What Is Decentralized Finance (DeFi)?
One of the most exciting sectors in blockchain today is DeFi, and it’s changing the way we think about money, investment, and wealth.
Updated January 31, 2022 • 5 min read
Decentralized finance (DeFi) is a new financial framework consisting of decentralized blockchain protocols and underlying smart contract technology. DeFi, as it is most commonly known, makes it possible for users to access different types of financial products and services without the need for a centralized authority. Here, we examine some of the ways DeFi is changing our financial world and discuss a few of its key characteristics.
What Is DeFi’s Role in a Changing Financial World?
The finance industry is undergoing a period of foundational change, much of which has been brought about by new types of financial technology (FinTech). Perhaps one of the most groundbreaking sectors of FinTech is blockchain. Blockchain-based technologies like cryptocurrency and DeFi are facilitating entirely new financial products and services that can reduce reliance on legacy gatekeepers and traditional finance industry stakeholders. Below, we’ll outline decentralized finance’s (DeFi’s) transformative effect on finance today.
The wide-scale proliferation of DeFi technologies has given rise to a new paradigm of financial products and services that leverage blockchain and tokenized digital assets. Decentralized finance platforms are built atop blockchain protocols that operate in a decentralized fashion — with low to no reliance on centralized intermediaries such as brokerages, exchanges, or banks. DeFi protocols tend to offer a variety of financial instruments such as staking, borrowing, lending, investing, and derivatives trading. The growth of the industry has been staggering, reaching up to $100 billion USD in value locked in DeFi projects in 2021.
How Does DeFi Work?
Over the past several years, most blockchain-specific decentralized finance projects — protocols such as MakerDAO, Aave, and Compound — have been developed exclusively on the Ethereum blockchain. However, DeFi has expanded to other networks like Cardano, Binance Smart Chain (BSC), Cosmos, Avalanche, Polkadot, and other networks that offer certain benefits and specialities. Regardless of the specific chain, the DeFi proposition remains the same. Let’s examine some of the strongest attributes of DeFi protocols.
Decentralized and permissionless: As noted above, one of DeFi’s main characteristics is its users’ ability to leverage various financial services in a decentralized manner, which means in a permissionless and nearly instantaneous fashion. A permissionless blockchain is a blockchain system that can be used by a network participant without obtaining permission from a centralized authority or any other entity. Permissionless blockchains are typically constructed in an open and decentralized manner employing the use of their own cryptocurrency. They operate in a peer-to-peer (P2P) manner and are generally considered open, public, borderless, neutral, censorship-resistant, transparent, and immutable.
Non-custodial: The majority of DeFi solutions operate in a non-custodial manner. This means that they do not hold on to your funds in the way a bank normally does. Instead of relying on centralized exchanges or systems, users are able to leverage any number of financial instruments (DeFi lending, DeFi borrowing, DeFi staking, and more) on their own terms, without the types of third party approval or custody that a bank requires, and can remove their funds whenever they want. This gives users a high degree of control over their DeFi investment decisions in real time, often through a mobile wallet or DeFi application on their computer or mobile device.
Immutable: Immutability is the characteristic of data becoming irreversibly codified in the shared data ledger of a blockchain network after transaction execution. DeFi technologies and blockchain systems are immutable, irreversible, and tamper-proof through verifiable cryptography, making it practically impossible to change, reverse, or falsify records. Immutability helps allow DeFi systems to be secure, private, and transparent, which is vital to the long-term viability of the industry and safety of DeFi users.
Programmable: Through programmability, smart contract systems allow users to carry out specific tasks in real time without an intermediary. Such tasks include executing contractual agreements and triggering on-chain mechanisms to make various financial services possible. Because of their autonomous, secure, and open nature, programmable DeFi networks typically offer low operational costs. These DeFi solutions may save time, capital, and labor when compared to the majority of database solutions.
Open and interoperable: Most public DeFi ventures operate using an open framework, meaning that they are designed to be accessible to anyone with access to the internet. Further, the full potential of DeFi crypto systems is contingent on network interoperability, which refers to the ability of various blockchain protocols to work and interact with each other and transfer value (such as digital assets) between each other through cross-chain communication.
Decentralized Finance Trends and Innovative DeFi Solutions
Now, let’s examine some examples of the many types of financial products and services made possible through DeFi.
DeFi lending/borrowing and DeFi staking: While DeFi has many uses, perhaps the most common thus far has been protocol-specific money markets. Decentralized money markets allow users to borrow, lend, and stake crypto assets by providing liquidity to the protocol through different types of collectivized liquidity pools. One of the leading examples of a decentralized P2P money market is Compound, which was one of the pioneering protocols to legitimize DeFi in crypto. MakerDAO is another pioneer in the decentralized lending and money market space. Moreover, current industry leaders such as Yearn.Finance, Balancer, Venus, and Curve are examples of exchange protocols employing the use of collectivized DeFi investment pools.
Decentralized exchange platforms: A decentralized exchange (DEX) is a P2P marketplace that connects cryptocurrency buyers and sellers. In contrast to centralized exchanges (CEXs), decentralized platforms are non-custodial, meaning a user remains in control of their private keys when transacting on a DEX platform. In the absence of a central authority, DEXs employ smart contracts that self-execute under set conditions and record each transaction to the blockchain. Uniswap, Sushiswap, 1inch, and PancakeSwap, are examples of leading DEX protocols.
Synthetic assets: Synthetic assets allow for the creation of blockchain-based tokenized assets that mimic real-world assets such as stocks (equities), bonds, commodities (i.e., gold and silver), indexes, fiat currencies, and interest rates. Synthetix, Mirror Protocol, Injective Protocol, and Universal Market Access (UMA) are examples of synthetic asset blockchain platforms.
Non-fungible tokens: Non-fungible tokens (NFTs) are immutable, verifiable cryptographic assets that can represent anything from trading cards to artwork to special access passes. Recently, NFTs have continued to expand their market share and are quickly becoming one of DeFis biggest markets. Axie Infinity, The Sandbox, and Illivium are examples of blockchain platforms that make use of in-game play-to-earn systems that reward users with different types of NFTs. Leading NFT marketplaces such as OpenSea and Nifty Gateway have cemented themselves as the go-to platforms for the purchase and trading of NFT cryptoart.
Central bank digital currencies: Central bank digital currencies (CBDCs) are cryptocurrencies minted by governments and major banks in nations throughout the world. In addition to Ethereum, numerous Layer-1 blockchain protocols have been designed to offer networks capable of managing the use of CBDCs including Cardano, Stellar, and Algorand. While CBDCs are generally centralized initiatives rather than DeFi projects, many experts predict that CBDCs and DeFi will increasingly dovetail as complementary parts of an emerging next-generation global financial system, with CBDCs showing strong potential to function as onramps into the DeFi ecosystem.
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