What is Decentralized Finance (DeFi)?

What is Decentralized Finance (DeFi)?

Decentralized Finance (DeFi) is an emerging model for organizing and enabling cryptocurrency-based transactions, exchanges and financial services.

The core premise of DeFi is that there is no centralized authority to dictate or control operations. It is a different approach than the traditional fiat currency or centralized finance (CeFi) funding models within the cryptocurrency markets. With centralized models, there is an underlying authority that can influence and control the flow of transactions. The central authority is often also responsible for the custody of assets.

There is no central authority in DeFi. Instead, authority is distributed in a decentralized approach designed to give individuals more power and control. In the DeFi model, all transactions for buying, selling, lending and paying with cryptocurrency can be done without a central authority in a peer-to-peer (P2P) approach.

Asset custody is a fundamental part of any financial model. In the DeFi approach, individual traders are in control of the private cryptographic encryption keys that enable custody of cryptocurrency assets. Financial transactions within the DeFi model are enabled with smart contracts, often supported on Ethereum-based blockchains.

The DeFi model also includes the notion of decentralized exchanges (DEXs), which work with the aim of connecting and empowering people who wish to execute cryptocurrency transactions. DeFi is also often closely associated with the concept of decentralized apps (dApps), typically for financial services use cases.

How does DeFi work?

DeFi relies on the use of a blockchain, often based on Ethereum in many DeFi operations.

A blockchain is a form of immutable distributed ledger that cryptographically secures entries used for transactions. Blockchains are also the basis of cryptocurrencies, which are tokens created on a blockchain that have value.

With an Ethereum-based blockchain, smart contracts help the DeFi model work. A smart contract is an application that runs on a blockchain and uses the inherent distributed ledger and cryptographic encryption capabilities. The smart contract sets the conditions for performing a specific operation.

Instead of a central authority enabling a transaction, a smart contract is activated programmatically to carry out the financial transaction specified in the contract. A smart contract can contain cryptocurrency assets that can be sent from one entity to another.

With DeFi smart contracts, the terms and conditions of a transaction are also transparent and available in code, meaning they can be viewed by others for review and analysis. No central authority is required to enable a smart contract with DeFi as the system operates in a P2P model. Thus, if two peers can agree on the execution of a transaction, this can be done without the need for a third-party central authority.

Within the DeFi model and its use of smart contracts, the focus is on empowering the individual user. Custody of cryptocurrency assets relies on control of both private and public encryption keys. With the decentralized approach, custody in the form of private cryptographic encryption keys lies with the person.

CeFi vs. Defiant

When it comes to cryptocurrency-related financial services, two predominant models are used today, CeFi and DeFi. When comparing CeFi and DeFi, it is important to note that there are similarities and differences between the two approaches.

Both models allow traders to buy, sell and lend cryptocurrency assets and have a concept of an exchange that can help facilitate transactions. Blockchain-based technologies are also central to CeFi and DeFi models.

The two approaches differ with dramatic results in organization and management. The CeFi model relies on a central authority that regulates transactions. The central authority also holds assets in custody.

In contrast, the DeFi approach relies on smart contracts and a decentralized P2P approach to enable financial services. Instead of the custody of assets being the responsibility of the centralized exchanges, it is individual users who have custody of their own cryptocurrency assets.

Advantages of DeFi

DeFi offers users a number of benefits that can help improve confidence, security, and confidence in cryptocurrency-based transactions and applications, including the following:

• decentralized Because DeFi is decentralized, it is not subject to the inherent risks of CeFi, where the failure of an exchange can result in a complete collapse and loss of user funds and accounts.
• Permissionless. As a decentralized model, no central authority is required to approve or facilitate a transaction. Instead, the model is permissionless, as the programmatic logic of smart contracts defines what is possible.
• Transparency. The smart contract model can allow users to understand the terms and logic of a transaction in a transparent model with no hidden code.
• Anonymity. While smart contracts can be transparent on the blockchain, there is no need or requirement for users to be identified. With DeFi, the know-your-client requirements common to centralized and regulated models do not specifically apply.
• Custody. In DeFi, users control assets and custody of the cryptographic private key for cryptocurrency tokens is held by the user.
• Dapps. DeFi supports dApps, where users can benefit from financial services applications and other use cases like gaming and social media.
• Fees. Without a central authority, DeFi offers users the promise of lower fees than transactions executed in the CeFi model.

Challenges of DeFi

While DeFi has its fair share of benefits, it also has several potential challenges, including the following:

• Complexity. The perceived complexity of DeFi is probably the model’s biggest challenge. DeFi operates on a P2P model using smart contracts and sophisticated algorithms that may be difficult to understand for the uninitiated. This complexity can also lead to confusion about how a service or application works.
• Customer service. Without a central authority or service to ask for help, customer service with DeFi can often be challenging.
• Volatility. There may potentially be more volatility in DeFi approaches as there is no central moderating authority to control or limit transaction or market dynamics.
• Security. DeFi platforms have been increasingly targeted by attackers in recent years. A Federal Bureau of Investigation alert issued in August 2022 warned that over $1 billion in assets had been stolen in just three months.

Using DeFi

There is a wide range of use cases implementing DeFi today, including the following:

• payments. DeFi can enable P2P payments without the need for a central authority.
• loan. The ability to lend and borrow cryptocurrency assets is a common use case for DeFi.
• NFTs. Non-fungible tokens allow users to own tokens that can be traded.
• stablecoins. An increasingly common use of DeFi is in stablecoins. The purpose of a stablecoin is to limit the volatility of the cryptocurrency by pegging the value of a coin to another asset, commodity, or currency.
• yield farming. For those using DeFi as an investment vehicle, yield farming allows individuals to earn interest income from cryptocurrency investments.
• Dapps. DApps run on DeFi and enable multiple types of use cases, including financial services and gaming.

Several DeFi services and platforms are available today, including the following:

• Avalanche. Avalanche is a proof-of-stake blockchain to support DeFi smart contracts. It also has its own token with the AVAX cryptocurrency.
• DYdX. DYdX is a DEX that enables cryptocurrency trading.
• index cooperative. Index offers several features, including the DeFi Pulse Index, which tracks the performance of DeFi assets and cryptocurrencies.
• MakerDAO. MakerDAO is a decentralized autonomous organization for managing cryptocurrency operations and created the stablecoin Dai, which is pegged to the US dollar.
• TrueFi. TrueFi offers a credit log as well as the TRU token.

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