uses a blockchain technology that is more suited to a DeFi system. As a result, DeFi is largely built in the Ethereum blockchain.
Ethereum's blockchain technology is easier to use than Bitcoin's. But more importantly, it allows for smart contracts, which most DeFi transactions use. Bitcoin's underlying technology doesn't allow for these smart contracts.
The Ethereum project is currently in the process of creating Ethereum 2.0, which is a set of upgrades designed to make Ethereum technology and DeFi more scalable, secure and sustainable.
How to Build DeFi
One of the central characteristics of decentralized finance is that anyone can participate. As a result, anyone can create and deploy their own DeFi project. There's no doubt that building a DeFi app requires significant skill. According to the Ethereum website, it takes five steps. The process starts with creating the right environment to create and test smart contracts.
- Install Truffle and Ganache.
- Create an ERC20 token.
- Compile the ERC20 token.
- Deploy the ERC20 token.
- Create a FarmToken smart contract.
Visit Ethereum's website for a more in-depth guide to creating and launching a DeFi project.
Is It Safe to Use?
It's important to note that while DeFi is becoming increasingly popular and has more uses than ever before, it still comes with plenty of risks.
First, unlike the traditional financial system, DeFi isn't heavily regulated. Traditional banks follow regulations to protect customers. And if you store your money in a bank and the bank goes out of business, FDIC insurance kicks in to protect your money. If you invest with a broker that goes under, SIPC insurance insures your stocks. But no such protections currently exist for DeFi services.
A second risk of decentralized finance comes with the technology. As with all technology, there is room for error and bugs. And because smart contracts are automated once they are built, errors can't be easily removed later.
Third, DeFi investments come with plenty of risk of losing your money. Cryptocurrencies and other tokens are volatile assets. And because there isn't a long history to look to, it's impossible to know how they'll weather storms and how quickly they'll bounce back after a crash.
benefits of defi
risks and downsides of defi
The Bottom Line
It's impossible to say just how DeFi will expand and grow, but it's likely it will become an increasingly important part of our financial system. Because of the transparency and accessibility it provides, many people trust DeFi more than the traditional financial system. Decentralized finance offers room for more innovation, and we'll almost certainly see it replicating more of the transactions that take place in other areas of our lives.