What is DeFi? Your Guide to Decentralised Finance

Tom
Tom June 2022 Content Creator 15 min

Table of contents

Decentralised finance—or DeFi as it’s coming to be known—is big news. Tracking service DeFI Pulse released statistics on the recent value of DeFi assets, demonstrating it has shot up from less than $1 billion USD in 2019 to more than $80 billion USD in May 2021.

Proponents of DeFi champion it as the future of finance while others take a more measured approach to its future, waiting to see how things pan out. Others less involved in the finance world may be a little foggy on the details: what does decentralised finance actually mean, and how could it change the financial systems work today, if it even has the potential to do so?

This post is a post for the uninitiated and the ones curious to dig a little deeper; let us walk you through the annals of DeFi’s labyrinthine halls: what is DeFi, how does it work, what are the different types, and whether or not you should be worried about it. 

Also, in our FAQ section, find at the end of this post some of the most commonly asked questions regarding decentralised finance.  

What is DeFi in a nutshell

  • Decentralised finance or DeFi proposes an alternative model to current financial system,s focusing on peer to peer lending
  • DeFi can spread financial inclusion to remote communities by circumventing profit-focused centralised finance models
  • Small businesses can benefit from DeFi’s simpler, more direct transaction methods
  • New, more creative finance apps can be created with DeFi technology
  • Blockchain technology allows users to track and record transactions on public ledgers
  • At the core of DeFi and cryptocurrency is peer-to-peer lending, outline in a white paper by the creators of bitcoin
  • Decentralised exchanges or DEX allow users to trade directly without interference from third parties
  • Stablecoins are cryptocurrencies backed by traditional currencies or other cryptocurrencies
  • Prediction markets are where users can bet on the stocks changing based on the outcome of an event
  • Yield farming and liquidity mining allow users to passively generate income on cryptocurrencies and tokens
  • Inherent in the risks of DeFi is false information being entered into smart contracts or bugs causing them to falter
  • Users will struggle to hold thieves accountable in the DeFi sphere
  • The disparity of expertise between users in the DeFi sphere makes those new to trading vulnerable to scams and unable to recover their losses

What is decentralised finance (DeFi)?

Decentralised finance is an alternative model to the current financial systems in place. Instead of entrusting the safety and value of your money to banks, who lend it to third parties to generate interest which you pay to have them keep it, DeFi focuses on peer to peer financial activity. 

What this means is, two people who wish to conduct a private transaction with each other can do so without involving banks, without adhering to terms and conditions, wait times, and fees. It proposes a way for the average customer to dictate what happens to their own money and to trade with it on their own terms—without resorting to burying it in the backyard. 

Decentralised vs centralised finance

Understanding DeFi is about first grasping how the current systems under the model of centralised finance work. 

Let’s take a look first at the defining features of centralised finance, also called traditional finance: 

Centralised financeDeFi
Government regulatedUnregulated
Managed by a group of people or organisation such as a bank or financial services companyManaged publicly via blockchain software
Closed financial systemOpen, transparent financial system
High barriers for employment (licensing, authorisation from regulators, etc.)Low barriers for involvement (anyone with programming skills can build their own financial services atop public blockchains)
Bureaucracy-heavyNo bureaucracy (peer-to-peer direct transactions)
Internal, closed software used to manage dataServices built with free open source software
Transactions intercepted by third parties (card issuers, senders and recipients banks)Transactions direct between sender and receiver
Delayed transaction times with feesInstant or near-instant transaction times with no fees 

Hopefully, the ways in which DeFi stands apart from traditional models are coming into focus. To summarise the above, where centralised or traditional finance involves others when handling money between senders and receivers, DeFi is only handled by two people: the sender and receiver. 

What can DeFi do?

New possibilities for DeFi are still being thought of every day. As with developing technologies, they are limited to the imaginations of their creators until the limits of such a technology are discovered or imposed via regulations. 

These are some of possible use cases for the technology that are being implemented and experimented with today:

Broadening geographical reach

The problem of bringing financial inclusion to remote communities is one which will require a great deal more than what DeFi can offer. The technology does, however, play a part in this. 

Because centralised finance relies on investing and profiting from customers’ money, they are reluctant to offer their services to communities with poorer infrastructure and lower earning averages. Decentralised finance, however, does not profit from its users in the same way. This means that with internet access and smartphones, members of these communities neglected by traditional institutions are able to participate, offering global services, trading in stocks and bonds—above all controlling finances in ways centralised finance previously didn’t allow. 

Assisting small businesses

Via person-to-person transactions, DeFi removes the transactional barriers entrepreneurs have had to deal with in the past. Entrepreneurs can set up their small businesses with less and compete earlier, focusing on growth sooner. 

Many banks are reducing their lending allowances to SMBs, making it difficult for founders to get their ventures off the ground via traditional finance models. DeFi allows users to get things off the ground immediately. There are obviously many more hurdles and systemic factors affecting the success of small business, however DeFi can at least remove the barriers of entry for more small business hopefuls. 

Always keep an eye on your finances – with the Penta Business Account.

New app technology

Where new technology takes root, apps will grow around it to feed from its nutrients. As with small business formation, DeFi stands to remove the barriers for app creation and allow more programmers to experiment and bring their ideas into the marketplace. Lending apps like Dharma, crypto trading apps like Bancor Network, and DeFi marketplace apps like DAI all take advantage of the freedom offered by DeFi. 

It’s also true that DeFi is a complex technology that is daunting for any uninitiated person to begin using. It is predominately used by programmers, coders, and traders with a deep knowledge of finance and the stock market. Bringing in finance apps with sophisticated, simple interfaces and educational components will allow the general public to reap the rewards of decentralised finance. 

How does DeFi work?

At first glance, DeFi may seem impossibly complex to unravel. Terms like Etherum, cryptocurrency, peer-to-peer trading, and blockchain have left programmer circles and come into common parlance, but they haven’t arrived with simple explanations. 

That said, some of these terms are necessary to use in order to understand how DeFi works. Let’s unpack them. 

DeFi and blockchain

Decentralised finance encompasses financial applications which utilise blockchain technology in order to solve inherent problems within traditional finance. These problems, as mentioned earlier, are to do with third party money lending and transaction roadblocks. 

Blockchain helps solve this problem because instead of money and transactional information being stored by a centralised institution (i.e. a bank), it is stored on a publicly distributed database. 

Also called ‘distributed ledger technology’, blockchain allows transaction information to be recorded and distributed. Through this it becomes secure without the need for a third party because the transaction between two parties has been recorded and is accessible. If something goes wrong, the breadcrumb trail leads right to the perpetrator.

DeFi and peer-to-peer transactions

Bitcoin creator Satoshi Nakamoto defined their invention as a ‘peer-to-peer electronic cash system’. Identifying the problems of fraud and disputes between merchants and customers, they said in a white paper on bitcoin:

‘What is needed is an electronic system based on cryptographic proof instead of trust, allowing any two willing parties to transact directly with each other without the need for a trusted third party.’

P2P is at the heart of the decentralised finance system, because it would allow transactions to take place without the interference of bank or card issuer. When the information is distributed on a ledger accessible by both parties, the control over the transaction is in the hands of the two people: peer-to-peer.

What is defi compared to traditional financial systems

What are the types of DeFi?

Now that we have definitions out of the way, let’s dig a little deeper into DeFi—specifically the terms and tools being developed thanks to DeFi technology. This will give us a broader understanding of how the model is being used today. 

Decentralised exchanges

Called DEX for short, decentralised exchanges are marketplaces based on the P2P model. Transactions in this marketplace occur directly between traders dealing in cryptocurrencies like bitcoin. 

DEXs are a resulting manifestation of one of the core promises of DeFi and the problem outlined in Nakamoto’s white paper: they foster financial transactions without a third party or intermediary such as a bank or financial institution. 

Popular DEX marketplaces like Uniswap and Sushi swap require users to obtain a crypto wallet, in which they can store such cryptocurrencies as bitcoin or Ethereum’s Ether (ETH). A DEX can be accessed by the inbuilt browser of a Coinbase wallet, however the websites can be accessed directly on your browser. 

Stablecoins

The idea behind stablecoins is to provide a stable alternative to highly volatile pure cryptocurrencies like bitcoin. Cryptocurrencies fluctuate more heavily than traditional currencies. Due to their institutionalised nature and high number of investors, traditional currencies are more protected during a crash or recession. For instance, bitcoin’s value sat at a low of $4,000 USD in March 2020 and shot up to almost $65,000 in April 2021, only to then drop 50% over the next two months.

To combat this instability, stablecoins are often backed by traditional currencies. TrueUSD, for example, is a popular stablecoin with the USD as collateral. Other stablecoins have precious metals like gold or silver as their collateral, meaning the value of the coin is in part dependent on the value of something much more stable like gold or a strong currency like the USD. 

Other stablecoins are backed by other cryptocurrencies. The DAI is backed by ETH and other high valuing cryptocurrencies, softening the impact of a crash or downturn. 

Lending platforms

Lending platforms are where DeFi transactions play out. P2P is a lending platform that allows transactions to go ahead between sender and receiver without intermediaries. Within the world of peer-peer-lending however, there are services which provide a marketplace for traders offering fixed-term loans in the thousands. Some of these marketplaces focus on crypto, while others allow lending of traditional currencies.

Prediction markets

Similar to futures markets, prediction markets are groups of traders speculating on events and trading on their outcomes. Where futures markets trade on what the value of an asset might be in at a future point in time, traders in predictions markets will predict the outcomes of:

  • Election results
  • Exchange averages
  • Company quarterly sales results
  • Movie box office performance

The price placed on these particular events is essentially a bet that a particular event is going to occur. The trader is actually betting on an increase in the value of stocks based on the election of a certain candidate or success of a cultural property. 

For example, if a Marvel superhero movie grosses highest at the box office on opening weekend, traders in prediction markets can bet that Marvel and Disney stocks will go up as a result of that movie’s success. As the owners of that property—the event and the rise in stocks are directly correlated. 

Yield farming

A form of lending and borrowing that is usually handled by experienced crypto traders, yield farming leverages DeFi to maximise returns on cryptocurrency.  

To participate in yield farming, a trader will put their coins or tokens into a DeFi app (like a crypto wallet or DEX). They can then trade their crypto as the market fluctuates, speculating on changes in value and trading or selling depending on the performance of certain currencies. 

Yield farming requires an advanced knowledge of crypto trading because to know when to trade crypto and which markets to keep an eye on requires understanding the yearly fluctuations of these markets and how the market moves, i.e. when to buy and sell. 

Liquidity mining

DeFi changed the face of crypto trading by offering traders to passively accrue income. Instead of direct trading between others and understanding the complex method of day trading, users could place their assets in decentralised exchanges and allowing capital to increase as the markets fluctuated. 

Liquidity mining, like yield farming, is a trading technique that is possible thanks to DeFi technology. When lending assets to a DEX, traders gain rewards thanks to trading fees which average at 0.3% per swap, and the reward depends on how much the trader has invested in a particular liquidity pool. So traders are gaining from the rewards of each trading fee. 

What are the risks of DeFi?

Decentralised finance and crypto currencies

DeFi presents many exciting possibilities not only for traders, but for small business owners and communities neglected by financial institutions. But as with all revolutionary technologies, especially in their early stages, DeFi comes with a great deal of risks that users need to be aware of. 

Let’s now step away from the possibilities and methods of DeFi to take a sober look at the risks. 

Smart contracts risks

DeFi transactions include the use of many smart contracts on the blockchain network. Smart contracts are programs stored on blockchains that run automatically when predetermined conditions are met (i.e. the conditions agreed upon between sender and receiver regarding the transaction). 

All programs are at the mercy of glitches and bugs, and smart contracts are no different. Even if the program doesn’t falter, you as the sender may enter in information incorrectly and lose your funds forever. 

The reason your funds may become irretrievable is because traditional finance has options to reverse payments or retrieve incorrectly sent funds. PayPal for example has a system set up to cancel transactions in case money is sent to the wrong email address. This doesn’t exist in DeFi. Remember Nakamoto saying that the idea behind bitcoin was to stop the possibility of reversible transactions to protect senders? This is the flip side of that (bit)coin.

Lack of accountability

The blockchain network is set up to protect users in ways that centralised or traditional finance fails to. With public ledgers and P2P trading, there is no risk of the banks mishandling your money and the risk of customers cheating merchants by retracting their funds after having purchased your product is virtually non-existent. 

That said, accounts can still be hacked, funds rerouted from wallets, and computers can crash in the middle of a transaction. When this happens, there are far fewer financial authorities to whom users can go to report their stolen funds or assets. Consider actor Seth Green’s stolen NFTs: he’s had to plead with the thief to return his stolen merchandise because there is no authority that can help his case. 

One of the most exciting things about the DeFi landscape is its unregulated approach to financial transactions, but unregulated also means, in many cases, unprotected. 

Disparity between users

As the content in this post may have shown, DeFi is a complex topic. The technology boasts so many possibilities and a whole lexicon of jargon which, if you wish to involve yourself with it, you will have to study and learn. 

At the same time, despite its complexity, DeFi has seen a huge boost in popularity and the introduction of NFTs saw thousands more trying to profit from it. Following this wave of DeFi came public hacks and millions in theft, largely for one reason: people getting involved with DeFi, NFTs, and crypto didn’t know what they were doing. In many cases, hackers simply intercepted and rerouted transactions to their own wallets. Incomprehensible for many, simple for some. 

DeFi is complex and it should not be taken lightly. Experts will take advantage of those who believe they can read a few blog posts and start making millions. And with its lack of regulation, thieves go scot free and victims remain financially wounded forever. 

Conclusion

DeFi is an exciting technology, there’s no doubt about that. It promises to upend a problematic industry and the tools are in place to see that happen. The most exciting aspects of the technology are its potential to breed innovation among those who might not have had the opportunity before due to governmental regulations and requirements from financial institutions. 

Hopefully, our blog post on what is DeFi has given you a suitable primer to get curious about the world of DeFi. There is still plenty more to learn and good incentive to do so. Educating yourself on the possibilities and the risks will lead you into  a more financially secure future.  

Stay secure with a Penta Business Banking Account

Your all-in-one business banking account to power up your business.

FAQs about DeFi

Below are some of the most frequently asked questions about decentralised finance, with clear and simple explanations for readers.

DeFi tokens differ from coins in a few ways. While coins operate on a blockchain, tokens operate on the blockchain of other coins, for example Ethereum. Where crypto coins are handled by the blockchain’s ledger, tokens rely on smart contracts. Once a token is spent, it is physically moved from one place to another. As an example, NFTs or non-fungible tokens, are one-of-a-kind items meaning that a change in ownership is handled manually. Crypto coins on the other hand do not move, it is only the account balances of the senders and receivers which change.

DeFi wallets, also called crypto wallets, are what crypto investors use to store their coins and tokens. Each wallet comes with a private key for security which is similar to a password. Only the possessor of this key can access the account. The government is not able to freeze an account the way they can under traditional finance models, giving the user a much more secure way to keep their money.

Staking is a DeFi concept in which users lock their crypto tokens into a smart contract. The aim is to generate more tokens in return. A traditional finance equivalent would be putting one’s money in a fixed deposit. It is one of the many ways to passively earn via cryptocurrency and decentralised finance.

One of the emerging DeFi projects, Kava is a software which uses multiple cryptocurrencies that allows users to borrow and lend assets under the decentralised model.

Back to top