Decentralized Finance (DeFi): Definition, How It Works

• Decentralized finance or DeFi is a financial system that reimagines financial transactions by removing intermediaries and is based on blockchain technology, typically Ethereum.
• Various financial transactions are possible with DeFi’s ‘smart contracts’ that execute financial transactions under certain conditions.
• There are many different decentralized applications, or dApps, and uses within DeFi that open accessibility but come with risk.
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Decentralized finance or DeFi is a global financial system that’s available on blockchains that are public — most often Ethereum. 

“DeFi stands for decentralized finance. In simple words it stands for self-custody finance. Unlike traditional finance where a company, bank, fund is responsible for your money, in DeFi no one but you has access to it,” explains Anton Mozgovoy, co-founder of Mover, a DeFi Savings platform.

Through this new emerging technology, DeFi expands what’s possible with cryptocurrency and moves beyond just currency and creates sophisticated systems with an abundance of uses with the creation of applications, typically referred to as decentralized apps, or dApps, which we’ll get into later.   

DeFi was coined in 2018 by a group of entrepreneurs and Ethereum developers who wanted to open up finance applications from traditional systems. The abbreviation sounds like defy, which is intentional.

How DeFi works 

DeFi, previously referred to as “open finance,” takes out the middleman in financial transactions. So instead of having your bank or credit card issuer be the intermediary between you and a merchant when you make a purchase, you use the digital currency and have ownership of it to use directly. DeFi is primarily based on Ethereum, the top cryptocurrency next to Bitcoin.

Here are the main tenets of DeFi: 

• There are no intermediaries, so no banks or institutions overseeing your money 
• There’s a level of transparency, as the code is available for anyone’s review 
• There are open networks that transcend geographic borders 
• There are many applications for users, primarily based on Ethereum

Though DeFi is usually a main player in the cryptocurrency conversation, it goes beyond creating an alternative digital currency or value. DeFi works to replace the role of traditional financial systems through its smart contracts. 

“DeFi is all about code. With the help of things called smart contracts, your money is programmed to perform various [functions]. It creates a unique opportunity for anyone with a computer and internet connection to participate in the global economy,” notes Mozgovoy.

One of the most attractive parts of DeFi for people is that it eliminates the barrier to entry for many of these financial transactions. You no longer have a government or corporation manage your money or need to qualify for certain financial products. 

Using traditional financial systems, you apply for a loan and may be rejected based on your credit. You have a bank account or investment brokerage with a company that oversees your money. 

With DeFi’s smart contracts, certain financial transactions are executed after specific conditions are met. The smart contracts allow for borrowing, lending, and more and the terms of the transaction are literally written in the code. While that makes these transactions easy-to-use and more efficient, it can also make them more susceptible to errors that can’t be fixed. 

Because of these smart contracts and the ability for Ethereum to create applications, DeFi can be used:

• As a lending network, which offers peer-to-peer borrowing and lending 
• Through decentralized exchanges, where users can exchange one type of currency for another. For example, trading ether for US dollars 
• For betting, where users bet on potential outcomes of certain events 
• As stablecoins, which connect a type of cryptocurrency to a more traditional type of currency like the US dollar, in order to lower price volatility and add more stability 

Pros and cons of DeFi

The rising popularity of DeFi and other cryptocurrency make it seem like an attractive investment. But it’s important to understand what you’re getting into before taking the plunge, and understand the benefits and drawbacks. 

“In DeFi you hold your money, you control where your money goes and how it’s spent. DeFi is efficient, since everything is programmable, in a click of a button you can perform complex transactions,” explains Mozgovoy.

The accessibility factor can remove some barriers, but there are a number of cons to be aware of. 

“DeFi is new and experimental. Since everything is code, it can have bugs. Bugs lead to money loss or hacks. DeFi is new and complicated,” says Mozgovoy. “User experience can still be rough. Learning curve is still steep, but it will change.” 

All investing comes with some level of risk and DeFi is no different. But any cryptocurrency or DeFi application may have a higher level of risk due to difficulties with regulation (though the SEC is looking to fix that) and potential scams. A good rule of thumb is to not invest any money you can’t afford to lose.

The financial takeaway

DeFi is an expansive financial ecosystem that strives to take out the middleman and allow for financial transactions between users. Currently, there is a lot of hype around DeFi and crypto. If you want to take part, be sure to understand not only the rewards but also the risks before getting started.