Decentralized finance (DeFi): definition, how it works
- Decentralized Finance or DeFi is a financial system that reinvents financial transactions by removing intermediaries and is based on blockchain technology, usually Ethereum.
- Various financial transactions are possible with DeFi’s “smart contracts” which execute financial transactions under certain conditions.
- There are many different decentralized applications, or dApps, and uses within DeFi that open up accessibility but come with risks.
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Decentralized finance or DeFi is a global financial system available on public blockchains, most often Ethereum.
“DeFi stands for decentralized finance. Simply put, it means self-sustaining finance. Unlike traditional finance where a company, a bank, a fund is responsible for your money, in DeFi no one but you has access to it, ”explains Anton Mozgovoy, co-founder of Mover, a DeFi Savings platform.
With this new emerging technology, DeFi expands what is possible with cryptocurrency and goes beyond mere currency and creates sophisticated systems with an abundance of uses with the creation of applications, generally referred to as decentralized applications, or dApps, which we’ll cover later.
DeFi was invented in 2018 by a group of Ethereum entrepreneurs and developers who wanted to open up financial applications for traditional systems. The abbreviation sounds like challenge, which is intentional.
How DeFi Works
DeFi, previously called “open finance,” eliminates the middleman in financial transactions. So instead of your bank or your credit card issuer being the middleman between you and a merchant when you make a purchase, you use and own digital currency to use it directly. DeFi is primarily based on Ethereum, the first cryptocurrency alongside Bitcoin.
Here are the main principles of DeFi:
- There are no middlemen, so no banks or institutions monitoring your money
- There is a level of transparency, as the code is available for anyone to review
- There are open networks that transcend geographic boundaries
- There are many applications for users, mostly based on Ethereum
While DeFi is typically a major player in the cryptocurrency conversation, it goes beyond creating an alternate currency or digital value. DeFi strives to replace the role of traditional financial systems through its smart contracts.
“DeFi is all about code. With the help of things called smart contracts, your money is programmed to perform various [functions]. This creates a unique opportunity for anyone with a computer and an Internet connection to participate in the global economy, ”Mozgovoy notes.
One of the most attractive things about DeFi for people is that it removes the barrier to entry for many of these financial transactions. You no longer have a government or corporation to manage your money or you no longer need to qualify for certain financial products.
Using traditional financial systems, you apply for a loan and you may be rejected based on your credit. You have a bank account or an investment brokerage house with a company that oversees your money.
With DeFi smart contracts, certain financial transactions are executed once specific conditions are met. Smart contracts make it possible to borrow, lend, etc., and the terms of the transaction are literally written in code. While this makes these transactions easier to use and more efficient, it can also make them more susceptible to errors that cannot be corrected.
Due to these smart contracts and Ethereum’s ability to build applications, DeFi can be used:
- As a lending network, which offers borrowing and peer-to-peer lending
- Through decentralized exchanges, where users can exchange one type of currency for another. For example, exchanging ether for US dollars
- To bet, where users bet on the potential outcomes of certain events
- As stable coins, which connect a type of cryptocurrency to a more traditional type of currency like the US dollar, in order to reduce price volatility and add more stability
Advantages and disadvantages of DeFi
The growing popularity of DeFi and other cryptocurrencies make it an attractive investment. But it’s important to understand what you’re getting yourself into before you get started, and understand the pros and cons.
“In DeFi, you keep your money, you control where your money goes and how it is spent. DeFi is efficient, since everything is programmable, with one click you can make complex transactions,” Mozgovoy explains.
The accessibility factor can remove some barriers, but there are a number of downsides to be aware of.
“DeFi is new and experimental. Since everything is code, it can contain bugs. Bugs lead to money loss or hacks. DeFi is new and complicated, ”Mozgovoy explains. “User experience can still be difficult. The learning curve is still steep, but it will change. ”
Any investment carries a certain level of risk and DeFi is no different. But any cryptocurrency or DeFi app may pose a higher level of risk due to regulatory difficulties (although the SEC is looking to fix this) and potential scams. A good rule of thumb is not to invest money that you can’t afford to lose.
The financial report
DeFi is a large financial ecosystem that strives to cut out middlemen and enable financial transactions between users. Currently, there is a lot of hype surrounding DeFi and crypto. If you want to participate, make sure you understand not only the benefits but also the risks before you jump in.