What is Decentralized Finance (DeFi)?

Written by Steven WhiteUpdated: 18th Sep 2021
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Waiting for bank transfers to process and paying the associated bank fees can be quite frustrating for individuals who frequently perform such transactions.

Fortunately, a new solution is on the horizon. Decentralized Finance (DeFi) is poised to reshape the traditional financial systems that have been in place for so long.

A Brief History of DeFi

If DeFi is to become the new norm, it may help to know where its roots lie. Let’s start from the beginning.

DeFi began when Bitcoin was first created by Satoshi Nakamoto. Nobody knows exactly who Satoshi is, but he is responsible for enabling the entire cryptocurrency industry.

Some people would also consider Bitcoin to be a form of DeFi because it allows you to send payments around the world in a decentralized manner. As payments are one area of finance, the term Decentralized Finance actually fits.

Finance doesn’t stop at sending and receiving payments, though. Future cryptocurrencyand blockchain developments allowed the DeFi industry to grow at a rapid pace.

Ethereum, which was developed by Vitalik Buterin, attracted many developers to the industry. Many of them became interested in DeFi, because through Ethereum’s blockchain, decentralized applications can be created. These applications can range from games to financial tools.

After Ethereum gained a firm foothold in the DeFi world, ICOs became prevalent as a means of decentralized fundraising.

Unfortunately, many of the ICOs that came to be were overhyped projects that raised significant amounts of money with little follow through or delivery on promises.

Still, even though many ICOs ultimately failed, there were plenty of ICOs that had significant impact on the DeFi industry.

For example, Synthetix, which was previously known as Havven, was one ICO project that stood out. Their team created a liquidity protocol for derivatives.

Other examples of effective DeFi ICOs include REN, Kyber Network, Ox, and Bancor. Each of these developed useful protocols that could be used in the DeFi space.

Down the line, around 2018 and 2019, there were plenty of DeFi projects with protocols on the Ethereum mainnet.

Yet, eventually, Black Thursday happened. If you haven’t heard of this event, it is the day that ETH dropped by more than 30% in less than 24 hours.

This occurred on March 12, 2020, and the cause was global fear over the pandemic. Fortunately, Ethereum was able to survive this stress test.

Following Black Thursday, there was a period of growth called “DeFi Summer”. This period started when Compound started rewarding users for lending and borrowing.

In exchange for these actions, they were given COMP tokens. This enabled the development of yield farming, as people using Compound had the incentive to switch between borrowing and lending different tokens in order to achieve the most equitable yield.

This resulted in Compound governance, which allowed users with COMP tokens to vote on proposed changes to the protocols.

There were many tokens that copied Compound’s protocols. Furthermore, this isn’t the only project that had a role in “DeFi Summer”.

There were more, but they are quite complex. From what’s been stated so far, you should have a solid understanding of where DeFi got its start.

Now, let’s cover everything you need to know about DeFi.

What Is DeFi?

Decentralized finance is an alternative way to execute financial transactions. This method relies on decentralized applications, rather than traditional financial institutions.

Transactions are conducted over the blockchain, removing brokerages, centralized exchanges, banks, and all other intermediaries.

Smart contracts are essential to DeFi, as they allow for complete decentralization and autonomy on the blockchain.

Smart contracts are pieces of code that are written to perform certain actions once the proper conditions have been met.

Over time, DeFi has actually become a more general term for any business that uses blockchain technology or cryptocurrency to create financial products.

Now, people are leveraging DeFi to prevent onerous expenses, save time, and avoid fraud. As the industry continues to evolve, we are certain to see more examples of DeFi in our everyday life.

How Does Decentralized Finance Work?

People who want to develop DeFi products have to use the blockchain to successfully do so. On the blockchain, people can create tokens that can be used in financial transactions.

They can also create applications that perform a variety of financial services. For example, the Ethereum blockchain can be used to perform a variety of financial transactions, including lending, borrowing, scheduling payments, and investing in index funds.

Why Is DeFi Important?

Decentralized Finance is an open, global system that was built for the internet age. It has less friction than legacy financial infrastructure and processes.

It also gives participants exposure to global markets and alternatives to using their local currency. Through DeFi, financial services become available to everyone who has an internet connection.

Better yet, DeFi products are often largely owned and maintained by their users. In fact, there are currently tens of billions of dollars’ worth of crypto being used across thousands of DeFi applications.

What Are the Benefits of Decentralized Finance?

These are some benefits of using DeFi technology:

Transparent

With DeFi, there is a built-in level of transparency. This is because DeFi products use blockchains, which make all transactions public to other users.

The distributed ledger on a blockchain features a lot of information about any activities that occurred on the blockchain network.

This could improve due diligence for financial services providers that choose to develop their products using DeFi technology.

Wildly Flexible

DeFi products can be used for any number of purposes. If there isn’t yet a DeFi product that provides the service you need, then you also have the option to create one.

This is a far more flexible alternative to traditional banking and other financial institutions, which are usually very slow-moving.

Accessible to All

Anyone can use DeFi services. This allows for balance in the industry. It also provides people with little access to financial services with the option to engage in financial transactions that they otherwise wouldn’t be able to.

This can benefit populations that are struggling economically and have little financial infrastructure.

Pseudonymous

All transaction activity on the blockchain is pseudonymous. This means that your real name won’t be shared publicly.

While it is possible to find the identity of a user on the blockchain, the pseudonymous nature of the system makes it highly secure and private.

Secure Transactions

One common concern that prevents people from using DeFi is their uneasiness about the security of such services.

Because the blockchain is typically immutable, there isn’t anything to worry about as long as you are working with a trusted, legitimate source. This can significantly vary depending on the project and particular blockchain. Choose wisely.

DeFi Technology Stack Explained

DeFi technology is a technology stack that has several components. Some of these components are stablecoins, while others are services, such as lending or crypto exchange.

These are the different layers of the DeFi technology stack:

Settlement Layer

The settlement layer is the most basic layer upon which other DeFi solutions are developed. It includes any public blockchain and its native digital currency. In most cases, DeFi apps will use the native currency for most transactions.

Protocol Layer

Protocols are the rules and standards that have been tailed to govern specific activities and tasks.

The protocol layer consists of the collection of rules and principles that all participants must follow.

The protocol layer enables interoperability and allows the DeFi ecosystem to reach the desired liquidity level.

Application Layer

All of the decentralized applications in a DeFi technology stack are on the application layer. You can find many types of services in this layer, such as lending services and decentralized exchanges.

Aggregation Layer

This is the final layer of the DeFi tech stack. It consists of aggregators that connect different applications from the application layer. Through the aggregation layer, people can access the services offered through the DeFi stack.

What Is DeFi Ethereum?

DeFi is a collective term for any financial products that are accessible through Ehtereum. With DeFi, there are no centralized authorities that can limit, block, or deny access to the system.

With DeFi Ethereum, financial services that used to be slow and subject to human error are now automated and safely handled by code.

The code is public too, so users have the option to scrutinize it before using it.

What Is an Example of DeFi?

If you are curious about how DeFi works, an example may help.

Imagine you aren’t using DeFi and you need to manage your money or perform a transaction. In this situation, you would have to rely on traditional financial infrastructure, such as banks.

You also have to depend on these banks to not mishandle your money. If you wish to use financial services, you’ll need to apply. Similarly, the markets close because workers must have breaks.

For most of these situations, the opposite would be true if you were using DeFi. According to Ethereum.org, there have been many DeFi users that have received massive loans and paid them back without ever filling out an application.

Solana is another blockchain with a thriving DeFi ecosystem.

What Does DeFi Mean for Bitcoin?

DeFi refers to financial services that rely on blockchain networks for their operation.

Bitcoin prioritizes security over speed and therefore doesn’t leverage the full DeFi stack (yet), it does allow for decentralized financial transactions.

It’s unclear how many Layer 1 blockchains will exist 100 years from now.

With this in mind, you can assume that DeFi has a positive effect on Bitcoin. As DeFi normalizes, Bitcoin will benefit in the long term.

How Does DeFi Affect Yield Farming?

With DeFi, you can stake assets that you own into DeFi protocols. By doing so, you can earn profit that most people in this space refer to as “yield”.

These yields allow you to grow your crypto stack over time, without risking it through trading or other similar economic activities.

What Are the Downsides to DeFi?

One of the most prominent downsides of DeFi is that DeFi projects can be difficult to scale up.

Many DeFi projects have significant difficulty involved with congestion that cause transactions to become very expensive.

DeFi can also be problematic because of feelings of uncertainty. If there are changes being made to a blockchain, like Ethereum, mistakes could be made that impact the entire blockchain.

There is also the fact that DeFi projects don’t take any responsibility for mistakes that you make using their products or services. This gives power to the user, but it also limits protection.

Is Decentralized Finance Safe?

Decentralized Finance is safe. Millions of people use DeFi services today. While there may be some downsides to the new DeFi ecosystem, overall, the systems and services offered by legitimate companies are safe.

How Do I Make Money with DeFi?

To make money with DeFi, you need to stake assets you own into DeFi protocols. This will allow you to earn yields that can be used to grow your crypto stack.

Through this process, you can earn residual income that grows steadily as you continue to stake assets.

With this method, you won’t have to worry about market dips, as your investment can continue to grow even when prices are dropping.

You can also make money through DeFi by becoming a liquidity provider. As a liquidity provider, you can earn a 0.3 percent fee for any swaps between token pairs, like ETH and USDT.

While this doesn’t always guarantee a profit, it is a way to make money. Fortunately, there are ways to mitigate loss with liquidity providing, but it takes detailed industry knowledge.

Is Investing in DeFi Safe? Is It Smart?

Investing in DeFi is both safe and smart. If you don’t have access to traditional financial systems, DeFi will help you access services that you otherwise wouldn’t have been able to.

How smart it is depends on how you navigate the system, but in most cases, leveraging DeFi is a smart move.

Bottom Line: What Is DeFi?

DeFi is a groundbreaking ecosystem of blockchains, applications built on those blockchains, protocols, and settlements.

It allows for flexible transference of assets and safe transactions. As Ethereum continues to grow, so will DeFi as a whole. Therefore, if you haven’t yet staked any assets in DeFi, now is the time to try.

Steven White
Steven White

Steven White is a SimpleMoneyLyfe authority on Cryptocurrency. He started his writing career producing content for higher education institutions. Steven worked frequently on content that was intended to encourage finance students to pursue Master’s level education. After moving on from that position, he has also held editorial roles for online cryptocurrency publications, like The Daily Hodl. Steven’s area of expertise is bitcoin, cryptocurrency, and financial technology.