Decentralized Finance (DeFi)

Decentralized finance, also known as DeFi, uses cryptocurrency and blockchain technology to manage financial transactions.

DeFi aims to democratize finance by replacing legacy, centralized institutions with peer-to-peer relationships that can provide a full spectrum of financial services, from everyday banking, loans and mortgages, to complicated contractual relationships and asset trading.

How Decentralized Finance (DeFi) Works

Through peer-to-peer financial networks, DeFi uses security protocols, connectivity, software, and hardware advancements. This system eliminates intermediaries like banks and other financial service companies. These companies charge businesses and customers for using their services, which are necessary in the current system because it's the only way to make it work. DeFi uses blockchain technology to reduce the need for these intermediaries.

How DeFi is Being Used Now

DeFI is making its way into a wide variety of simple and complex financial transactions. It’s powered by decentralized apps called “dapps,” or other programs called “protocols.” Dapps and protocols handle transactions in the two main cryptocurrencies, Bitcoin (BTC) and Ethereum (ETH).

While Bitcoin is the more popular cryptocurrency, Ethereum is much more adaptable to a wider variety of uses, meaning much of the dapp and protocol landscape uses Ethereum-based code.

Here are some of the ways dapps and protocols are already being used:

• Traditional financial transactions. Anything from payments, trading securities and insurance, to lending and borrowing are already happening with DeFi.
• Decentralized exchanges (DEXs). Right now, most cryptocurrency investors use centralized exchanges like Coinbase. DEXs facilitate peer-to-peer financial transactions and let users retain control over their money.
• E-wallets. DeFi developers are creating digital wallets that can operate independently of the largest cryptocurrency exchanges and give investors access to everything from cryptocurrency to blockchain-based games.
• Stable coins. While cryptocurrencies are notoriously volatile, stable coins attempt to stabilize their values by tying them to non-cryptocurrencies, like the U.S. dollar.
• Yield harvesting. Dubbed the “rocket fuel” of crypto, DeFi makes it possible for speculative investors to lend crypto and potentially reap big rewards when the proprietary coins DeFi borrowing platforms pay them for agreeing to the loan appreciate rapidly.
• Non-fungible tokens (NFTs). NFTs create digital assets out of typically non-tradable assets, like videos of slam dunks or the first tweet on Twitter. NFTs commodify the previously uncommodifiable.
• Flash loans. These are cryptocurrency loans that borrow and repay funds in the same transaction. Sound counterintuitive? Here’s how it works: Borrowers have the potential to make money by entering into a contract encoded on the Ethereum blockchain—no lawyers needed—that borrows funds, executes a transaction and repays the loan instantly. If the transaction can’t be executed, or it’ll be at a loss, the funds automatically go back to the loaner. If you do make a profit, you can pocket it, minus any interest charges or fees. Think of flash loans as decentralized arbitrage.

What are the key benefits and risks to DeFi users?

Overall, DeFi offers users more control over their money. Financial assets can be transferred or purchased in a matter of seconds or minutes. Service fees would largely be abolished, as there would be no third-party companies assisting with transactions. Your money would be converted to a “fiat-backed stablecoin” and made accessible via digital wallet so you wouldn’t have to deposit funds into a bank. And because bank accounts will no longer be necessary, almost anyone with an Internet connection can have access to the same financial goods and services.

The biggest risk is that DeFi is unregulated. There is no FDIC backing (nor that of any other regulatory entity) to protect your funds should a major glitch, error, or cyber hack make your funds unavailable or cause them to disappear.

Also, the technology is so new that there’s no unified or comprehensive way to determine whether any part of a DeFi system is operating at optimal capacity or is free from scams. In theory, each technological component in a DeFi ecosystem should operate in a fast, efficient, and secure manner. In practice, however, it’s still untested.

How to Get Involved with DeFi

Get a Crypto Wallet

“Start by setting up an Ethereum wallet like Metamask, then funding it with Ethereum,” says Cosman. “Self-custody wallets are your ticket to the world of DeFi, but make sure to save your public and private key. Lose these, and you won’t be able to get back into your wallet.”

Trade Digital Assets.

“I recommend trading a small amount of two assets on a decentralized exchange such as Uniswap,” says Doug Schwenk, chairman of Digital Asset Research. “Trying this exercise will help a crypto enthusiast understand the current landscape, but be prepared to lose everything while you’re learning which assets and platforms are best and how to manage risks.”

Look into Stablecoins

“An exciting way to try out DeFi without exposing oneself to the price swings of an underlying asset is to try out TrueFi, which offers competitive returns on stablecoins (AKA dollar-backed tokens, which aren’t subject to price movements),” Cosman says.