What is DeFi (Decentralised Finance)?
By Bahira Maisoon, Updated on: Apr 07 2023.
Decentralised finance (DeFi) is a progressing financial system that is “decentralised” and non-mediated. Here, decentralisation means the system is free from any central regulatory power and anyone can be a part of DeFi. Thus, DeFi is a peer-to-peer, distributed, and blockchain-based method secured with a cryptographic technique.
As our world is driving crazy around technology, several sectors of our life are stretching their hands for implying innovative ideas. Specifically, the financial industry is proliferating with tens of thousands of developments that serve users with necessary features. One of the biggest technologies in finance is definitely, decentralised finance.
Have you ever thought about finance becoming completely decentralised and democratic? How effectively decentralised structure enables users to yield profit from finance? How well are financial transactions processed without a banking system? Before answering these mind-blowing questions, let’s dive deeper into the basics of decentralised finance.
Imagine a situation where there is no central power regulating our monetary system! In such a situation, central banks or private banks have no power to control finance, and they do not act as a mediator between money holders. This is where decentralised finance or DeFi proudly stands. In simple words, decentralised finance is a system where there is no central power or intermediary body to deal with transacting money and the entire system works on decentralised digital technology, meaning that the power is not on a single institution but rather spread out across the network.
If the DeFi works on a decentralised notion, how does it function properly without any banking system? The answer is, the DeFi system completely works on blockchain technology and cryptocurrency. For those out of the loop, blockchain is a method for storing digital data via an interconnected chain of blocks where data is protected and secured by cryptographic mechanisms.
Besides the above-mentioned definition, DeFi can be well explained as an open-source global financial system that gives users more control and precise details over their money. As an alternative to the traditional financial system, DeFi is a completely automatic, safer, and faster way to buy and send digital assets, namely cryptocurrency. So, in brief, DeFi is a substitute for the traditional banking system and cryptocurrency is a substitute for fiat money (currency). However, to buy any crypto, you need to pay for it using fiat currencies.
How does DeFi (Decentralised Finance) work?
So far, we have learned about all the major concepts of DeFi and its components. Now we need to put all these together to set the wheels in motion.
As previously explained, important technologies deployed in decentralised finance are blockchain, cryptocurrency, and smart contracts. It is a well-known concept that all the transaction details in a traditional finance system are stored in a private ledger that is monitored and controlled by an institution. Likewise, in DeFi, all the transaction history is stored in a ledger, but in a completely public ledger.
In this way, blockchain technology is distributed and all the DeFi users can get an identical replica of the public ledger. As the transactions are stored in an encrypted version, DeFi provides anonymity to users, verified payments, and details of asset ownership.
A Brief History of DeFi
Bitcoin, the first cryptocurrency in the world, was launched in 2009 by an anonymous blockchain developer known by the alias “Satoshi Nakamoto”. DeFi is also claimed to have taken birth during this period, although its creation started years ago.
However, DeFi became more popular in 2017 when the Ethereum blockchain publicised smart contracts.
But, What is a Smart Contract?
Smart contracts are the basis for DeFi and these are irreversible programs on blockchain that execute transactions on a DeFi network. In simple words, a smart contract is nothing more than a simple set of rules (a program) that also relies on the blockchain thus making it safer and immutable (it can’t be changed).
Decentralised Finance (DeFi) Vs. Centralised Finance (CeFi)
|DeFi (Decentralised Finance)
|CeFi (Centralised Finance)
Now, you have imbibed some basic ideas on DeFi and what makes it different from Centralised Finance (CeFi). With this knowledge, let’s move to the unique differences between DeFi and CeFi.
In DeFi, you don’t have to provide all the possible personal data and documents to start a transaction. Instead, all you need is a digital cryptocurrency wallet. Meanwhile, the traditional banking system or CeFi requires personal details and major documents such as proof of identity.
People always like to look for a convenient time whenever they need to handle financial matters. Here is where DeFi outstands CeFi, as users can transact and trade on it at any time. DeFi is open 24/7, whereas CeFi holds limited banking hours as it is human-operated. Subsequently, if you have an internet connection, just sit in your space and earn from DeFi! You don’t have to commute to other locations. On the contrary, traditional banking necessitates the direct presence of the right person for any transactions.
Another pivotal point is that financial services and products on DeFi are accessible to anyone with an internet connection and there is no intermediary power controlling the system. CeFi has a controlling unit, for instance, a private company in the case of a private bank, and central government for government banks.
Transactions on DeFi are faster, more secure, transparent, and cheaper. Despite the fact that security is still a major concern in DeFi and there have been a few hacking cases on DeFi platforms, the security of DeFi systems still stands strong as no central power can make decisions over it to serve its own personal agenda.
In the case of storing funds, DeFi users can have self-custody over their funds, which helps them to ward off fund loss or misuse. On the other hand, CeFi users cannot have custody of their funds as it is controlled by a bank.
As known, digital assets in traditional banks are handled by companies or people, which is contrary to decentralised finance. DeFi uses certain smart protocols to manage digital assets. DeFi protocols are some set of codes that operate digital assets on a blockchain network.
Notably, unlike CeFi, DeFi does not require high transaction fees. To note, in some exceptional cases, some DeFi platforms demand high fees depending on the complexity of a transaction.
One of the most appreciated features of DeFi is scalability. This feature hooks many DeFi users because DeFi can work effectively irrespective of workloads or unfavourable situations. A recent study by venture capital firm Hashkey Capital signifies that DeFi has more scalability compared to a traditional financial system.
The availability of stablecoins is also a driving feature of DeFi. These are the cryptocurrencies pegged to the value of the US dollar and usually do not fluctuate (stable) in price, unlike other coins. Stablecoins are also important on DeFi as it provides stable values for making lending and borrowing coins easy. Besides using other cryptocurrencies, Ethereum also uses stablecoins on its DeFi chain. For instance, DAI is a USD-pegged stablecoin working on Ethereum.
What Can We Do With DeFi?
DeFi service has proven to be a worthwhile source to earn profit. There are several ways through which you can earn income through DeFi.
- Trade Cryptocurrencies
Basically, what you can do on DeFi is trade cryptocurrencies without any intermediaries. You can enjoy all the benefits of DeFi, and sell and buy your coins depending on the market condition. Some traders buy crypto when the market price of that crypto is down, whereas others sell their crypto when the price goes up.
- Earn income through APY
What happens when you store/deposit your cryptos for a particular time on a DeFi platform? The answer is, you are going to earn some passive income out of it, known as Annual Percentage Yield (APY). This process is also called yield farming, and the place where you store cryptos is known as a liquidity pool.
To note, you can withdraw your liquidity at any time. Also, you can earn yields only by storing trading pairs such as BTC-ETH, USDT-USDC, etc.
Unlike, in the yield farming system, DeFi users can stake/lock up their cryptocurrencies for a fixed time and earn rewards. You cannot withdraw your liquidity as per your decision. There is a particular time fixed by a staking platform until which you have to store your cryptocurrencies. Also, you can lock up cryptocurrencies instead of trading pairs.
Some of the coins that allow for staking include Ethereum (ETH), Cardano (ADA), Solana (SOL), and Tron (TRX).
- Lending and Borrowing
You can also earn rewards by lending and borrowing digital assets on DeFi. When you lend cryptocurrencies (liquidities) to a pool, borrowers can borrow from it. These borrowers should pay a specific amount of interest, from which a particular amount will be transacted to the lender.
DeFi enables users to borrow money in two significant ways; one is peer-to-peer and the other is a liquidity pool-based method. In the peer-to-peer method, you can borrow money directly from a lender, whereas, in a pool-based system, borrowers can borrow from liquidities provided by a lender.
- Know the benefits of stablecoins
We know that stablecoins are pegged to traditional assets such as USD and their value is not always volatile as other cryptocurrencies. This feature of stablecoins allows users to earn profit through lending, borrowing and taking stablecoin loans.
- Trade NFTs
NFTs (non-fungible tokens) are unique cryptographic tokens that cannot be owned by any other person other than their creator and are called non-fungible because their uniqueness doesn’t allow them to be mixed with other tokens. Like how cryptocurrencies work, NFTs also rely on blockchain technology and what makes them really special besides monkey photos, it’s the fact that the are a unique and irrefutable signal of ownership over a particular element. Some interesting NFTs use cases are: concert tickets, identity documents, title deeds, artwork, music tracks, etc
Trading NFTs on DeFi also gives income to traders, in the same way, cryptocurrencies generate profits. Let’s say, you can use methods such as staking, lending/renting, and earning royalties for earning passive income through NFTs.
Royalties are rewards or income that go to an NFT creator when he chooses to licence his work, for example let’s say an NFT that owns the soundtrack Sympathy for the Devil by Rolling Stones exists and instead of being published through a label, the Rolling Stones go and self publish their soundtrack on a decentralised music platform. What will happen is that the system will know who is the ultimate and unique owner of that soundtrack and a smart contract will simply attribute royalties to the creator every time the soundtrack is downloaded by simply checking which cryptocurrency wallet owns the NFT for the soundtrack..
- Collateralize your assets
Imagine, if you want to borrow money from banks, you have to keep collateral, from which the bank earns income. Likewise, in DeFi, a borrower places collateral and borrows coins from a lender. The lender can hold the collateral and liquidate it until the borrower pays back the loans.
Collateralization on DeFi is applicable for cryptocurrencies, stablecoins, NFTs, and other digital assets.
Aside from all the mentioned use cases of DeFi, there are certain ways through which you can conduct profitable trading using crypto. In a commercial bank, where you save your money, inflation rates may lead to a decline in the value of your saved asset.
Meanwhile, in a DeFi scenario, you can trade crypto profitably as the value of the crypto you hold may increase. To point out, let’s take Bitcoin, which has the highest value and market capitalization among all other cryptocurrencies. If you buy a Bitcoin at the dip, you can store it and sell it when its price goes up. Thereby, you can earn money by selling Bitcoin at a bullish rally.
Although 2022 was a crypto winter for the crypto market, the late months of 2021 showed an uptrend for all the major digital coins. Bitcoin reached $69,000 during this time. So, the buyers who already purchased a coin before this uptrend and sold when its price reached an all-time high can get a high profit.
In short, cryptocurrencies have high storing value as their price may surge after a tumble down, unlike the fiat currencies in our traditional savings accounts.
Decentralised Exchanges (DEX)
A decentralised exchange (DEX) is a DeFi marketplace where crypto holders meet to buy and sell their coins. DEX deploys all the features of DeFi, such as peer-to-peer and distributed systems, and uses smart contracts for transactions. In simple terms, the exchange happens directly between parties without an intermediary ever holding custody of funds.
Like DeFi and dApps, decentralised exchanges also work on a peer-to-peer, decentralised, and non-mediated mechanism. Reports show that there has been increased usage of DEX since 2021.
To cite an example, Uniswap is a decentralized exchange that works on the Ethereum network. This popular DEX provides you with innumerable tokens and NFTs to trade. A few of the tokens tradable on Uniswap include Ether, Dai Stablecoin, ApeCoin, FunFair, Lido DAO Token, ChainLink Token, and much more. All these tokens are ERC-20 tokens, and any such tokens can be traded on Uniswap.
From the users’ point of view, Uniswap, which is the first DEX on Ethereum, ensures safe and secure transactions. Nevertheless, Uniswap also holds some disadvantages. If you are a person not willing to spend high fees on transactions, then Uniswap is not the correct place for you. In the case of gas fees (transaction fees), Uniswap mostly costs users a high rate due to the busy traffic on the Ethereum network and the complexity of the smart contract transaction.
Decentralised Applications (dApps)
Decentralised applications or dApps are digital programs that work on a peer-to-peer blockchain network across several computers. Usually, the common digital apps that we daily use rely on a single device like a computer. But dApp requires a network of computers to function.
Also, the common apps we use are controlled by a single organisation that manages and detects user activity. For example, Twitter is under Elon Musk and Facebook is owned by Mark Zuckerberg. Contrastingly, there are no controlling units for dApps even though there are developers who create dApps. If the code is designed correctly they won’t have any control over altering user transactions or information.
In DeFi, dApps help to organise financial transactions; send and receive cryptocurrencies.
Let’s take an example of a dApp— PancakeSwap— that works on a Binance Smart Chain protocol, with over 1.4 million users and 55 million trades. The native token of PancakeSwap is the CAKE token. The dApp uses an automated market maker (AMM) system that automatically provides liquidity to trade cryptocurrencies. This indicates that if there is enough liquidity in a pool, users can trade their coins.
A low transaction fee (0.25%) is one of the appreciable features of PancakeSwap. However, one of the cons of this dApp is that it does not support fiat deposits for buying crypto as it’s a purely cryptocurrency driven solution.
Decentralised Autonomous Organisations (DAOs)
All the commercial traditional banks have an organisation that includes management and its members. These managerial individuals have the duty to create rules and execute them whenever necessary. The same acting body in DeFi is known as a decentralised autonomous organisation (DAO), but their mechanism is different.
In a DAO, there is no central authority and it is handled by DAO token holders who manage and decide strategies via voting on the blockchain. Thus, all casted votes can be publicly seen for any participants. The concept of DAO was first introduced in 2016.
For instance, DAO Maker is a decentralised autonomous organisation holding its governance token— DAO. This ecosystem works on an Ethereum-based blockchain and provides freedom for users to facilitate any decisions. Like all the DAOs, DAO Maker also works using users’ investments or money provided by the organisation. So, if you want to be a part of any DAO, you can join, invest some money, and make decisions for the governance of the organisation. Thanks to the decentralised concept!
DAO Maker is known for its fundraising utility. So, you may think, what is fundraising in a decentralised system and when did it officially burst?
Well, in 2018 initial coin offerings (ICOs) became a profound interest for blockchain enthusiasts and it was during this time DAO Maker launched.
ICO, in simple terms, is a method of raising funds for cryptocurrency projects. While investors share their money with the ICO of a startup company, they will in turn get cryptocurrencies that have some utilities (hopefully).
But, to note, you should be careful about the possibilities of hacking attempts on DAO Maker. Like in all the decentralized autonomous organisations, smart contracts in DAO Maker may also become vulnerable to hackers. Reportedly, in past years, hackers stole over $7 million in ERC20 tokens from DAO Maker.
Now, you may have got an idea on how DeFi is implemented on decentralised applications, decentralised apps, and decentralised autonomous organisations. Basically, all these pivotal concepts utilise smart contracts to signal automated operations on them. Most of the DEX platforms act as dApps and DAOs. Uniswap and PancakeSwap are DEXes, dApps and DAOs. No matter how sparkling these platforms are, they face some challenging pitfalls. If DAO relies on decisions taken by token holders, there would be a chance for over-focus on voting power. To elaborate, if there are investors in a DAO who hold more governance tokens, chances are high that their suggestions would be more accepted as they have high voting power.
Advantages and Disadvantages of DeFi
We know that nothing is perfect in this world. All technologies have their own advantages and disadvantages. Although you can earn innumerable advantages from using DeFi, there are also certain downsides that you should be careful about.
Decentralization is a core advantage of DeFi because this factor is the one that removes any controlling power over decentralised finance. Also, this is the feature that makes users show interest and participate in DeFi.
- Distributed and peer-to-peer system
Anyone can participate in DeFi and the mechanism is distributed among computer nodes that are involved in it. In the peer-to-peer system, users can transact digital assets and participate in DeFi, in a way that they can even vote for creating a decentralized autonomous organisation.
What makes DeFi immutable is due to its blockchain and cryptographic technologies. As long as these technologies are there, no one can alter or delete any single data on DeFi.
DeFi works automatically using a set of codes called programmes which are permanently stored in the blockchain. In other words, there are smart contracts that perform automatic functions on DeFi. As we have discussed, smart contracts are the essential fuel for the functioning of DeFi.
- Hackers are on their way
Security is at its best for the DeFi system but certain features are more prone to hacking. It is obvious that a blockchain in DeFi cannot be altered, however, technology services upon which DeFi can rely are sometimes vulnerable to fraudsters.
Blockchain analysis platform Chainalysis recently reported that in 2022, October is the worst month for DeFi protocol hacks.
- Lack of consumer protection
Users of traditional banks have access to consumer protection rules and regulations. There are financial and monetary rules that cater to consumer protection acts for customers. This is not the case in DeFi, as it is completely decentralised. In fact, consumer protection is not quintessential in DeFi, because transactions usually go perfectly on it, nonetheless, if something goes wrong, there is no law to protect you.
- High Collateralization is definitely unpleasant
Collateral is something stored as a security or substitute in banks with an agreement to repay loans. DeFi requires over-collateralization while taking loans as the value of staked assets must be more than 100% of the amount of the loan.
- Time to panic if you lose your private keys
DeFi requires a private key to secure your crypto wallet. If you lose your private keys this means that you’ll permanently lose access to your funds. Real cryptocurrency users have to be extremely careful about how they handle their keys. Otherwise, Lost is lost!
While there are a lot of people celebrating the good sides of decentralised finance, there are some who are very far away from this technology. So, any readers who believe that DeFi is not legitimate, learn about it, and then you will realise the incredible potential to change the future it has..
DeFi brings you a different financial freedom that you cannot enjoy in traditional financial organizations. In short, DeFi’s power-less play, P2P trading and its transparent nature along with encompassing smart contracts enable every user on earth to join this financial system.
The launch of blockchain technology has paved a way for the arrival of the DeFi system. The reason for the increase in DeFi users, as explained, is because of its peer-to-peer, decentralised, and distributed mechanisms that are in no way comparable with traditional finance or CeFi.
DeFi applications are plenty that you will not feel to leave them untouched. Starting from trading DeFi tokens and NFTs, lending and borrowing, staking and earning rewards, and collateralisation, to participating in DAOs and voting for protocol rules, the DeFi ecosystem is really a vast place for your prosperous life.
Whatsoever, even if we say that DeFi is secure, play your role in DeFi very carefully, as this system can be sometimes exposed to fraudulent activities. As you know, wherever there is money, there are hackers, DeFi protocol hackers are gearing up their techniques to hack.
DeFi has undergone several technological changes and as of this writing, it has now reached the latest stage called Smart DeFi, often dubbed as DeFi 3.0, which was launched in early 2022 by FEG Token team. Smart DeFi is a safe and interoperable token launchpad for holding tokens with the idea of “unruggable and guaranteed asset backing.”
As tech developers are on their way to creating innovative ideas, DeFi is expected to re-emerge more efficiently in the future. All you need is a proper education on DeFi and blockchain technology, as well as cryptocurrency trading tips. Contextually, DeFi enthusiasts should not only learn more about DeFi but also keenly observe and tackle any impairment on it, caused by fraudsters.
Whatever the future holds for decentralised finance, if you’re tired of trusting your money to institutions that play with it on your back and without your consent, DeFi can definitely be an interesting option for you to explore.
Frequently Asked Questions
How to invest in DeFi?
Investing in a DeFi project is an easy task if you play your cards right. Initially, create a digital wallet, for instance, MetaMask, to store your cryptocurrencies.
Buy cryptocurrencies using your fiat money (for example, USD, EUR, GBP) and then store your cryptocurrencies in your own cold wallet. By the very moment where you make your initial purchase and hold your assets under self-custody (on wallets like MetaMask, Ledger or Trezor) you became part of DeFi as no one can come and take your money without your private keys.
What is a DeFi Wallet?
DeFi wallet is a non-custodial and decentralised wallet that holds your private keys and is only under your control.. Users can access their wallet using their private key, which is a set of some lengthy random numbers. Private keys are the security keys to a wallet.. DeFi wallets also holds your identity in an anonymous way to a DeFi platform and acts as a door to your trading.
What are some examples of well-known DeFi Applications?
PancakeSwap, Transit Swap, MeanFi, GoodDollar, 1inch Network, and MetaMask Swap are some of the most popular DeFi applications.