Decentralized Finance (DeFi) encompasses a diverse range of financial products and services that operate without a centralized authority, such as a bank. This decentralization is enabled by blockchains and smart contracts, which are fundamental to Web3.
For instance, consider firms like Chase or PayPal that facilitate currency trading, loans, or global payments. These services are provided by a centralized authority, i.e., a bank or broker. DeFi, on the other hand, aims to deliver similar or even superior financial services with transparent and publicly verifiable processes via automated smart contracts between peers.
The key feature of DeFi tools is that they eliminate intermediaries like banks. This is made possible by decentralized technologies, such as blockchain networks, which are at the core of Web3. Similar to Web3, DeFi is characterized by:
Trust minimization: Instead of relying on centralized databases managed by banks or brokers, DeFi uses blockchain technology, thereby eliminating the need for blind trust in large organizations with opaque regulations.
Permissionless: DeFi is accessible to anyone with a crypto wallet, regardless of financial credentials or government approvals.
DeFi also offers several potential benefits, such as:
Lower fees: Without intermediaries, DeFi can potentially offer lower fees for financial services.
More accessible: DeFi can potentially offer financial services to people who might not have access to traditional banking or financial services.
Transparency: The use of blockchain technology in DeFi provides publicly verifiable transparency and allows users to see exactly how transactions are being processed.
Innovation: DeFi is still a relatively new and rapidly evolving field, which means there are many opportunities for innovation and new financial products and services.
However, DeFi is not without its challenges and risks. Some of these include:
Volatility: Many DeFi projects and tokens are highly volatile and can experience extreme price fluctuations.
Security risks: DeFi platforms and smart contracts can be vulnerable to hacks and other security risks, which can result in the loss of funds.
Regulatory uncertainty: The regulatory landscape around DeFi is still evolving, and there is a risk that some DeFi projects and activities could be subject to regulatory scrutiny or even crackdowns.
Liquidity: Many DeFi platforms and tokens can suffer from low liquidity, which can make it difficult to buy or sell assets at a fair price.
Smart contracts and DApps power the DeFi ecosystem. In 2015, Ethereum, the first “programmable” blockchain, introduced smart contracts, specialized programs that reside on a blockchain. Ethereum’s innovation allowed developers to create decentralized apps (DApps) on a blockchain, rather than on a company-owned server, by layering and combining smart contracts like building blocks.
This advancement led developers to construct various DeFi DApps and protocols that offer financial services such as lending, borrowing, trading, derivatives, and more to the crypto market. DeFi’s popularity on the Ethereum network surged, providing users with the ability to take direct control of their finances without relying on governments or banks. Several blockchains with comparable programmability and their DeFi ecosystems have now arisen following Ethereum’s lead.
Challenges with Traditional Finance
One might question why DeFi tools are preferable over the options provided by traditional finance. After all, traditional finance has more regulations, rules, and customer safeguards, doesn’t it? In truth, traditional financial systems can impede people’s access to financial services and force them to place trust in institutions that are often untrustworthy.
Lack of Accessibility to Traditional Financial Services
Financial institutions establish their own regulations and rules under the guise of “safety.” However, the bureaucracy and red tape of banks and intermediaries often harm individuals rather than assist them. Traditional finance imposes economic and geographic restrictions that prohibit people from accessing financial services.
For example, savings accounts that reward higher account balances with better interest rates, charge fees for falling below a minimum bank balance, or require minimum transaction amounts. Predatory lending models that take advantage of people seeking to borrow money plague many regions. Even transferring money from one bank account to another can result in service fees. Sending remittances overseas incurs additional limitations and charges imposed by intermediaries.
Traditional finance is centralized, with powerful institutions that profit from charging users for services, with limited viable options. The issue, however, isn’t only about fees.
The opportunity to access financial markets, such as stocks and derivatives, is decreasing and being dominated by the wealthy. In the United States, for instance, the top 10% of households by net worth possess more than 85% of equities, while the bottom 50% own less than 1%. In several nations, people don’t have access to stock markets. This demonstrates how “closed” the global economy truly is.
Traditional Finance Relies on Big Banks’ Trustworthiness
Traditional finance is also founded on trust. For instance, when you deposit money into a bank, you are relying on that institution to safeguard your assets and make them accessible for withdrawal as per your wish. Nonetheless, once you deposit funds, banks can use that money in ways that you may not approve of. Your account balance, at any given time, is only a number on a screen. A percentage of that balance is usually loaned out to other customers, invested, or used in other ways. During emergencies, it is not unusual for customers to withdraw funds in large numbers, creating a “bank run” that can deplete a bank’s entire cash reserves.
Traditional finance is old, slow, and based on a system of centralized control and unequal access that favors the wealthy. Decentralization offers the potential to reform this industry.
Advantages of DeFi
Speed, Open Access, and Reduced Costs DeFi is the rejection of Big Banks that have come to dominate the financial markets, similar to how Web3 is a rejection of Big Tech that dominates the Internet.
DeFi relies on smart contracts, which automate processes and eliminate intermediaries, resulting in faster transactions and reduced overhead costs. DeFi systems cut out institutions and intermediaries that charge fees for basic financial services. They also remove central authorities, governing agencies, underwriters, and KYC requirements. As a result, DeFi is a streamlined financial system operated by and for everyday people.
The Associated Risks of DeFi
However, DeFi users must manage their own assets and exercise caution when using DeFi DApps. There is always the risk of bad actors attempting to steal assets, as well as faulty smart contracts that may provide opportunities for hackers to exploit. In the event of a problem, there is no central authority or government guarantor to turn to. Unlike the Federal Deposit Insurance Corporation (FDIC) in the US, there is no DeFi equivalent. Despite the risks, the popularity of DeFi and the billions of dollars invested in DeFi protocols indicate that many users are more willing to trust code than Big Banks.
To enjoy the benefits of DeFi, users must accept some level of risk. However, the good news is that DeFi protocols are becoming more user-friendly and secure with each passing day.
What are the possibilities of DeFi?
DeFi allows users to access similar products and services as banks or financial institutions, but with direct peer-to-peer interaction. These services include global payments, trading, borrowing, lending, and derivatives. Unlike traditional finance, DeFi doesn’t require a central authority to oversee the process.
For instance, in traditional finance, getting a loan involves a lengthy process of providing financial data to a bank. However, in DeFi, users can visit a DeFi DApp, deposit some cryptocurrency as collateral, and borrow against it instantly. The borrowed assets come from other users in the ecosystem who are lending their assets, earning interest payments in return.
DeFi offers opportunities for users to participate not just as consumers, but also as providers of financial services. This is a role typically reserved for banks and financial institutions.
Decentralized exchanges (DEXs) enable peer-to-peer trading, where users supply liquidity and earn rewards. Traders can then trade between assets using the crowdsourced liquidity, and trades are executed through smart contracts.
Note: DEXs should not be confused with centralized crypto exchanges (CEXs), where a central authority facilitates transactions, trades, and has the final say on users’ assets. Trading on a DEX allows users to retain control of their private keys, providing self-custody of their assets and reducing susceptibility to issues like bank runs in traditional finance.