What Is DeFi? Decentralized Finance Basics

What is DeFi?

DeFi, short for decentralized finance, is a digital financial infrastructure built on publicly accessible blockchain technology. The idea behind DeFi is to eliminate traditional intermediaries like central banks, government agencies, or credit card issuers from financial transactions. 
It also seeks to enlarge the world of crypto by decentralizing a range of financial services beyond digital money. DeFi and crypto are often spoken of in the same breath, but there is a distinction. While specific cryptocurrencies are digital units of value built using blockchain, DeFi is more of a concept that describes an entire range of blockchain-enabled financial services and applications. Most DeFi systems are currently built on the Ethereum blockchain.

Why is DeFi important?

DeFi expands the basic premise of cryptocurrency from digital money, like Bitcoin and other types of cryptocurrencies, to an entire system that enables more complex financial exchanges. You could think of DeFi as a digital, peer-to-peer version of Wall Street, but without the associated costs or centralized authority. 
Because DeFi eliminates the need for banks to approve and facilitate loan applications or transactions, it ostensibly allows easier, more equitable access than traditional finance. Some people believe it has the potential to create more free and fair financial markets and make them available to anyone with an internet connection and a digital wallet.

How does DeFi work?

DeFi works based on the execution of peer-to-peer smart contracts, which are bits of code running on the blockchain that securely authorize and execute nearly any kind of contract agreement or cryptocurrency transaction. Basically, the code sets up an “if/when A happens, execute B” protocol that is recorded on the blockchain. For example, smart contract code could indicate that funds will only be released if/when the unspent funds in your digital wallet are greater than the sum requested.
On its own, a smart contract can only be used for one type of transaction. Decentralized apps, also called dapps, link a series of smart contracts together for more sophisticated operations. Dapps facilitate a range of peer-to-peer transactions, including game play, DeFi lending and borrowing, NFT trading and collecting, purchases, and more.

DeFi coins and tokens

DeFi coins and tokens are often conflated, but there are key differences. A DeFi coin is essentially digital fiat money you can use to make purchases, as it transfers value over the course of a financial transaction. DeFi coins are built on their native blockchain networks. 

Conversely, DeFi tokens can be built on already-existing blockchain networks. And, though tokens do transfer value like coins, that value may not always be a type of currency. Tokens can be used to represent physical assets like real estate or cars, unique virtual items like NFT digital art, or as passwords to access certain resources.

Currently, the six most popular DeFi coins and tokens by market cap are:

• Terra (LUNA)
• Avalanche (AVAX)
• Wrapped Bitcoin (WBTC)
• Dai (DAI)
• Chainlink (LINK)
• Uniswap (UNI)

How safe is DeFi?

Any new trend in the crypto world presents risks, and DeFi is no exception. Scams, like rugpulls and phishing attacks, are all too common. User diligence and well-crafted smart contracts can mitigate some of the risks. Creators of DiFi projects are also working to reduce risk through actions like code audits of new tokens; Ethereum’s security and scam prevention guidelines are intended to help users stay more secure.

Benefits of DeFi

Like every piece of the crypto puzzle, DeFi presents advantages and disadvantages for consumers looking for an alternative to traditional finance. Proponents of DeFi tout the following advantages:

• Autonomy: Your assets are yours alone, so no central authority can block your transactions or freeze your accounts.  
• Accessibility: You don’t need a centralized bank account, which means that approximately 7.1 million “unbanked” Americans and 1.7 billion people worldwide could potentially use DeFi as an alternative if they have access to the internet and a smart wallet.
• Immutability: Once deployed or verified, smart contracts cannot be changed.

Transparency: A record of every transaction is publicly available on the blockchain.

Disadvantages of DeFi

As discussed above, the emerging nature of DeFi makes it a fairly risky endeavor. Some of the downsides include:

• Lack of consumer protection: Because Defi isn’t regulated like traditional finance, you and your assets aren’t protected by the same laws and oversight that govern things like bank accounts and stocks.
• Volatility: Like the crypto market in general, DeFi assets tend to be highly volatile, with values often rising and falling rapidly.
• Uncertainty: DeFi is only as stable as the blockchain upon which it is built. Instability of or changes in the blockchain could mean greater risk.
• Time and expense: DeFi transactions can sometimes take longer than traditional transactions to process, and the transaction fees may jump at times of congestion.

How to invest in DeFi

If you’re willing to do the research and take the risk, there are many ways to get involved in DeFi. You’ll need to open a digital wallet and purchase coins or tokens for the DeFi protocol you want to use. Then, you can do things like:

• Lend your crypto to other users in order to earn interest. Interest rates in DeFi lending vary by lending platform, and some users attempt to maximize their rate of return by moving their funds among different DeFi protocols as interest rates fluctuate.  
• Put your funds in a decentralized exchange, where you can swap them with other users in peer-to-peer transactions. Keep in mind that transaction fees vary among exchanges, and may fluctuate rapidly.  
• Invest in DeFi projects. New projects are constantly emerging, so there are ample opportunities. However, new projects can often be especially risky, and fraud is a common concern.

Many crypto-curious investors ease into the world of DeFi by simply investing in cryptocurrency or related investments before they dive into the more complex world of DeFi lending and other activities.

The future of decentralized finance

Decentralized finance is a relatively new and evolving concept. As it continues to develop, the specific answer to “What is DeFi?” will also evolve. Though the idea of a more equitable, decentralized system may be appealing, questions about accountability remain. And regulated, centralized institutions probably aren’t going anywhere anytime soon. Trends indicate that the future of DeFi may land somewhere between the two systems, resulting in a hybrid structure that provides both increased access and accountability. What is clear is that DeFi, crypto, and other new ways of thinking about financial systems are firmly a part of the current conversation.