What is DeFi?

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Main Points

  • Decentralized Finance (DeFi) are financial services that are conducted with no central authority. 

  • DeFi services are controlled entirely by blockchain technology rather than intermediaries like bankers. 

  • DeFi works using smart contracts to facilitate trustless, peer-to-peer transactions for a wide range of financial services. 

Cryptocurrencies like Bitcoin were invented as a way to change the way we think about currency and payments. As the popularity of Bitcoin has increased over the years, people have begun to apply its principles and technology to other facets of the financial sector. These innovations are known as Decentralized Finance or DeFi. DeFi eliminates the need for banks, financial institutions, or intermediaries and allows people to conduct financial transactions directly with one another. 

What is DeFi exactly, and why is it so important? What will the future of DeFi look like? This guide will help you understand the basics of decentralized finance. 

What is DeFi? 

Decentralized Finance (DeFi) are financial services that are conducted with no central authority. DeFi services are controlled entirely by blockchain technology rather than intermediaries like bankers. 

The problem with traditional financial services 

Traditional financial institutions like banks, lending companies, and insurance agencies are centralized, meaning someone at the top controls them. Humans are generally pretty vulnerable to compromise, so institutions run by humans are prone to mismanagement, fraud, and corruption. 

Of course, financial malfeasance is not guaranteed to happen, but it has happened in the past. Remember the Great Financial Crisis of 2008? Much of the blame for that crisis is on the leaders of big banks and lending companies who made some very bad decisions. 

In addition to a flawed past, the present financial ecosystem is simply not accessible to so many people. Traditional banking and lending are famous for high fees, slow transaction times, long waiting periods, and discriminatory practices. In general, financial structures are outdated and overly complicated. 

Have no fear. Modern-day technological advances like Bitcoin and blockchain technology are here to save the day or at least make the financial services industry more efficient and accessible. 

Bitcoin began to solve these problems

When it comes to financial services, we are forced to trust people with our money that have proven they cannot always be trusted. Bitcoin was invented in light of the Great Financial Crisis to remove the need for trust in finance and streamline the process altogether. 

Bitcoin is a decentralized currency used to send payments to anyone, anywhere in the world, quickly and at a low cost. Rather than relying on the trust of intermediaries and banks, Bitcoin runs on a distributed ledger of millions of computers worldwide called nodes that use the mathematical principles of cryptography to verify transactions and eliminate the risk of fraud. 

Bitcoin has truly revolutionized the way we think about money. But, Bitcoin is pretty limited in capabilities. It can only be used for just one small portion of the financial system - money transfers. 

What if the rest of the financial ecosystem could be trustless and fraud-resistant and come at a much lower cost for the user? Decentralized Finance takes the best parts of Bitcoin and applies them to the rest of the financial system. 

How DeFi works

DeFi works primarily through the use of smart contracts. A smart contract is a software program that uses blockchain technology to create cryptographically secure self-executing contracts with the terms of agreement written directly into the code. The code controls the execution, and all transactions are trackable and irreversible. Smart contracts permit trustless transactions and agreements to be carried out among different, anonymous users without the need for a central authority.

Ethereum is the most commonly used ecosystem for DeFi because it was the first blockchain network to introduce smart contracts. While Ethereum is the leader, there are a growing number of alternative blockchains that support smart contracts like Polkadot, Cardano, and Solana. 

Beyond creating a trustless system, DeFi is incredibly transparent and immutable because all terms and transactions are recorded on a blockchain which means they cannot be changed or erased. Blockchains are permanent public records which means they are also censorship-resistant. Plus, costs are substantially lowered by cutting out the middlemen because no lenders, lawyers, and bankers are charging fees.

Popular DeFi Protocols 

DeFi systems, referred to as protocols, seek to decentralize various functions of the financial ecosystem. Below, find four of DeFi’s most popular projects.

1. Decentralized Lending and Borrowing

DeFi lending platforms provide the ability to borrow and lend cryptocurrencies directly with one another. Aave is one of the most popular DeFi lending projects. Aave allows people to borrow a wide range of cryptocurrencies free from oversight from banks, brokers, or intermediaries of any kind. 

Learn more about the way Aave works here. 

2. Stablecoins

A stablecoin is a cryptocurrency that uses smart contracts to back up its value by a reserve asset like a government-issued currency or gold to offer price stability. Among the most popular stablecoins is USD Coin which is pegged to the United States dollar, so 1 USD Coin can always be redeemed for $1.00.

Stablecoins like USDC are very popular when using other DeFi protocols like lending because they provide the fast processing and privacy of cryptocurrencies while simultaneously offering the stability of fiat currencies like the US dollar, euro, or yuan. They mitigate the volatility risk of cryptocurrencies and are often used in crypto loans. 

Learn more about USD Coin here. 

3. Oracles

Oracles are a blockchain software used in DeFi that acts as an intermediary, translating off-chain (or real-world) data to smart contracts on the blockchain and back again. In other words, oracles provide reliable, tamper-resistant inputs and outputs for complex smart contracts. Oracles can be set up to monitor almost anything. Some oracles monitor weather, sports results, account balances, stocks' value, and so much more. 

Chainlink is the most popular oracle project. It uses smart contracts to provide information from off-blockchain sources like the real world to on-blockchain smart contracts via oracles. 

Learn more about how Chainlink works here. 

4. Decentralized Exchanges

Decentralized Exchanges (DEXs) allow users to buy, sell, and trade crypto without centralized oversight. DEXs use smart contracts to match buyers with sellers to facilitate trades directly, peer-to-peer. Popular DEXs include Uniswap, Pancakeswap, and Binance.

Learn more about Binance here.  

The Future of DeFi

DeFi has begun to revolutionize many aspects of the financial services sector.  As it stands, the DeFi sector is worth hundreds of billions of dollars. DeFi is used to streamline processes and make the financial system more efficient and equitable. It is clear that DeFi and the technology behind it are here to stay. 

However, DeFi is still very much in its infancy, and the industry at large faces its share of risks. For starters, DeFi is currently totally unregulated, unlike the traditional financial sector, which is heavily regulated. Regulations are sure to come and, in many ways, are welcomed to bring clarity to the space. Laws that are too harsh, however, could seriously stifle innovation and stop the industry from growing further. 

Additionally, new projects are popping up all the time, and the coding behind the protocols isn't always perfect. There are plenty of malicious actors out there looking for any vulnerabilities in DeFi protocol code to exploit. Unfortunately, this has happened many times already, and users of certain protocols have lost a lot of money. To be clear, you can rest assured that the DeFi coins and tokens supported by CoinFlip (listed above) are already well established in the space. The risk of those projects being compromised is extremely low. 

Final Thoughts

I sincerely believe many of the risks associated with DeFi will soon be ironed out, and decentralized financial tools and services will be commonplace in the future. DeFi protocols make the financial ecosystem run more efficiently and provide new opportunities for those traditionally left behind from centralized finance. 

If you believe in the power of DeFi and want to invest in some DeFi cryptocurrencies, CoinFlip has you covered. 

Convert your cash to DeFi tokens like AAVE, LINK, and USDC at a CoinFlip ATM near you or by bank transfer through our Trade Desk!

Financial Advice Disclaimer: Nothing in this blog constitutes professional or financial advice, performance data or any recommendation that any specific cryptocurrency, portfolio, index, investment product, transaction or investment strategy is suitable for any specific person. You assume the sole responsibility of evaluating the merits and risks associated with all financial decisions and should seek the advice of a registered financial advisor when in doubt.