What is DeFi (Decentralized Finance)?

By Kirsty Moreland

Are you excited about DeFi? You absolutely should be – it’s giving you more options than ever, and returning power to regular people like you and me. What’s DeFi? Here, we explain.

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. These are the financial applications built using blockchain technology—but mostly on Ethereum. 

DeFi has exploded in popularity and with a constantly evolving ecosystem of applications, is likely to keep growing and being adopted by more people. Here’s what you need to know before trying it out for yourself. 

What is DeFi?

In a nutshell, Decentralized Finance is a term used to describe the decentralized financial tools, protocols, and platforms people use to manage their money, without having to rely on traditional financial infrastructure—like banks, remittance platforms, and government-issued currencies. 

DeFi vs. CeFi (Centralized Finance)

Both these terms refer to different financial services ecosystems within the cryptocurrency space. But they differ on a number of key points, including: their structure, their approach to self-custody, whether they are regulated and their KYC requirements. Let’s begin by explaining each one, looking at closely at each of these elements.

CeFi Explained

Centralized Finance within the crypto space generally refers to centralized exchanges: examples include Coinbase, Binance, Bitfinex, Gemini and Kraken.

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, and 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, and entails each new customer to a platform providing details and documents to confirm their identity. Nearly all centralized exchanges now require customers to undergo KYC when they onboard, for example.

As with banks, this creates an imbalance between users and the institution – with users required to fork over significant personal data, and trust the institution to keep that data safe, just to access the service.

Uses Custodial Wallets

Another key component of CeFi is the question of custody. Generally speaking, customers on centralized exchanges must keep their funds in the platform’s own custodial wallet, and the platform controls the private keys. 

There are advantages and disadvantages to this for the user: some people like that they don’t need to worry about managing their own crypto private keys. Instead, they simply “login” to their 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 is no way for you to access your coins, and they’ll be lost.

DeFi Explained

Decentralized finance is defined by the decentralized nature of its platforms, lack of personal data requirements and low barriers to entry, and how it handles crypto custody.

No Central Entity – Only Smart Contracts

In 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 since they are technically not a legal entity.

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

Speaking of wallets, a DeFi platform also handles crypto custody differently. With no centralized entity behind the project, 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 – and you will also be responsible for securing your private keys.

Why is Decentralized Finance(DeFi) Important?

Arguably the most significant benefit of DeFi applications is their accessibility. 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 that 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.

What Makes Up Decentralized Finance(DeFi)?

OK, now we’ve covered the basics of what DeFi is, and what it’s bringing to the table, let’s get to the nuts and bolts: it’s time to talk about DeFi services.

Ethereum Applications

DeFi exists as an ecosystem of applications (dApps) offering different financial services. What’s unique about these applications is that they sit on a foundation of blockchain: this is the infrastructure that enables dApps to handle value-based transactions without any central financial entity.

The majority of DeFi applications (at the time of writing) exist on the Ethereum blockchain; this is because dApps utilize something called smart contracts to manage their interactions with individuals, and Ethereum was the first to introduce these. As such, the majority of DeFi services (and other dApps) exist within the Ethereum ecosystem.

Most Common Use-Cases of DeFi

Some of the best-known examples of Ethereum DeFi applications include the following:

Decentralized Exchanges (DEXs)

A DEX, or decentralized exchange, does exactly what it says on the tin – it enables you to exchange your crypto for alternative coins or tokens.

What’s special about a DEX is that it makes your exchange without any centralized entity or company overseeing the service, and without you giving custody of your money to that service – it’s all done directly from your crypto wallet, and regulated by smart contracts.

DEX services such as Paraswap, Uniswap and Curve are all great examples you can interact with directly from your crypto wallet.

DeFi Lending & Borrowing Services

The beauty of DeFi is the possibility of trustless transactions – peer-to-peer interactions that are completely safe for both parties despite having no middleman or banker.

One of the benefits of this is that users can put their crypto to work – by lending it out to other users, for example This is where DeFi lending protocols like Compound come into play.

DeFi lending services enable anyone with a crypto wallet to contribute their crypto to a protocol and be borrowed by other users – in exchange, the lender will be paid back with a rate of interest. And this entire relationship is managed by smart contracts.

Automated Market Makers (AMMs)

AMMs are DeFi applications that automatically create markets by using mathematical formulas to set the price of a token based on ratio of assets stored in the platform’s liquidity pools, rather than supply and demand like most centralized exchanges. For more on how that works, check out our deep dive into the world of AMMs.

DeFi Staking Services

DeFi also offers some totally new options not available anywhere else – staking might well be the best example. Staking involves “locking up” some of your inactive crypto (normally via a service) as part of the process of securing a given 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 – and with new platforms and services being developed constantly, we’re sure to see more and more possibilities opening up for crypto users as time goes on.

What are the Main DeFi Risks?

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

Crypto Scams, Rugpulls and Malicious Smart Contracts

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.

Do Your Own Research (DYOR)

Instead, users rely entirely on their own research when it comes to assessing protocols they get involved with. This is why it’s imperative to get to grips with DYOR, by learning to read smart contracts, understand white papers and use resources like Discord to thoroughly investigate projects and services you’re interested in, before parting with your crypto.

Conclusion

The DeFi industry has skyrocketed in interest among developers and users alike – and it’s set to keep going. A recent survey projected a growth rate of more than 42% per year for the DeFi industry until 2030 – making it an area of explosive growth, with tracking closely.

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.

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 services.

Keep learning! If you enjoy getting to grips with crypto and blockchain, check out our School of Block video Get Rich Quickly In Crypto