Crypto 101: What is DeFi?
A beginner’s guide to decentralized finance (DeFi)
Decentralized Finance (“DeFi”) is an umbrella term for an emerging financial system within the crypto universe. CEO of Coinbase, Brian Armstrong, has even called DeFi “the future of where this industry is going.”
These financial services are hosted on public blockchains, primarily Ethereum, which allow individuals and businesses to purchase, borrow, lend, and trade without needing an intermediary. This makes financial transactions accessible to anyone with an internet connection, cuts out processing time and paperwork, and eliminates surcharges and fees.
It’s helpful to compare DeFi with our traditional financial system. In centralized finance, third-parties, such as banks and stock exchanges, hold money and facilitate transactions.
This means that “simple” purchases, like buying groceries with a credit card, involve multiple middlemen, as the charge must be processed by an acquiring bank, a credit card network, and the consumer’s bank. Once that charge is approved, its approval must be sent back to the credit card network, the acquiring bank, and, finally, the grocery store.
This system is not only inefficient, but costly: each intermediary must be paid for its services, requiring the merchant to pay for credit and debit card use.
How does DeFi work?
DeFi replaces those middlemen with blockchain-based software called “smart contracts.” Smart contracts are programs that automatically execute an agreement once established conditions have been met. They allow trustworthy and transparent peer-to-peer (P2P) transactions.
For example, a landlord and an incoming tenant could utilize a smart contract to exchange a security deposit for an entry code. Once both parties have fulfilled the conditions of the contract, the entry code and the security deposit are distributed to the appropriate parties automatically and simultaneously. If the landlord does not input the entry code the security deposit won’t be released, and vice versa.
Benefits of Smart Contracts
These smart contracts, the backbone of DeFi, result in a host of benefits, including:
- Speed and efficiency: Because smart contracts are automated and allow for direct transactions, agreements can be executed instantaneously. No lengthy paperwork, no miscommunications, and no delays.
- Security and trust: As with crypto generally, information that is stored on a blockchain cannot be altered once it has been finalized. This provides security from hackers and ensures that contracts are not tampered with once they’ve been verified.
- Transparency: Encrypted records of transactions are shared amongst all involved parties, providing a level of transparency that is rare in traditional financial systems.
- Lower cost of use: Smart contracts might not eliminate fees, but, since DeFi transactions don’t require intermediaries, conducting transactions doesn’t come with all of the costs associated with traditional banking, borrowing, and investing.
Other Benefits of DeFi
As well as facilitating direct, P2P financial transactions, DeFi has the potential to empower all users with economic autonomy. Users can engage with DeFi via decentralized apps (dApps), software that runs on the Ethereum blockchain.
Due to DeFi’s lack of centralization and emphasis on P2P transactions, accessing dApps and using dApps does not require bank approval. Anyone, anywhere, can participate in DeFi as long as they have an internet connection. This democratizes finance, offering financial services and tools to people for whom traditional banking is inaccessible.
Some of the functions offered to DeFi users, without needing an application or to open an account are:
- Obtaining a loan: DeFi makes it possible for users to get a loan, almost instantaneously.
- Savings: Savings account alternatives often offer better interest rates than traditional banks.
- Investing: In DeFi, everyone has access to investment tools that were previously restricted to professional financial services. This gives everyone the ability to become savvy traders and potentially capitalize on this new, evolving market.