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What is DeFi? Everything you need to know

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(Image credit: Shutterstock / Bro Crock)

Decentralized Finance or “DeFi” (deef-eye) is a novel financial system that operates independently and does not rely on centralized financial intermediaries like banks, credit unions, or insurance funds. Instead, users have the ability to transfer, trade, invest, and transact peer to peer using cryptocurrencies and digital assets via automated smart contracts, eliminating the need for these slow and costly intermediaries.

DeFi is underpinned by advanced distributed ledger technology (DLT) - or blockchain - that aims to disrupt the current financial order and allow for a more transparent and equitable financial system.

Another distinct feature of DeFi is that it expands the blockchain from simple data or value transfers to more complex financial use cases such as trading, lending, yield farming, flash loans, and derivatives.

About the author

Kadan Stadelmann is CTO at Komodo

The industry boomed in 2020 during the ‘DeFi Summer’ where the total value locked (TVL) in DeFi smart contracts rose sharply from a few hundred million dollars to more than US $20 billion in a matter of months. While this is still small when compared to the traditional financial system, interest and investment in the space does not appear to be slowing down anytime soon. In a nutshell, DeFi is an open, permissionless and borderless financial system.

What's wrong with traditional finance?

In addition to being slow and costly to its customers, centralized financial systems are also vulnerable to hacks, data breaches, and security failures.

Think of it as having all your eggs in one basket. If your money is in the bank, and the bank decides to up its fees, makes a bad investment, gets robbed, or goes under, the customer loses out. In DeFi, the products, applications, and services, as well as the assets they service, are decentralized and therefore free from these points of failure found in centralized financial systems.

Traditional financial systems are also inaccessible to millions of people who do not meet the criteria for opening a bank account. This may sound odd to those in developed nations or wealthy regions, but insufficient identification and access to capital, geographic isolation and government oppression restrict millions around the world from accessing traditional financial services.

Cryptocurrencies and DeFi do not discriminate and allow anyone with an internet connection to access financial services, easily, cheaply, and equitably.

Where did DeFi come from?

While the term DeFi took off in the summer of 2020, the story really began with Bitcoin (BTC).

Bitcoin, by design, is inherently decentralized and brought about the idea of DLT as a means of creating decentralized networks for people to transact.

When Bitcoin was launched in 2009 by anonymous cryptographer Satoshi Nakamoto, people began transacting on a decentralized peer-to-peer network based on cryptography for the first time. It is this use of blockchain that led to the development of the trillion-dollar cryptocurrency ecosystem that we see today.

In just 12 years, Bitcoin has created an entirely new financial system worth more than $800 billion and a new set of financial ideals based on transparency and freedom.

Satoshi Nakamoto’s vision was to give people back their freedom through a P2P financial system. Bitcoin was the first currency to achieve this but is just one example. While Bitcoin itself is the pillar of DeFi, it’s only the first chapter of the story. After 2009, other networks started to emerge with a similar vision of building a new financial system.

Where is DeFi and how can I access it?

The most widely used blockchain is Ethereum. This is where the vast majority of DeFi applications are based and where billions worth of transactions occur every week. 

The Ethereum network is often heralded as “the next internet” due to its ability to decentralise many services, especially financial services, and bring together communities from across the globe. 

Among the hundreds of decentralised applications (dApps) available on the Ethereum blockchain, the top ten account for more than one million monthly users and the network consistently attracts a 24 hour trading volume of more than $35 billion. 

The Ether (ETH) cryptocurrency serves as the fuel for the network as each transaction attracts a fee that is used to incentivise those building and maintaining the network. 

The rapidly increasing number of users to the network paired with the sharp increase in the price of Ether have caused a spike in the ‘gas’ fees charged to make transactions. The issue of scalability is the main limitation for the network as it begins its transition to Ethereum 2.0 in 2021. 

What are the advantages of DeFi?

Decentralized finance offers users the flexibility to transact and trade whenever, wherever with only an internet connection.

The most immediate benefits of DeFi are instant or extremely fast transfers and drastically reduced fees and charges. Additionally, as there are fewer intermediaries taking a slice of the financial pie, users receive added additional benefits not seen in traditional finance. For example, DeFi lending protocols typically offer much higher interest rates for deposits as well as lower fees and more favorable terms on loans and lines of credit.

DeFi offers the opportunity to give equitable access to financial services. There are millions of people that do not have access to financial services due to isolation, lack of funds, political oppression, and so on.

Another benefit of DeFi is the extremely high yield trading known as “yield farming” that allows investors to borrow and lend their cryptocurrencies at much higher rates than traditional banking and investments.

Smart contracts and the future of global finance

The future of decentralized finance looks very healthy. As the world hurdles further towards a digital and decentralized future, we are already seeing tokenized assets including digital gold, Non-Fungible Tokens (NFTs), and artworks become more common while many governments around the world are looking to establish central bank digital currencies (CBDC).

The use cases for smart contracts are exponential, spanning from DeFi to gaming, tokenized real-world assets, conditional payments, gambling and betting applications, and prediction markets.

As the manner in which both individuals and organizations interact, exchange information, and access financial services continues to be revolutionized by decentralized technology, smart contracts and DeFi will continue to create transparency and financial freedom.