Our current financial system is built on centralized infrastructure managed by institutions (e.g., banks). The ethos of DeFi, on the other hand, is to create an open financial system that doesn’t require organizations to manage and facilitate the movement and creation of money/assets.
DeFi wants to decentralize and democratize, so that anyone can access the financial system with nothing but a digital wallet and an internet connection. Basically, it removes the need to interact with banks, opting instead for peer-to-peer financial transactions that are facilitated through software.
It’s a whole new way to think about how we access financial services like daily banking, loans, mortgages, and trading.
As of 2022, DeFi is made up of:
- New financial inventions like stablecoins.
- Software-defined contracts (“smart contracts”).
- Decentralized exchanges (“DEX”).
- Decentralized applications (“Dapps”).
While interest in DeFi has exploded over the last few years, the space remains quite risky due to lack of regulation and the risks of evolving tech.
DeFi vs. Traditional Finance (TradFi)
What’s so wrong with our current financial system that we even need DeFi?
Let’s dig into some of DeFi’s core benefits, versus the way things are today. In the traditional financial system:
- Many people can’t access the banking system or use financial services due to their income levels.
- Financial transactions are not settled instantly and suffer inefficient or costly time lags.
- Governments and centralized institutions can shut or freeze markets whenever they want.
- Intermediaries like banks place markups on financial services to earn revenue for their own operations.
- Asset trading hours for things like stocks are limited to defined business hours across different time zones.
- Centralized institutions hold significant power in how they govern the overall financial system, without potentially considering the perspectives and needs of those who actually use it.
DeFi is meant to solve these problems.
How Does DeFi Work?
DeFi applications initially started on the Ethereum blockchain, but it has since expanded to other networks that automate financial transactions like Solana, Binance Smart Chain, and Avalanche.
Read more: 8 Alternatives to Bitcoin
Everything in DeFi runs on blockchains and cryptocurrencies, where financial transactions are facilitated through software called “smart contracts” instead of through banks (centralized platforms).
Smart contracts are programmed to carry out specific functions (like lending) and, once written, no one can change the smart contract once it’s deployed.
For example, a contract that’s designed to hand out a weekly allowance could be programmed to send money from one account to another every Friday, provided specific conditions are met and so long as there are funds in the account that’s distributing the funds.
(While DeFi applications can be very complex, this is a simple example.)
Another example of DeFi in action is the MakerDAO lending system, and the creation of its stablecoin, DAI. (Stablecoins are unique cryptocurrencies designed to match the value of a fiat currency; DAI tracks the U.S. dollar.)
Read more: What is Cryptocurrency? Everything You Need to Know
With Maker, those who hold Ethereum can “deposit” their tokens in smart contracts that, in turn, create DAI. Those who own DAI can use it to spend on goods or services, or can save it and earn interest.
For example, the Coinbase Card allows users to spend DAI by converting it to dollars on a Visa card.
Read more: Best Crypto Credit Cards
What are Decentralized Exchanges (DEXs)?
Among the DeFi applications generating lots of attention are decentralized exchanges (or DEXs).
A DEX is a peer-to-peer marketplace where transactions occur directly between crypto traders. This is very different from traditional stock trading where you have a stock brokerage or investment bank, a stock exchange, a clearing house, a transfer agent, and custodial service providers all involved to facilitate transactions.
DEXs are a great example of what it looks like to conduct financial transactions autonomously from centralized parties or intermediaries. They are simply a set of smart contracts working together to establish the prices of cryptocurrencies via algorithms and use pools of locked-up tokens to facilitate trades.
All DEX transactions are then settled directly on the blockchain so they are visible and accessible to anyone. DEXs are also commonly open-source, so anyone can see exactly how they work.
Today’s most popular DEXs include Uniswap and Sushiswap. Both run on the Ethereum blockchain and have their own tokens.
The promise of DeFi applications like DEXs extend to all sorts of peer-to-peer lending applications and enable fast, instant transactions.
Are All Blockchains Decentralized?
Eliminating systems that are controlled and alterable by a single party underpins DeFi. But not all blockchains are equal in terms of how decentralized they are.
Without getting too technical, the way a blockchain is built (“Proof of Work” versus “Proof of Stake”) and how big investors’ token holdings are can result in varying levels of decentralization across blockchains.
Since blockchains are built on the idea of community, less decentralized blockchains are more at risk of being controlled by a few individuals, resembling centralized platforms. As such, there is truth to the argument that blockchains are not fully decentralized.
To get a sense of how decentralized a blockchain is, you’ll need to understand things like how many people/groups are involved in the decision-making process governing the individual blockchain, and how the influence of each participant is established.
If you want to learn more about the technical elements of Decentralization, this article provides additional overview: Measuring Decentralization: Is Your Crypto Decentralized?
The Risks of DeFi
Despite how exciting the many applications of DeFi are, it’s still a very risky space.
Over the last few years, there have been several highly visible instances of DeFi software being hacked or subject to theft and fraud, resulting in billions of lost crypto. In 2021 alone, $10.5 billion was lost in DeFi, with $12 billion lost over the last two years.
In 2022, there have been two instances of DeFi participants melting down or succumbing to the volatility that’s been ripping through crypto markets, erasing tens of billions.
In May, one of the most popular U.S. dollar-pegged stablecoin projects, Terra and its native token LUNA, self-destructed, costing holders over $60 billion. This collapse was the crypto world’s equivalent of the Bear Sterns collapse during the 2008 financial crisis.
In June, Celsius Network, an interest-earning crypto platform, froze withdrawals after using failed DeFi strategies.
These collapses and failures, compounded by the fact that DeFi remains unregulated, make playing in this market very risky. This is especially true since many DeFi investors might not understand how exactly the high interest rates DeFi famously generates are created.
Read more: 5 Things You Should Know Before Investing in Crypto
Final Thoughts: What’s the Future of DeFi?
As the crypto market matures, DeFi is set to continue playing a larger role. As someone who is fascinated by this space and personally invested in Ethereum, I believe it can have a bright future and wider adoption. However, this will likely depend on more regulation coming into effect and the technical kinks getting sorted so that DeFi hacks are not a common occurrence.
General adoption of DeFi also requires the creation of more easily understandable and accessible infrastructure. Today, getting involved in DeFi requires a high degree of technical savvy between setting up wallets, buying crypto, finding the right DeFi programs, and managing everything yourself. It’s not a user-friendly experience like just turning on Netflix. Once more consumer-friendly products with slick UXs come to market, more people may be inclined to dive in.
But until then, DeFi will likely continue to be a very high-risk, high-reward space that is used by crypto enthusiasts who have the required skills, patience, and wherewithal. If you are interested in participating, be sure to get educated and only risk that which you are OK to ultimately loose.
Featured image: Andrii Yalanskyi/Shutterstock.com