Decentralized finance—DeFi—is what happens when traditional finance meets blockchain technology. DeFi is a lot like the internet of money.
Imagine a seesaw, with lenders on one side and borrowers on the other. The post in the middle is legacy financial institutions, enabling and controlling all interactions. Decentralized finance removes the need for the middle post, empowering marketplace participants to transact directly.
Defining DeFi—decentralized finance
Decentralized finance is an emerging sector of the financial industry that uses blockchain technology to enable peer-to-peer transactions. Decentralized finance is radically different from the legacy financial system because it eliminates the need for intermediaries between buyers and sellers or borrowers and lenders.
Decentralized finance applications use smart contracts and cryptocurrencies on public blockchains like Ethereum. DeFi protocols and applications can support an array of financial functions, including—
- Lending and borrowing: DeFi platforms like MakerDAO and Compound enable participants to autonomously lend and borrow cryptocurrency.
- Trading: Blockchain technology supports decentralized exchanges—DEXs—like Uniswap. Participants can trade digital assets directly and create their own liquidity pools.
- Yield generation: Participants in some DeFi platforms can earn interest on their digital assets. Staking and yield farming—both prevalent on major blockchains like Ethereum—are two ways to potentially earn crypto rewards.
Decentralized finance also supports the creation and exchange of advanced financial instruments like derivatives. Blockchain-based protocols including Augur and Gnosis enable financial prediction markets, leveraging blockchain technology to make these markets more transparent and efficient.
DeFi is extending the use of blockchain technology from simple transfers of value—via digital currency—to complex financial use cases. Decentralized finance protocols and apps are potentially creating a financial ecosystem in which each participant plays a direct and active role in its operation.
How does decentralized finance work?
Decentralized finance platforms use smart contracts and digital currency to operate. Smart contracts are blockchain-based agreements that can be programmed to execute automatically under predefined conditions.
Let’s imagine that you want to use the Uniswap platform to buy Bitcoin without an intermediary. Here’s how this decentralized finance platform operates—
- User initiates a transaction: A user with a digital wallet connected to the platform can initiate a transaction by identifying the trade that they want to make.
- User interacts with a liquidity pool: The user accesses the relevant liquidity pool and enters the required information to complete a trade. The Uniswap protocol is an automated market maker that uses supply and demand data to automatically determine a token’s price—and liquidity pools on Uniswap are funded by the platform’s users.
- User pays the liquidity fee: The user pays a fee for the trade at the same time that the trade is executed. This fee is distributed as a reward to the liquidity providers in the pool.
- Pool and wallet balances update: The completion of the trade causes token balances—for the liquidity pool and the user’s digital wallet—to update. The change in supply in the liquidity pool could impact the token price for the next trade.
Uniswap is just one example of a DeFi platform that uses sophisticated smart contracts to operate. Uniswap enables any platform user to create a new liquidity pool, further enhancing its decentralization.
Know the advantages and risks of DeFi
Using decentralized finance can have many advantages—and participating in DeFi is also risky. What are the major pros and cons of decentralized finance in 2023?
What to love about decentralized finance
Many benefits of blockchain technology apply directly to DeFi applications. Using blockchain protocols for institutional and consumer finance may confer these key advantages—
- Financial autonomy: Decentralized finance can empower users with total financial control and privacy. Removing third-party intermediaries creates a permissionless financial system.
- Worldwide accessibility: Decentralized finance protocols are generally available to anyone with an internet connection. A financial system that is accessible to everyone has the potential to democratize global capital systems.
- High transparency: Decentralized finance transactions use blockchain technology to create a high degree of transparency for every transaction. All users of a DeFi platform access the same public information.
- Potential cost savings: Transacting on a decentralized finance platform may cost less than using the services of a traditional financial institution.
- Time savings: Using a decentralized finance platform can significantly increase transaction speeds for some types of transactions. Even complex financial transactions may occur in minutes rather than days.
- Return potential: Engaging in DeFi activities focused on yield generation can enable investors to grow their crypto portfolios. Many DeFi platforms advertise much higher yields than those offered by legacy institutions.
Why to approach DeFi cautiously
Participating in any type of decentralized finance activity is risky. Here’s why—
- Technological complexity: DeFi apps and platforms are generally not easy to use. Many are in the early stages of development and have multiple requirements for successful onboarding. Participating in decentralized finance may require a specialized skill set.
- Security risks: Decentralized finance platforms can create many different types of security risks. Smart contracts may create vulnerabilities through code defects, liquidity providers can suffer impermanent losses, and sophisticated scams can (and do) occur.
- Price volatility: Cryptocurrency prices are notoriously volatile—including and especially on decentralized exchanges. A DeFi platform with low trading volumes may face liquidity issues that exacerbate price volatility.
- Platform failure risk: The newness of decentralized finance means that every DeFi app and platform is recently established. Decentralized finance platform users assume the risk of the DeFi platform failing completely.
- No customer service: The self-serve nature of decentralized finance means that typically there’s no easy way to get help. Limited customer support can make it difficult for average users to solve urgent or complex financial problems.
Decentralized finance is driving disruptive innovation
DeFi app developers are aiming to establish transparent, permissionless, and global financial systems that can potentially replace traditional financial intermediaries. If that sounds radically disruptive—that’s because it is. The disruptive potential of decentralized finance is increasing in tandem with awareness, adoption, and app usability.
Autonomous DeFi platforms are becoming increasingly interoperable and the programmability of smart contracts is supporting new financial use cases. More participants in the marketplace are becoming accustomed to the idea of significant financial autonomy.
None of that bodes well for legacy financial institutions unwilling to innovate. Banks, brokerages, and insurance companies all have a choice—to either embrace decentralized finance protocols or potentially be rendered obsolete by them.
Is DeFi here to stay?
Yeah, probably—decentralized finance is likely a permanent part of the modern financial landscape. DeFi offers many tantalizing benefits for users and exciting opportunities for financial innovators. With the decentralization of finance just beginning, it’s especially important to do your own research before getting involved with DeFi in any way.