What Is Decentralized Finance (DeFi) and How Does It Work?

Decentralized finance (DeFi) is an emerging financial technology based on secure distributed ledgers similar to those used by cryptocurrencies.

In the U.S., the Federal Reserve and Securities and Exchange Commission (SEC) define the rules for centralized financial institutions like banks and brokerages, which consumers rely on to access capital and financial services directly. DeFi challenges this centralized financial system by empowering individuals with peer-to-peer transactions.

KEY TAKEAWAYS

How Decentralized Finance (DeFi) Works

Through peer-to-peer financial networks, DeFi uses security protocols, connectivity, software, and hardware advancements. This system eliminates intermediaries like banks and other financial service companies. These companies charge businesses and customers for using their services, which are necessary in the current system because it’s the only way to make it work. DeFi uses blockchain technology to reduce the need for these intermediaries.

Blockchain

A blockchain is a distributed and secured database or ledger. In the blockchain, transactions are recorded in blocks and verified through automated processes. If a transaction is verified, the block is closed and encrypted; another block is created with information about the previous block, along with information about newer transactions.

The blocks are «chained» together through the information in each proceeding block, giving it the name blockchain. Information in previous blocks cannot be changed without affecting the following blocks, so there is no way to alter a blockchain. This concept, along with other security protocols, provides the secure nature of a blockchain.

Using applications called wallets that can send information to a blockchain, individuals hold private keys to tokens or cryptocurrencies that act like passwords. These keys give them access to virtual tokens that represent value. Ownership of the tokens is transferred by ‘sending’ an amount to another entity via a wallet, whose wallet, in turn, generates a different private key for them. This secures their ownership of the token, and the blockchain design prevents the transfer from being reversed.

Applications

DeFi applications are designed to communicate with a blockchain, allowing people to use their money for purchases, loans, gifts, trading, or any other way they want without a third party. These applications are programs installed on a device like a personal computer, tablet, or smartphone that make it easier to use. Without the applications, DeFi would still exist, but users would need to be comfortable and familiar with using the command line or terminal in the operating system that runs their device.

DeFi applications provide an interface that automates transactions between users by giving them financial options to choose from. For example, if you want to make a loan to someone and charge them interest, you can select the option on the interface and enter terms like interest or collateral. If you need a loan, you can search for providers, which could range from a bank to an individual who could lend you some cryptocurrency after you agree on terms.

Some applications let you enter parameters for the services you’re looking for and match you with another user. Because the blockchain is a global network, you could give or receive financial services to or from anywhere in the world.

Decentralized finance does not provide full anonymity. Transactions do not include an individual’s name but are traceable by anyone with the knowledge to do so. This includes governments and law enforcement, which, at times, are necessary for protecting an individual’s financial interests.

Goals of Decentralized Finance

Peer-to-peer (P2P) financial transactions are one of the core premises behind DeFi, where two parties agree to exchange cryptocurrency for goods or services without a third party involved.

Using DeFi allows for:

Peer-to-peer lending under DeFi doesn’t mean there won’t be any interest and fees. However, it does mean that you’ll have many more options since the lender can be anywhere in the world.

Decentralized Finance Uses

Decentralized finance, originally conceived of as a way to bring financial services like loans and banking to those who don’t have access to them, has morphed into an industry where you can take part in many different sectors or endeavors. Here are a few of the most popular:

How to Get Involved in DeFi

Becoming involved in decentralized finance might seem intimidating at first, but there are many ways to do so. The first thing you should do if you want to get into DeFi is to research the activities that interest you the most. You’ll need a wallet, but because there are so many to choose from, you’ll need to learn more about them and find the one that appeals to you.

Once you identify your wallet and activity, you can find a reputable exchange that provides the activity you want to get involved in or use, buy some cryptocurrency, and get started.

Concerns About DeFi

Decentralized finance is constantly evolving. It is unregulated, and its ecosystem is vulnerable to faulty programming, hacks, and scams. For example, one of the main ways hackers and thieves steal cryptocurrency is through weaknesses in DeFi applications.

Laws have not yet caught up with advances in technology. Most current laws were crafted based on the idea of separate financial jurisdictions, each with its own set of laws and rules. DeFi’s borderless transaction ability presents essential questions for this type of regulation. For example:

DeFi Hype

Just like other blockchain- and cryptocurrency-related projects, businesses, and activities, decentralized finance is subject to considerable hype, hoping to attract users and their money.

There is a considerable amount of money flowing through cryptocurrency exchanges, but it isn’t nearly as much as you might be led to believe. Most people still use the traditional financial systems we are all used to. For example, only 0.56% of all money is tied up in cryptocurrency and decentralized finance—a very small figure that should encourage you to do your research to learn if using DeFi apps, platforms, and cryptocurrency is worth it.

It might be just what you’re looking for regarding your finances. However, it might not—the decentralized finance industry is still in its infancy and evolving, making it somewhat of a gamble for most people.

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