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 new technological and organizational approach to savings, lending, insurance, investment, trading, and asset management.
Decentralized finance 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, creating an anonymous bank account is impossible. Many of them will require personal data and biometrics to open an account. On most DeFi platforms, the identity verification procedure — the principle of KYC or knowing 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 based on smart contracts. This means that the fulfillment 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, such as 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, its essential elements, and how does it work?
DeFi is a financial system implemented within the crypto industry and represented by many decentralized platforms, which are interconnected to a greater or lesser degree.
At the core of decentralized finance is the idea of replacing 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.
There are many DeFi platforms today, and their number is constantly growing. Most of them operate on the Ethereum network, but decentralized financial services exist 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 blockchain projects 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.
DeFi tokens, 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. Hot wallets are constantly connected to the internet, while cold wallets 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.
- Smart contracts. These contracts take the form of computer code and set the terms of the transaction, define the actions of the counterparties using a given algorithm, and monitor the fulfillment of all of the parties' obligations.
DApps such as decentralized exchanges, lending platforms, and platforms for staking cryptocurrencies are built based on 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 worldwide.
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 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, a crypto wallet is all you need to connect to and use DeFi.
Despite this, DeFi does have significant downsides.
Many DeFi platforms are pretty inconvenient and require a certain skill level.
- A lack of regulation on the crypto market and the DeFi sector 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 relatively complicated for many people, and general levels of financial literacy are sorely lacking when it comes to crypto. Fraudsters exploit 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 several famous DeFi platforms, such as 1inch, SushiSwap, and PancakeSwap. All you need to do to exchange on a 24/7 basis is connect your crypto wallet to the platform of your choosing using WalletConnect.
Tangem Wallet supports the exchange of cryptocurrencies directly in the wallet powered by 1inch. This decentralized liquidity aggregator uses order routing technology and offers users favorable terms for exchanging 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 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).
Copies of the original coins may be required to trade on decentralized platforms that run on networks 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 data.
- Earn through staking, crypto lending, farming, and liquidity mining. You can read our article on the topic to learn more about these and other forms of passive income.
- 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 can adapt and provide new solutions as user demand shifts. Boasting a wide variety of platforms, from DEXs to GameFi, the sector opens 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 – say ETH – and receives a token in return, which would be aETH. Its value is pegged at 1:1 to the original ETH that has been invested. For example, the user can take a loan against their deposit 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 on the Ethereum network. Users take funds out of their crypto wallets and place them in a liquidity pool, creating token pairs that they 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 complete list of popular DeFi platforms, visit defillama.com.
DeFi is an innovative concept that challenges the traditional financial system and offers a decentralized, transparent, fair, and accessible alternative. In 2023, DeFi will continue to grow in popularity and attract more users, thanks to its increasing variety of tools, protocols, and platforms.