What Is DeFi: Beginner’s Guide to Decentralized Finance

By Thasni Maya
Joel Taylor
Edited by Joel Taylor

Published February 28, 2022.

DeFi written on  futuristic background

How many times have you scratched your head in silence as your friends go on and on about this newfangled finance topic known as DeFi? How many times have you Googled ‘DeFi’ only to be tyrannized by the flurry of jargon?

This has to end. 

In this article, we will explain what DeFi is and how it makes a difference.

What Is DeFi?

DeFi, short for decentralized finance, is an umbrella term for the emerging peer-to-peer financial services that run on blockchains

Cryptocurrencies like bitcoin are built on blockchain technology. They facilitate decentralized transactions, throwing centralized financial institutions and middlemen out of the picture. However, the scope of blockchain technology is not limited to coins and payment executions.

DeFi applies blockchain technology to deliver complex financial use cases like insurance, lending, borrowing, yield farming, trading, staking, crowdfunding, and lotteries. Here, instead of a central authority or a third party, a smart contract facilitates the transactions.

Smart contracts are programs stored on a blockchain that run when predetermined conditions are met. Unlike traditional contracts, smart contracts don’t require tedious paperwork or expensive intermediaries. They are automatic and self-executing agreements, featured by transparency and immutability. 

Decentralized Finance vs. Centralized Finance

How does DeFi stand apart from centralized finance? Here is a quick look. 

In centralized finance, assets and transactions are managed by a set of people or institutions. Centralized finance is not confined to institutions based on fiat currency. For example, many popular crypto exchanges like Coinbase and Binance use a centralized business model similar to traditional stock exchanges. When it comes to decentralized finance, DeFi protocols do the part. Instead of humans, you place your trust in predefined algorithms.

As you sign up for centralized financial services, you hand over the control of your assets to the platform. If the platform’s security is at risk, so are your funds. In decentralized finance, you keep your assets in decentralized wallets like Metamask. Here, nobody can access your funds except you, as long as the password is hidden.

The Benefits of DeFi

  • Transparency DeFi replaces trust with transparency. The transactions on a DeFi application can be seen and verified by anybody. 
  • Atomicity DeFi transactions are made indivisible by blockchain technology. All the sequential actions in a transaction have to be completed for it to process, or else they fail collectively. 
  • Anonymity DeFi applications provide users with better anonymity than their centralized counterparts. They don’t ask for your name, phone number, or ID. All you need is a wallet address to get started. If your jurisdiction bans cryptocurrency, the government can always freeze your assets in centralized applications. Your best bet in this scenario for the safekeeping and transaction of digital assets would be DeFi.
  • Faster trading DeFi can facilitate the exchange of cryptocurrencies faster since decentralized exchanges rely on automated market-maker (AMM) protocols rather than limit order books. 
  • Open around the clock DeFi services like lending, borrowing, yield farming, and insurance are available throughout the day. 
  • Accessible to all The most attractive feature of DeFi is that it makes financial freedom feasible for all. Passive streams of income like yield farming and liquidity mining opened our eyes to the massive potential of DeFi. When applying for a DeFi service, your income, financial statements, and credit score don’t matter. 

The Risks of DeFi

  • For starters, smart contracts lack the human element, which is key to making decisions in many circumstances.
  • If any error makes its way to the smart contract, all transactions are at risk. 
  • The blockchain ecosystem is still figuring out interoperability and cross-chain transactions. 
  • The erratic fluctuations and volatility in the market can lead to huge losses. 
  • Moreover, if you lose access to your wallet, all your funds are gone. There is no way of retrieving them. 

What Is the Future of DeFi?

In the last two years, DeFi has played a key role in bringing cryptocurrencies to the mainstream. The innovative streams of revenue characterized by transparency and anonymity continue to lure people in. The huge market caps of DeFi tokens stand testimony to its success. 

However, DeFi is not without its share of limitations. Like all blockchain applications, DeFi is still in its infancy. The industry is prone to scams, frauds, and failures like its centralized counterpart. 

With a more robust infrastructure, will DeFi and DeFi 2.0 find their way to the masses? Only time will tell.