Many of us share a common pain: our banks are stuck in the past and offer minimal interest rates while charging high fees for even the smallest transactions.
And with so many aspects of our life depending on banking, finding better alternatives can be a strategy that not only saves you money but also makes money.
This is where decentralized finance enters the conversation. DeFi is upending traditional finance and becoming a viable alternative to centralized financial institutions by providing all the products and services you already use and helping you perform financial transactions without the need for an intermediary.
But how is this possible?
We have all the answers you need in today’s guide to decentralized finance, including how Defi works as well as the advantages and risks of using this emerging technology.
What is Decentralized Finance?
Decentralized finance - or DeFi for short - refers to financial products and services that rely on cryptocurrency and blockchain technology to conduct transactions such as payments, loans and transfers.
One of the main goals of DeFi is to democratize finance away from, you’ve guessed it, centralized institutions like banks, governments and regulators. Other benefits of using a decentralized platform include reduced transaction times and easier access to financial services to pretty much anyone with, well, internet connection.
Before we get into the nitty-gritty, two more aspects that will help you get a quicker understanding of DeFi: finance takes place in a peer-to-peer format (so no third parties involved), and DeFi applications are resistant to centralized control and even censorship. We’ll be getting back to this in just a moment.
But if no one is in charge of overseeing the financial system, how can we be sure that DeFi is secure and working efficiently? Great question. Well, the answer is smart contracts.
Simply put, a smart contract is a digital contract that automatically self-executes based on the terms of the agreements that have been coded in. This is a significant technological advancement as it can simplify transactions between parties without the need of a middleman while ensuring that the terms of the underlying agreement are fully met.
DeFi applications are on the rise as an alternative to the traditional financial system, supporting a wide number of financial services you’re certainly familiar with like everyday banking, loans and payments. But that’s not all. More recently, the technology has also been used to explore emerging opportunities and innovative instruments in crypto across products such as crypto derivatives, crypto loans and tokenization of digital assets.
How Does Decentralized Finance Work
Many DeFi applications are created using an open-source blockchain framework called Ethereum, enabling direct, peer to peer payments between two anonymous parties without the intervention of any trusted third party.
Another popular application of DeFi includes peer to peer borrowing, but we will dive into it a little ahead.
This entire system is based on information being distributed across thousands of individuals and their computers across the world, which is clearly a very different approach from a centralized financial system as that's typically closed-source and controlled by a small number of large institutions.
Let’s think about it in simpler terms.
Unless you’re already knowledgeable about blockchain technology and crypto, chances are that your hard-earned money is being kept in a bank account and every time you want to make a transaction, your bank will act as an intermediary between you and the other party involved in a financial exchange. In return, for letting your bank make your life easier, you pay a transaction fee.
Since decentralized finance removed the need for an intermediary, not only can you make faster transactions, you’re also able to save money in fees.
Multiple technologies and protocols are used to achieve the decentralization of the financial system. As mentioned, DeFi is built on top of a blockchain network while also involving software.
In particular, transactions are enabled through smart contracts that automate the terms of a financial agreement between buyers, sellers and borrowers.
Thanks to the use of advanced cryptographic algorithms, DeFi can be considered a safe financial system, ensuring enhanced security across all transactions.
What Are The Main Components of DeFi
Now that we’ve got the basics covered, we know that DeFi protocols work based on the following mechanisms:
Blockchain: DeFi protocols run on networks with rigorous verification and validation processes for data registered in the system.
Smart contracts: financial transactions take place automatically, which guarantees compliance with the preset and agreed upon conditions.
Decentralization: enables a global financial system without the control or need for intermediaries.
As with any software solution, DeFi is executed via a stack of components:
1. Settlement Layer
Also known as Layer 0, the settlement layer provides the base on which all DeFi transactions are built. It consists of a public blockchain, its native cryptocurrency or a tokenized version of real world assets. An example of a settlement layer is Ethereum and its native token ether (ETH), which is traded on crypto exchanges.
2. Protocol Layer
The protocol layer is where the standards for governing specific tasks or activities are defined. In other words, this is where a set of principles and rules that all participants in a given industry have agreed to follow as a prerequisite for operating in the industry are set. An example of a DeFi protocol is Synthetix, a derivatives trading protocol on Ethereum.
All these protocols are interoperable and can be leveraged by any app or service building in the DeFi stack.
3. Application Layer
As the name suggests, the application layer is where consumer-facing applications reside. The most common applications in the cryptocurrency ecosystem, such as decentralized cryptocurrency exchanges and lending services, lay within this layer.
4. Aggregation Layer
Finally, the aggregation layer consists of aggregators that connect various applications from the previous layer to provide products to investors. Lending, banking services, and crypto wallets are an example of the types of services existing within this layer.
What Can I Use DeFi For?
Decentralized finance applications aim to recreate traditional financial systems, such as banks and exchanges, with cryptocurrency. As such, you will find in DeFi convenient financial offerings such as:
DeFi lenders lend out cryptocurrency just as centralized financial institutions would lend out fiat currency, and earn interest on that transaction. Borrowing and lending are among the most common use cases for DeFi applications and it’s easy to understand why. Interest rates are typically more attractive than with traditional financial institutions, there’s virtually no paperwork involved while the requirements to borrow are much simpler. In many cases, all you’ll need to take out a crypto loan is to provide collateral with other crypto assets you might have, like NFTs.
As decentralized apps keep maturing and become more complex, there are other financial products emerging, including the option to become a liquidity provider to a decentralized exchange.
However, with all this in mind, it’s worth also considering that DeFi can be riskier than traditional finance.
DeFi Passive Income
As we’ve just saw, decentralized finance allows you to invest in certain types of “accounts” or assets that can yield better interest rates when compared to typical financial institutions. However, another way of benefiting from the technology while having minimal involvement is to pursue a passive investment strategy. There are many ways of getting involved, including becoming a liquidity provider, trying out liquidity mining and yield farming. If you’re interested in learning more, check out our guide on how to earn passive income with DeFi.
DeFi Asset Management
In the DeFi space, users are given more control over their assets as you, and only you are the custodian of your crypto funds. By using crypto wallets like Metamask, users can safely store their encrypted passwords and private keys, thus restricting access to the account’s owner. This provided security and privacy over sensitive data.
Tokenization of Assets
The use of tokens is unleashing a new world of economic possibilities. As they are secure, programmable and easily transferable, there are no limits to what kinds of assets can be tokenized and stored on a blockchain. In essence, tokens can be considered a digital alternative for users access, trade, and store value.
Top DeFi Applications
Despite it being a fairly new type of technology, DeFi has already a number of established applications in the market for capital and financial services.
Decentralized exchanges are also known by the abbreviation DEX. On these platforms, users can trade cryptocurrencies on a peer to peer system , that is, from user to user, without intermediaries. As such, in a DEX, you’ll be able to perform all financial services directly. These platforms are typically very intuitive to use, they enable high speed at a low cost, they’re non-custodial and there’s no KYC involved. To use a DEX, users use a web3 browser or a DApp. Lastly, as operations are ruled through smart contracts, chances for fraud, market manipulating, theft or fraud are very low. Uniswap is currently the biggest decentralized exchange. Curious to learn more. Check out our earlier post on decentralized exchanges.
As perhaps you already know, cryptocurrencies are highly volatile and potentially a risk investment. On the other hand, stable coins are a special type of crypto asset whose value is paired with some other asset, such as fiat, gold, and oil. As such, these coins are much less likely to suffer major price swings and they’re a much better alternative to those looking to reduce their exposure to crypto volatility. Some of the most popular stable coins include:
- Tether (USDT)
- USD Coin (USDC)
- Binance USD (BUSD)
- MakerDAO (DAI)
In the crypto market, lending platforms resemble banks and financial institutions, but without the middleman. Therefore, when opting for a DeFi lending platform, users don’t typically need to provide personal data to a third party. Also, users are asked to provide some digital asset of greater or equal value to the amount of the loan they’re requesting. MakerDAO and Compound are some options within this alternative.
What Are The Main DeFi Protocols
The decentralized finance industry is rapidly expanding. However, there are some protocols that stand out from the rest:
This decentralized exchange (DEX) stands out in the cryptocurrency market due to its high trading volume and overwhelming popularity. Uniswap has its own token (UNI) and, as it is a DEX, transactions in the system are without intermediaries. Thus, each operation is automated with smart contracts that fulfill the agreements automatically, according to the conditions agreed upon.
This project stands out for being one of the first to be set up on the Ethereum network. Additionally, MakerDAO has a governance token (MKR). On this decentralized platform, it is possible to deposit cryptocurrencies as collateral and DAI as stablecoin tied to the U.S. dollar.
It is also a decentralized exchange (DEX) and has a native token (CRV). However, the focus of the platform is on stablecoin transactions . Therefore, the Curve Finance protocol does not require third parties to be involved in the operations that take place on the network. Thus, smart contracts are programmed to manage cryptocurrency prices, with the aid of algorithms.
Aave is a Defi platform focused on lending. That is, it is possible to lend or borrow cryptocurrencies. Hence, the lender can profit from the interest charged. Aeve has a native token for its platform, the AAVE. Aave also provides flash loans, a topic we delved into recently.
What Are The Advantages of Decentralized Finance
DeFi protocols can have both positive and negative aspects to it. Knowing both the benefits and the drawbacks can help you make more informed decisions.
Decentralized finance can be a great option for those seeking better rates, allowing them to get better deals and diversify their assets. Given the wide range of products available within DeFi, the options of the table are indeed many.
Let’s take a closer look at this:
Cost: DeFi applications tend to have cheaper fees compared to banks and institutions in the traditional market
Anonymity: it is not necessary to provide personal data, such as name, address or tax details to use a decentralized finance platform
Diversification: there are several segments of finance using DeFi technology, allowing the diversification of applications that can better suit a user’s interests
Flexibility: The market works around the clock, so you can trade your assets whenever you want and without asking permission from a third party
While all these benefits might be great, DeFi applications also come with some disadvantages and barriers that stand in the way of wider adoption.
What Are The Risks Associated with Decentralized Finance?
Generally speaking, every DeFi protocol and every DeFi project comes with different risk levels. Oftentimes, the higher the rewards, the higher the risk, especially when using instruments such as yield farming, for example.
Here are the major risks to keep in mind:
When borrowing on a DeFi application, you typically offer other crypto assets owned as collateral. However, since cryptocurrencies have experienced high levels of volatility, their value isn’t always stable. In case of a market downturn, the assets you’re using as a collateral might have seen a sharp decline, posing a problem. In some cases, some people might even see their positions entirely liquidated. Many DeFi users opt for using stable coins precisely to try and avoid this type of risk.
Depending on the protocol, there might be a significant amount of risk related to how the yield being earned is being generated. As DeFi isn’t an industry that’s regulated or insured, there aren't consumer protections in place in case something goes wrong. Self-custody is a key feature of decentralized finance and, as you’re the only person responsible for the management and safety of your assets, in case of a loss or theft (which can still occur even though there are many safeguards in place), you won’t necessarily find someone to ask help from in recovering your funds.
Smart contracts carry out a set of instructions on the blockchain and they are crucial to the functioning of decentralized finance applications. However, if for whatever reason there’s an issue with a developer’s code, this could present a weakness within the protocol. Remember that once the rules have been coded, it’s impossible to modify a smart contract.
Unfortunately, scams and frauds are still a frequent occurrence in the DeFi sector. As such, it’s always worth performing due diligence and establishing the credibility of a DeFi platform before using it.
What Else Should I Know Before Investing In DeFi Platforms
Decentralized finance is an unregulated financial system but many see it as a revolution in how we conduct financial transactions and how financial institutions act.
If you decide to invest in a DeFi application, the first thing you should do is vet the applications you’re exploring to make sure they’re secure and well-audited.
When you’re choosing an underlying network, such as a blockchain, protocol or exchange, it's best you look for one that isn’t controlled by a small group of players. That's a role played instead by centralized exchanges and centralized systems like, say, your local bank. So, not only should you preferably choose a fully independent DeFi option, you'll also be looking for a platform that can handle heavy user demand and has affordable transaction fees.
Meanwhile, a few red flags include DeFi apps that ignore concerns raised by its users about security or platforms that aren't transparent about their own code. In addition, if a project claims to offer very high returns while downplaying risk, that's another aspect that should set off alarm bells.
Ultimately, if something feels off, perhaps you should trust your instincts.
This text is informative in nature and should not be considered an investment recommendation. It does not express the personal opinion of the author or Sensorium Corporation. Any investment or trading is risky, and past returns are not a guarantee of future returns. Risk only assets that you are willing to lose.