What is DeFi (Decentralized Finance)?

By Kirsty Moreland

If you have been involved in the blockchain or cryptocurrency industry for more than a short stretch, then you have probably stumbled across the terms ‘decentralized finance’, or ‘DeFi’ on more than one occasion. But do you know what they mean?

These are the financial applications built using blockchain technology—and they are starting to shape the future of a decentralized economy. DeFi has exploded in popularity and with a constantly evolving ecosystem of applications, is likely to keep growing and being adopted by more people. So, before you dive into the wonderful world of decentralized finance, let’s explore exactly what it is and what it’s for.

What Is Decentralized Finance (DeFi)?

In a nutshell, Decentralized Finance is a term for the financial tools, protocols, and platforms people use to manage their money in a decentralized manner. With these platforms, users don’t have to rely on traditional financial infrastructure—like banks, remittance platforms, and government-issued currencies. 

This brand-new monetary system empowers users by offering an alternative to the old and outdated traditional financial system. However, instead of transactions relying on central entities for processing, DeFi protocols use the blockchain instead. To explain, DeFi apps operate using open and transparent smart contracts.

In short, these are blockchain-hosted computer programs that can complete a variety of different tasks without the need for middlemen. Since they use decentralized blockchains, Decentralized applications (dApps) operate without any centralized governing entity, allowing users to interact with each other in a completely trustless manner. 

How Does DeFi Work?

DeFi exists as an ecosystem of applications (dApps) offering different financial services. However, they don’t operate like the financial applications you might know. Since DeFi apps use a decentralized blockchain, they can execute actions without a central entity.

The majority of DeFi applications (at the time of writing) exist on the Ethereum blockchain. This is because Ethereum was the first network to support smart contracts. As such, it still hosts the majority of DeFi platforms today.

However, that doesn’t mean DeFi is ETH-specific. In fact, there are plenty of DeFi platforms on other networks such as Solana and Cardano.

Centralized Finance vs. Decentralized Finance (DeFi)

Centralized Finance and Decentralized finance share some similarities and a lot of differences. To understand the impact decentralization makes, let’s first look at how Centralized Finance works.

What Is Centralized Finance (CeFi)?

Centralized Finance within the crypto space generally refers to centralized exchanges. Examples of Centralized platforms include Coinbase, Binance, Bitfinex, Gemini, and Kraken. Centralized exchanges have a few key features:

Run by a central entity: A centralized crypto exchange is one that is run by a real-world company. This company oversees and controls the exchange’s operations. Since it is a legal entity, the company will be subject to the laws of its jurisdiction.

Requires KYC : To access the services of a centralized platform, users need to go through a process called Know Your Customer (KYC). This process is part of a global Anti Money Laundering initiative. In short, each new customer must provide details and documents to confirm their identity. Today, nearly all centralized exchanges now require customers to undergo KYC. Unfortunately, this creates an imbalance between users and the institution. To explain, users are required to trust the institution with their sensitive personal data in order to access the service.

Uses Custodial Wallets: Centralized exchanges leave their customers no choice but to keep their funds in the platform’s own custodial wallet. This means that the platform controls the private keys, and therefore the crypto in that account. But without private keys linking you directly to your blockchain address, your crypto is only as safe as the middleman itself. If the platform is hacked, goes bankrupt, or is censored by a legal entity, there will be no way for you to access your coins. This is why the custodial wallet system is inherently flawed.

CeFi vs Defi: What’s The Difference

While you can lend, borrow, and trade, just as well as you can with centralized protocols, DefI Protocols also offer a lot more control over your funds. For example:

DeFi doesn’t involve central entities and institutions: DeFi platforms and financial services are not run by any sort of central entity. Instead, they are protocols run on smart contracts. There is no central company or single point of failure, and they are not regulated.

No KYC, Personal Data, or Barriers: Since DeFi platforms are unregulated, users are not required to identify themselves or provide any documentation to access DeFi services.  A crypto wallet – and some crypto – are all that’s required.

Self-Custody is King: DeFi platforms offer full custody when trading. Using these platforms, there is no custodial “platform wallet”. Instead, users will interact with the platform directly from their own, non-custodial crypto wallet. You, the user, remain in control of your crypto at all times. However, with that control also comes the responsibility of securing your private keys.

Why Is DeFi Important?

Since the blockchain is permissionless,  DeFi applications can be accessed by anyone—no matter where in the world they reside. Anybody with a cryptocurrency wallet and an internet connection can interact with the world of Decentralized Finance—with no credit checks, KYC, or other barriers to entry. 

This is of particular importance for the 1.7 billion adults worldwide who lack access to a bank account. Through DeFi, these individuals, and everybody else now have access to a wide range of permissionless protocols that provide many of the same features as banks.

Uses of DeFi

Despite being a relatively new industry, Decentralized Finance has grown considerably in recent years. As a result, both the number and variety of DeFi applications in existence have also multiplied.  Nowadays, there is a DeFi alternative to practically every major financial service you already use. Some applications for DeFi technology are completely unique and some of them are not. But all are possible thanks to peer-to-peer blockchain technology.

So, what are the biggest use cases for DeFi today?

Decentralized Exchanges (DEXs)

A DEX, or decentralized exchange, does exactly what it says on the tin: It lets you exchange your crypto, coins, or tokens. DEXs can execute trades without a centralized entity overseeing the service, meaning you keep custody of your private keys. Furthermore, decentralized exchanges also allow users to trade without waiting for other participants. Instead of using an order book system like a centralized exchange, DEXs set their prices using liquidity pools and Automated Market Makers (AMMs). In short, this tech allows users to trade directly with the system.

Top Decentralized Exchanges (DEXs) such as Paraswap, Uniswap, and Curve all use this technology.

DeFi Lending & Borrowing Services

DeFi lending protocols like Compound and Aave allow users to lend and borrow crypto in a secure, trustless manner. Borrowers deposit funds as collateral and typically pay a fixed interest rate, while lenders earn a variable return on their assets.

DeFi lending services enable anyone with a crypto wallet to contribute their crypto to a protocol. This allows other users the chance to borrow it, and in exchange, the lender receives interest. However, instead of a central entity organizing this payment, the smart contract can execute the action itself.

DeFi Staking Services

DeFi also offers some totally new options not available anywhere else – and staking is a great example. Crypto staking involves “locking up” some of your cryptocurrency as part of the process of securing a blockchain. In exchange, you’ll receive rewards, meaning staking presents DeFi users with a unique option for making passive income. 

With many staking services offering the infrastructure to manage the details of that interaction, such as Kiln and Lido, staking is one of the prominent services in the DeFi ecosystem.

These are just a few of the different DeFi options that exist. With new platforms and services on the rise, we’re sure to see more and more possibilities opening up for crypto users as time goes on.

Decentralized Insurance:

Decentralized insurance protocols like Nexus Mutual allow users to protect themselves against a wide range of risks in the DeFi sector, such as hacks, theft, flash crashes, and almost anything else. Anybody can also contribute to insurance pools to earn a return for taking on risk. 

Synthetic Asset Issuance:

Synthetic Asset issuance platforms allow users to create a variety of crypto tokens that mimic the price or characteristics of another digital currency, real-world asset, or financial product. Synthetics are essentially crypto derivatives, and they give cryptocurrency users a way to trade and gain exposure to complex financial products through a single token (like ETFs, options, and basket funds). Plus, they also let users participate in markets that might otherwise be difficult to access. 

Advantages of DeFi

Arguably the most significant benefit of DeFi applications is their accessibility. Since there is no governing entity at the helm, and there are no regulations or rules to adhere to. DeFi applications are available to anyone—no matter where in the world they reside. Anybody with a cryptocurrency wallet and an internet connection can interact with the world of Decentralized Finance—with no credit checks, KYC, or other barriers to entry. 

This is of particular importance for the 1.7 billion adults worldwide who lack access to a bank account. Through DeFi, these individuals, and everybody else now have access to a wide range of permissionless protocols that provide many of the same features as banks.

But DeFi goes well beyond providing standard financial services to those that need them. It presents an entirely original system based on openness and transparency. Basically, it ensures participants can check exactly what is going on behind the scenes. It achieves this while dispensing with trusted third parties and costly intermediaries—driving access costs down to the bare minimum. 

Moreover, DeFi gives individuals a way to easily turn a profit on their digital assets by contributing to lending pools. These pools provide collateral-backed loans to borrowers and allow other users to exchange coins directly with the system. These are so attractive to users because they provide much better returns than banks offer.

Disadvantages of DeFi

DeFi offers regular people unprecedented access to financial services, control of their data, and passive income opportunities. However, just as with any activity, users need to be aware of the risks.

The Blockchain Isn’t Regulated

Smart contracts and blockchain have enabled anyone to develop a value-based application and offer it to the public, generating a new wave of exciting options – but this comes with a price.

But with no central entity or traditional infrastructure, DeFi apps are not subject to the same legal scrutiny as traditional consumer services. You have no real guarantee of who you’re interacting with, what’s behind a smart contract, or whether your project is genuine – and if you make a mistake, there’s nobody to help you get your crypto back.

Instead, users rely entirely on their own research. This is why it’s imperative to get to grips with DYOR. For example, just learning to read smart contracts and understand white papers is a great start. Then, navigating sources of information, like Discord, is invaluable when assessing new projects.

The Future of DeFi

In the last two years, the total value of tokens locked up in DeFi tools and protocols increased from $203 million to $9.53 billion. This represents a growth of more than 4,500%. But it’s not just everyday users, traditional financial institutions are becoming more interested in DeFi too. In fact, many firms are looking into how they can participate in the Decentralized Finance world too.

However, with DYOR and self-custody at the heart of this industry – and no second chance if you make a mistake – it has never been so important to understand exactly what you’re interacting with.

While many DeFi platforms genuinely act to return financial independence to users and provide access to new, potentially liberating, or profitable opportunities, not all are safe to use, and some are outright scams. With that in mind, it’s important to do your due diligence before investing in or using any DeFi platforms. You should only ever risk what you can afford to lose. 

So keep reading, stay up to date, and keep those private keys secure – Ledger Academy is here to guide you as you navigate this exciting new ecosystem of financial service