What is decentralized finance (DeFi)?
Cryptocurrency was built on the idea of decentralization. The blockchain technology itself that powers the Bitcoin network was purpose-built to be powered by independent operators so that no central authority could govern it.
Decentralized finance is one of the most popular innovations to come from cryptocurrency, allowing anyone to transact on the blockchain directly. Decentralized finance (DeFi) apps allow users to connect their digital wallets and access financial services, such as crypto trading and lending.
Read on for a breakdown of DeFi, what it is, how it works, and the most popular cryptocurrency in the DeFi space today. We’ll also cover some of the risks to consider before investing in and using DeFi platforms.
What Is Decentralized Finance (DeFi)?
Decentralized finance (DeFi) refers to the applications and networks that allow users to exchange cryptocurrency for goods and services on a decentralized blockchain. These transactions are typically managed by smart contracts, which are programs that govern financial transactions on the blockchain.
Although that may sound complicated, the real-world use cases of DeFi are much simpler.
Users can connect their digital wallet to an application and choose to trade, lend, borrow, invest, or make a purchase with the crypto in that wallet. This activity can range from purchasing a non-fungible token (NFT), to transferring crypto to another user, to playing a decentralized online game, to depositing crypto to earn interest.
There are many use cases for decentralized finance. Here’s how it works:
How Decentralized Finance (DeFi) Works
DeFi uses peer-to-peer networks of computers and servers (known as “nodes”) to process transactions and host applications (such as a lending application). Users interact with these applications with a digital wallet that carries a compatible cryptocurrency.
DeFi applications are specifically built to be decentralized, relying on node operators and validators to confirm transactions and secure the network. The distributed nature of DeFi means that there is no central governing authority to regulate the applications, but is instead a “trustless” system that uses smart contracts and a blockchain ledger to automate and secure transactions.
It’s easier to understand DeFi when comparing it to how traditional banking systems work.
When someone wants to borrow money from a bank, they need to prove their creditworthiness, provide detailed financial statements (including income and debt), and may be required to provide proof of collateral to secure the loan. There may be a down payment required, and a written agreement on payback terms and conditions that both parties sign.
In DeFi, when applying for a loan, a user can deposit their cryptocurrency as collateral (such as Bitcoin), select how much they wish to borrow against that balance, and the funds are instantly transferred to their digital wallet. Repayment typically happens at the borrower’s convenience, and the interest charged is simply added to the user’s debt balance over time.
DeFi removes banks from the middle of financial transactions. Money transfers, borrowing, lending, and crypto trading happens in an automated fashion.
Here’s how the blockchain and smart contracts are designed to facilitate DeFi applications:
The blockchain is a public distributed ledger that processes and validates cryptocurrency transactions. When a transaction is processed, a record of that transaction is created and multiple other users verify the transaction to confirm it is valid.
The transaction is added to a block on the network, where multiple transactions are stored in sequential order. After the transactions within a block are completely validated, the block is closed, and placed in sequential order just after the previous block.
This continuous chain of blocks makes up the blockchain, which cannot be altered, or it breaks the chain and invalidates the entire blockchain. All this data is encrypted and validated by independent parties, ensuring no bad actor or central authority can alter the blockchain.
DeFi applications are built on this blockchain, and all transactional activity uses the native blockchain of the application to record the activity. For example, if you use a decentralized exchange based on Ethereum like Uniswap to trade crypto, your transactions are all recorded on the Ethereum blockchain.
Yes, this sounds complicated. But you, as a user of DeFi apps, are simply connecting your digital wallet and interacting with an app. The blockchain manages all the data in the background.
Smart contracts are programs that automatically execute transactions on the blockchain when certain conditions are met.
For example, when a user of a DeFi lending application deposits cryptocurrency, a smart contract executes to automatically start paying interest to the user. Or, when executing a trade on a decentralized exchange, a smart contract automatically executes the trade at the agreed-upon price without a broker acting as a middleman.
There are infinite uses of smart contracts, and DeFi applications continue to find innovative ways to program smart contracts into their applications. They are the foundation of how DeFi apps function, and are used by most modern blockchains.
DeFi applications are the heart of decentralized finance and are built to allow users to buy, sell, and trade crypto, as well as perform other financial transactions, such as borrowing and lending. Here are a few examples of DeFi apps:
- Borrowing. Users who want to borrow against their crypto holdings can connect to a decentralized lending platform, deposit their crypto holdings as collateral, and borrow against those holdings. Users can borrow cryptocurrency up to a certain percentage of their collateral value, but can also be automatically liquidated if the value of their collateral drops too much.
- Lending. Crypto lending platforms allow users to borrow crypto, but on the flip side, users can deposit crypto to earn interest on their holdings. Users can deposit stablecoins to earn high interest rates, and the lending platform will lend out those coins to borrowers. This is how many use DeFi to earn passive income.
- Decentralized Exchanges (DEXs). A decentralized exchange is where users can trade crypto directly from their digital wallet. You can connect your wallet and select which crypto you want to trade. Buying and sellers are automatically matched to facilitate the transaction, and the DEX charges a small fee to pay for liquidity and transaction costs.
- Derivatives. Users can trade derivatives on DeFi applications, which are cryptocurrencies that are tied to the value of real-world items, such as a stock market index fund. DeFi apps use an “oracle” smart contract that ties in value data from real assets and attaches that value to a cryptocurrency or contract to allow users to trade derivative products.
- NFTs. Although not technically an application, non-fungible tokens (NFTs) are essentially a serial number for digital assets, such as artwork and metaverse items. These items are recorded on the blockchain, giving users verifiable ownership of a unique item. These items can be purchased on exchanges or traded within DeFi applications.
There are a growing number of DeFi applications as the space continues to evolve at a rapid pace. Time will tell how these applications will expand and impact the financial world.
Pros and Cons of DeFi
DeFi is exciting, innovative, and sometimes confusing. With so many applications and use cases being launched on a weekly basis, it is hard to keep up with the growth of this space. And while this creativity is sparking changes in the financial world, there are definite risks involved in DeFi. Here are a few awesome things about the space, as well as some concerns to be aware of:
Pros of Decentralized Finance (DeFi)
DeFi allows users to access financial services in a fast, unmoderated way. With around the clock functionality, lightning-fast transactions, and minimal fees, DeFi offers many advantages over traditional banking systems. Here are a few features that make DeFi great:
- 24/7 Availability. DeFi is decentralized and hosted on networks that are available 24 hours a day, seven days a week. With no governing authority to stop trading and transaction processing, users can transact whenever they want without waiting days for approvals and market availability.
- Low Fees. In general, DeFi offers low fees to process transactions, typically charging less than 1% of the total transaction. Compared to fees upwards of 4% for companies like PayPal, this is a major discount for services.
- (Partially) Anonymous. Although transactions are recorded on a public ledger and are traceable through the blockchain, users do not have to verify their identity or sign up for any account with any personal information to use DeFi applications. This allows a certain level of anonymity when transacting within DeFi apps.
- Fast Transactions. DeFi is fast and is getting faster as networks and protocols are continually upgraded. Users can get approvals for DeFi loans instantly, and transactions can be processed in just seconds.
Cons of Decentralized Finance (DeFi)
Although DeFi is rapidly changing the world of finance, there are some risks involved. Namely, scammers and hackers are in the business of trying to access the enormous amount of wealth being transacted within DeFi applications. Network fees can also fluctuate, causing a sharp spike in prices for transactions.
Here are a few risks of DeFi to be aware of:
- Scams. Unfortunately, with lack of regulation comes an influx of scammers and criminals trying to steal your money. Billions of dollars were scammed from DeFi users in 2021 alone, and the number is rising. Stolen digital wallet private keys and “rug pulls” (newly-issued tokens that become worthless) are two common types of these scams.
- No Insurance. While DeFi is unregulated by design, this means most DeFi applications do not have any consumer protections, including insurance. If you transfer your coins to the wrong digital address or an application gets shut down while it holds your tokens, you cannot recover any of those funds via insurance.
- Liquidations. Specific to lending apps, a liquidation happens when you provide collateral for a loan (say, Bitcoin), and the price of that collateral drops. Because DeFi lending is automated, if the price of your Bitcoin drops below a certain threshold, the DeFi can automatically liquidate your collateral to pay off the loan, leaving you with no collateral left.
There are other risks in DeFi, mostly stemming from the fact that it is unregulated, and anyone can create a DeFi app that looks legitimate, even if it is not. As always, protect your digital wallet private keys and always do your research before connecting your wallet to any DeFi application.
How to Get Started With DeFi
DeFi requires that users connect to applications using a digital wallet with some cryptocurrency in it. To get started, you can download a digital wallet application as an add-on to your browser or as a mobile app.
Once you have your wallet set up, you will need to purchase crypto and transfer it to that wallet. You can use a crypto exchange to make the purchase, and then transfer the funds to your wallet address.
Once you have the right crypto in your wallet — for example, ethereum (ETH) for use on Ethereum-based DeFi apps — then you can go to the website or application and connect your digital wallet. This allows you to transact on the DeFi app, including borrowing, lending or trading.
FAQs About Decentralized Finance
As a brand-new technology, DeFi can be confusing. Here are some answers to common questions about DeFi to help you get started.
Is Bitcoin DeFi?
Bitcoin is the original DeFi protocol — a decentralized distributed ledger to facilitate peer-to-peer payments without the need for a central bank or processing company. It laid the groundwork for all other cryptocurrency protocols, and created the blockchain.
That being said, in today’s vernacular, Bitcoin is not really known as DeFi. Today the term typically refers to DeFi applications that use smart contracts, which are mostly built on the Ethereum network and a few other blockchains.
Bitcoin is used as a payment system and is seen as a store of value, but not a DeFi application.
What Are the Top DeFi Coins?
The top DeFi coins are cryptocurrencies that support the underlying networks DeFi applications run on. This includes Ethereum — which hosts a majority of DeFi today — as well as Solana (SOL), Avalanche (AVAX), Cardano (ADA), and Terra (LUNA). These blockchain networks host DeFi applications, and their native cryptocurrencies are well established, worth tens of billions of dollars (or more).
As for DeFi projects that build decentralized applications, some of the top coins include MakerDAO (MKR), SushiSwap (SUSHI), Aave (AAVE), and Uniswap (UNI). These applications boast large daily transaction volumes and billion-dollar market caps.
What Are the Top DeFi Platforms?
There are hundreds if not thousands of DeFi platforms today, with more being launched in rapid fashion. Some of the top platforms are the native blockchains that host DeFi applications. Here’s a few of the top DeFi platforms available:
Ethereum. Ethereum was one of the first blockchain networks to launch smart contracts, and it was developed to allow users to create applications on top of the Ethereum network. There are hundreds of DeFi apps that run on Ethereum, and it is the most popular cryptocurrency outside of Bitcoin.
Solana. Solana is a blockchain platform that promises lightning-fast transactions and extremely low fees. Many DeFi applications have already been built on Solana, including borrowing, lending, NFT marketplace, and trading applications.
Avalanche. Avalanche is another fast blockchain network that offers extremely low fees and quick transactions. It hosts many decentralized exchanges and other DeFi apps, making it one of the top DeFi platforms available today.
Decentraland. Decentraland is a DeFi gaming platform that allows users to buy and sell digital assets for the metaverse, including digital real estate, digital avatar wearables, and names.
These platforms have proven track records and massive valuations, with millions of daily users.
How Are DeFi Transactions Taxed?
DeFi covers a wide range of financial services, and the taxes on each of these services vary depending on the type of DeFi application you’re using. DeFi taxes will either be classified as income or capital gains, depending on how it is earned.
When earning interest or rewards within a DeFi app, this is typically taxed as income. The same goes for mining crypto or receiving an airdrop of a token.
Buying and selling crypto also incurs taxes, similar to buying and selling stocks. When these transactions happen in DeFi, it is no different. Crypto held for under one year is taxed at short-term capital gains rates, and those held for one year or longer are taxed at long-term capital gains rates.
Overall, taxes of DeFi transactions can get fairly complicated, and it’s best to connect with a tax professional to understand the tax implications of your particular DeFi application use case.
How Will Ethereum 2.0 Impact DeFi?
Ethereum 2.0 is a network upgrade to the Ethereum blockchain, and will allow a much larger number of transactions. This will help lower the cost of network fees on the Ethereum network, as well as speed up transaction times.
Because most DeFi applications are built on Ethereum, this upgrade will drastically improve the overall performance of DeFi.
Are NFTs DeFi?
Although NFTs themselves are simply tokenized ownership of an asset (physical or digital), NFTs can be traded over the blockchain, making them a DeFi-compatible asset.
There are NFT marketplaces built on the blockchain that allow trading and listing of NFTs, and NFTs act as a store of value on the decentralized network. NFTs can also be used as collateral for DeFi loans, or “staked” to earn interest on DeFi applications.
So, although NFTs themselves are not DeFi items, they function within the DeFi ecosystem.
Decentralized finance (DeFi) is here to stay. There are thousands of applications providing financial services across the globe, and the number of use cases continues to grow exponentially. Investors in DeFi cryptocurrency anticipate this growth, with institutional investors joining at a rapid pace, investing in protocols such as Ethereum and Solana.
DeFi faces quite a few regulatory hurdles in the coming years, with scams on the rise and billions of dollars worth of crypto being stolen on a yearly basis. This is a problem that requires a solution, and authorities like the SEC and FinCEN are starting to get involved.
Although some view regulation as a bad thing for DeFi, creating a regulatory environment that allows DeFi to thrive while protecting consumers could help boost its popularity even more.
Overall, DeFi is a new technology that marries the blockchain with real-world use cases. Only time will tell how it impacts the world of finance in the coming years.