DeFi (Decentralized Finance) is an ecosystem comprising financial instruments in the form of decentralized applications (DApps) and services that run on the blockchain. Decentralized finance is an alternative to the traditional financial system, offering users a totally new technological and organizational approach to savings, lending, insurance, investment, trading and asset management.
Decentralized vs centralized finance: What's the difference?
Traditional fiat money is governed by central banks and other financial institutions controlled by specific states. In most countries around the world, it isn’t possible to create an anonymous bank account. In fact, many of them will require not only personal data, but also biometrics in order to open an account. On most DeFi platforms, the identity verification procedure – the principle of KYC, or know your customer – is either redundant or optional.
With centralized financial systems, there is always the risk that the entity looking after your money – a bank, for example – may freeze it. With DeFi, the parties to financial transactions interact on the basis of smart contracts. This means that the fulfilment of all previously agreed conditions of a given agreement by both parties is monitored by a mathematical algorithm.
Of course, DeFi doesn’t preclude the involvement of intermediaries such as banks or exchanges in transactions, but it isn’t essential to how they function. It’s also worth pointing out that the principle of decentralization isn’t completely universal in the crypto sector. There are also centralized players in the cryptocurrency market, including for example the Binance crypto exchange. These exchanges, just like traditional financial institutions, can block the crypto assets of their users and impose other restrictions.
What is DeFi, what are its key elements and how does it work?
DeFi is a financial system implemented within the crypto industry and represented by a large number of decentralized platforms, which are to a greater or lesser degree interconnected.
At the core of decentralized finance is the idea of creating a replacement for the traditional system of financial organizations (banks, investment funds, exchanges etc.) on the blockchain, based on the principle of decentralization. This system is managed by the people who use crypto assets themselves and, unlike the world of fiat, doesn’t have a central governing body.
DeFi is a relatively young trend in the crypto industry. Launched in 2017, MakerDAO is an Ethereum-based lending platform that pioneered decentralized finance applications. Nowadays, there are many different DeFi platforms, and their number is constantly growing. Most of them operate on the Ethereum network, but there are already decentralized financial services on other blockchains such as the BNB Chain, Polkadot, Solana and Polygon.
DeFi projects are open source, and all financial transactions are carried out using blockchain-based solutions.
- DeFi platforms. These are blockchain projects that allow users to buy, sell and exchange coins and DeFi tokens, borrow and lend, deposit crypto, invest in crypto projects, receive a passive income, and carry out other financial transactions with crypto assets.
- DeFi cryptocurrencies (coins, tokens, stablecoins). These digital assets can be bought, sold, exchanged and transferred via decentralized applications. There are also DeFi tokens which, in addition to their material value, have functions that go beyond simple payments, such as governance tokens that allow holders to participate in the life of DeFi platforms and vote on decisions around their operation and development.
- Crypto wallets. Wallets in the form of software user interfaces are used in order to manage crypto assets stored on the blockchain. There are a number of different kinds of crypto wallets: hot wallets that are constantly connected to the internet; cold wallets which are offline; custodial wallets where the private keys are stored by a service provider, such as a centralized exchange; and non-custodial wallets where the private keys are completely controlled by their owner and are inaccessible to anyone else. Tangem Wallet is a cold, non-custodial wallet.
- Smart contracts. These are contracts that take the form of computer code and set the terms of transaction, define the actions of the counterparties using a given algorithm, and monitor the fulfilment of all of the parties’ obligations. DApps such as decentralized exchanges, lending platforms, and platforms for staking cryptocurrencies are built on the basis of smart contracts.
DeFi doesn’t have a single point of failure, intermediary fees are significantly lower than in traditional finance, and financial services are available to people from different parts of the world.
From a technical perspective, DeFi comprises a system of interconnected platforms, services and tools that allow users to provide financial services in a decentralized environment.
The essential mechanisms of this system are smart contracts, AMMs (automated market makers), liquidity pools and various DeFi token mechanics.
Advantages and disadvantages of DeFi
The following are some of the main advantages of decentralized finance:
- Accessibility. Anybody with an internet connection anywhere in the world can connect to and take full advantage of DeFi.
- Lack of intermediaries. In DeFi, users interact with each other directly without intermediaries, while the smart contracts monitor compliance with all the terms and conditions of transactions.
- Conditional anonymity. Of course, everything and everyone can be tracked with enough effort, but for the most part all you need in order to connect to and use DeFi is a crypto wallet.
Despite this, DeFi does have significant downsides.
Many DeFi platforms are quite inconvenient and require a certain skill level to use them.
- A lack of regulation on the crypto market in general and in the DeFi sector in particular often creates issues for crypto companies and users.
- Hackers. Decentralized services get hacked, and not infrequently. As a rule, this happens because of errors or vulnerabilities in the smart contract code.
- Scams. The world of cryptocurrency, the blockchain and DeFi is fairly complicated for many people, and general levels of financial literacy are sorely lacking when it comes to crypto. Fraudsters take advantage of this by creating fake exchanges, investment projects and more.
What can you do with DeFi and how can money be made?
DeFi allows owners of crypto assets to conduct various financial transactions with crypto and earn money in doing so. Before the advent of DeFi, options for crypto market participants were limited to holding, trading and investing. Today, cryptocurrency users can do much more.
- Exchange coins and tokens on a DEX, avoiding the intermediaries associated with CEXs. This could include one of a number of famous DeFi platforms, such as 1inch, SushiSwap and PancakeSwap. All you need to do in order to exchange on a 24/7 basis is connect your crypto wallet to the platform of your choosing using WalletConnect. By the way, Tangem Wallet supports the exchange of cryptocurrencies directly in the wallet with the help of 1inch, a decentralized liquidity aggregator that uses order routing technology and offering users favourable terms for the exchange of DeFi coins and tokens by tracking their prices on dozens of DEXs in real time.
- Use cryptocurrency counterparts to fiat currencies, such as the dollar. This has been made possible with the help of stablecoins, which are cryptocurrencies that are pegged to fiat money at a ratio of 1:1. For example, 1 USDT = USD 1.
- Wrap tokens. Wrapped tokens are a “copy” of a cryptocurrency on one blockchain that has been issued on another network and backed by the original asset at a ratio of 1:1. Examples include Wrapped Bitcoin (WBTC) and Wrapped Ethereum (WETH). The copies of the original coins may be required in order to trade on decentralized platforms that run on networks which are incompatible with the original coins in a user's portfolio.
- Trade DeFi tokens on DEXs. Decentralized finance means you can trade without a centralized intermediary that would require you to provide your personal data.
- Earn through staking, crypto lending, farming and liquidity mining. You can read our article on the topic to find out more about these and other forms of passive income.Ъ
- Earn with decentralized games. GameFi projects allow users to earn rewards and interact with in-game economies using blockchain technology.
DeFi is a flexible and decentralized financial ecosystem that is able to adapt and provide new solutions as user demand shifts. Boasting a rich variety of platforms from DEXs to GameFi, the sector is opening up new horizons in use cases for crypto assets.
Popular DeFi projects
Let’s take a quick look at some popular DeFi platforms.
A decentralized liquidity platform that allows you to borrow and deposit assets. The project is governed using the native AAVE token. How does it work? The user visits the platform, invests an asset – let’s say ETH – and receives a token in return, which in this case would be aETH. Its value is pegged at 1:1 to the original ETH that has been invested. The user can take a loan out against their deposit, for example in USDT, which is later repaid in USDT. When closing the deposit, the holder returns the aETH and receives their original coins back.
A decentralized exchange and trading platform. It allows users to buy and sell tokens that run on top of the Ethereum network. Users take funds out of their crypto wallets and place them in a liquidity pool, creating token pairs which they then can use to generate an income.
An exchange that uses DeFi stablecoins to provide liquidity pools. It allows users to trade with low commissions, and incentivizes liquidity providers with its native CRV token.
For a full list of popular DeFi platforms, visit defillama.com.
Conclusion
DeFi is an innovative concept that challenges the traditional financial system and offers a decentralized, transparent, fair and accessible alternative. In 2023, DeFi is continuing to grow in popularity and attracting more users thanks to the increasing variety of tools, protocols and platforms it offers.