What Is Decentralized Finance (DeFi)?
Decentralized finance (DeFi) is an emerging financial technology based on secure distributed ledgers similar to those used by cryptocurrencies.
In the U.S., the Federal Reserve and Securities and Exchange Commission (SEC) define the rules for centralized financial institutions like banks and brokerages, which consumers rely on to access capital and financial services directly. DeFi challenges this centralized financial system by empowering individuals with peer-to-peer digital exchanges.
With DeFi, there is no central authority. Instead, authority is distributed in a decentralized approach that is intended to provide more power and control to individuals. In the DeFi model, all transactions for buying, selling, loans and payments with cryptocurrency can occur without a central authority in a peer-to-peer (P2P) approach.
Custody of assets is a fundamental component of any financial model. In the DeFi approach, individual traders have control over the private cryptographic encryption keys, which enable custody of cryptocurrency assets. Financial transactions within the DeFi model are enabled with smart contracts that are often supported on Ethereum-based blockchains.
In centralized finance, money is held by banks and third parties who facilitate money movement between parties, with each charging fees for using their services. A credit card charge starts from the merchant and moves to an acquiring bank, which forwards the card details to the credit card network.
The network clears the charge and requests a payment from the bank. Each entity in the chain receives payment for its services, generally because merchants must pay for the use of credit and debit cards.1
All financial transactions are overseen in centralized finance, from loan applications to a local bank’s services.
How does DeFi work?
DeFi relies on the use of a blockchain, which is often based on Ethereum in many DeFi operations.
A blockchain is a form of immutable distributed ledger that cryptographically secures entries, which are used for transactions. Blockchains are also the basis of cryptocurrencies, which are tokens that are created in a blockchain that have value.
In the blockchain, transactions are recorded in blocks and then verified by other users. If these verifiers agree on a transaction, the block is closed and encrypted; another block is created that has information about the previous block within it.
With an Ethereum-based blockchain, smart contracts help the DeFi model work. A smart contract is an application that runs on a blockchain using the inherent distributed ledger and cryptographic encryption capabilities. The smart contract specifies terms and conditions for the execution of a given operation.
Why is DeFi important?
DeFi takes the basic premise of Bitcoin — digital money — and expands on it, creating an entire digital alternative to Wall Street, but without all the associated costs (think office towers, trading floors, banker salaries). This has the potential to create more open, free, and fair financial markets that are accessible to anyone with an internet connection.
What are the downsides?
Fluctuating transaction rates on the Ethereum blockchain mean that active trading can get expensive.
Depending on which dapps you use and how you use them, your investment could experience high volatility – this is, after all, new tech.
You have to maintain your own records for tax purposes. Regulations can vary from region to region.
Lending markets are one popular form of decentralized finance, which connects borrowers to lenders of cryptocurrencies. One popular platform, Compound, allows users to borrow cryptocurrencies or offer their own loans. Users can make money off of interest for lending out their money. Compound sets the interest rates algorithmically, so if there’s higher demand to borrow a cryptocurrency, the interest rates will be pushed higher.
DeFi lending is collateral-based, meaning in order to take out a loan, a user needs to put up collateral – often ether, the token that powers Ethereum. That means users don’t give out their identity or associated credit score to take out a loan, which is how normal, non-DeFi loans operate.