What Is Decentralized Finance (DeFi)?
(Updated 5DEC2023)
Decentralized finance (DeFi) is an emerging financial technology based on secure distributed ledgers similar to those used by cryptocurrencies.
In the U.S., the Federal Reserve and Securities and Exchange Commission (SEC) define the rules for centralized financial institutions like banks and brokerages, which consumers rely on to access capital and financial services directly. DeFi challenges this centralized financial system by empowering individuals with peer-to-peer transactions.
KEY TAKEAWAYS
- Decentralized finance, or DeFi, uses emerging technology to remove third parties and centralized institutions from financial transactions.
- The components of DeFi are cryptocurrencies, blockchain technology, and software that allow people to transact financially with each other.
- DeFi is still in its infancy, subject to hacks and thefts because of sloppy programming and a lack of security testing before applications are launched.
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.
Blockchain
A blockchain is a distributed and secured database or ledger. In the blockchain, transactions are recorded in blocks and verified through automated processes. If a transaction is verified, the block is closed and encrypted; another block is created with information about the previous block and about newer transactions.
The blocks are “chained” together through the information in each proceeding block, giving it the name blockchain. Information in previous blocks cannot be changed without affecting the following blocks, so there is no way to alter a blockchain. This concept, along with other security protocols, provides the secure nature of a blockchain.
Using applications called wallets that can send information to a blockchain, individuals hold private keys to tokens or cryptocurrencies that act like passwords. These keys give them access to virtual tokens that represent value. Ownership of the tokens is transferred by ‘sending’ an amount to another entity via a wallet, whose wallet, in turn, generates a different private key for them. This secures their token ownership, and the blockchain design prevents the transfer from being reversed.
Applications
DeFi applications are designed to communicate with a blockchain, allowing people to use their money for purchases, loans, gifts, trading, or any other way they want without a third party. These applications are programs installed on a device like a personal computer, tablet, or smartphone that make it easier to use. Without the applications, DeFi would still exist. Still, users must be comfortable and familiar with using the command line or terminal in their device’s operating system.
DeFi applications provide an interface that automates transactions between users by giving them financial options to choose from. For example, if you want to loan someone and charge them interest, you can select the option on the interface and enter terms like interest or collateral. If you need a loan, you can search for providers, ranging from a bank to someone who could lend you some cryptocurrency after agreeing to the terms.
Some applications let you enter parameters for the services you’re looking for and match you with another user. Because the blockchain is a global network, you can give or receive financial services to or from anywhere worldwide.
Using applications called wallets that can send information to a blockchain, individuals hold private keys to tokens or cryptocurrencies that act like passwords. These keys give them access to virtual tokens that represent value. Ownership of the tokens is transferred by ‘sending’ an amount to another entity via a wallet, whose wallet, in turn, generates a different private key for them. This secures their token ownership, and the blockchain design prevents the transfer from being reversed.
Applications
DeFi applications are designed to communicate with a blockchain, allowing people to use their money for purchases, loans, gifts, trading, or any other way they want without a third party. These applications are programs installed on a device like a personal computer, tablet, or smartphone that make it easier to use. Without the applications, DeFi would still exist. Still, users must be comfortable and familiar with using the command line or terminal in their device’s operating system.
DeFi applications provide an interface that automates transactions between users by giving them financial options to choose from. For example, if you want to loan someone and charge them interest, you can select the option on the interface and enter terms like interest or collateral. If you need a loan, you can search for providers, ranging from a bank to someone who could lend you some cryptocurrency after agreeing on terms.
Some applications let you enter parameters for the services you’re looking for and match you with another user. Because the blockchain is a global network, you can give or receive financial services to or from anywhere worldwide.
IMPORTANT
Decentralized finance does not provide full anonymity. Transactions do not include an individual’s name but are traceable by anyone with the knowledge to do so. This includes governments and law enforcement, which, at times, are necessary for protecting an individual’s financial interests.
Goals of Decentralized Finance
Peer-to-peer (P2P) financial transactions are one of the core premises behind DeFi, where two parties agree to exchange cryptocurrency for goods or services without a third party involved.
Using DeFi allows for:
- Accessibility: Anyone with an internet connection can access a DeFi platform, and transactions occur without geographic restrictions.
- Low fees and high-interest rates: DeFi enables any two parties to negotiate interest rates directly and lend cryptocurrency or money via DeFi networks.
- Security and Transparency: Smart contracts published on a blockchain and records of completed transactions are available for anyone to review but do not reveal your identity. Blockchains are immutable, meaning they cannot be changed.
- Autonomy: DeFi platforms don’t rely on centralized financial institutions. The decentralized nature of DeFi protocols mitigates the need for and costs of administering financial services.
Peer-to-peer lending under DeFi doesn’t mean interest and fees won’t exist. However, you’ll have many more options since the lender can be anywhere worldwide.
Disadvantages of DeFi
Decentralized finance is constantly evolving. It is unregulated, and its ecosystem is vulnerable to faulty programming, hacks, and scams. For example, one of the main ways hackers and thieves steal cryptocurrency is through weaknesses in DeFi applications.
Laws have not yet caught up with advances in technology. Most current laws were crafted based on the idea of separate financial jurisdictions, each with its own set of laws and rules. DeFi’s borderless transaction ability presents essential questions for this type of regulation. For example:
- Who is responsible for investigating a financial crime across borders, protocols, and DeFi apps?
- Who would enforce the regulations?
- How would they enforce them?
What Does Decentralized Finance Do?
The goal of DeFi is to challenge the use of centralized financial institutions and third parties involved in all financial transactions.
Is Bitcoin Part of Decentralized Finance?
Bitcoin is a cryptocurrency. DeFi is designed to use cryptocurrency in its ecosystem, so Bitcoin isn’t DeFi as much as it is a part of it.
What Is Total Value Locked in DeFi?
Total value locked (TVL) is the sum of all cryptocurrencies staked, loaned, deposited in a pool, or used for other financial actions across DeFi. It can also represent the sum of specific cryptocurrencies, such as ether or bitcoin, used for financial activities.
The Bottom Line
Decentralized finance (DeFi) is an emerging financial technology that challenges the current centralized banking system. DeFi attempts to eliminate the fees banks and other financial service companies charge while promoting peer-to-peer transactions.
DeFi, like the blockchains and cryptocurrencies it supports, is still in its infancy. Significant hurdles must be overcome before it can replace the existing financial system, which has issues that are difficult to resolve. Lastly, financial service companies and banks are not going to be replaced without a fight—if there is a way for them to profit from the transition to a blockchain-based financial system, they will find it and make sure they are part of it.
