What Decentralized Finance is and How DeFi Works

What is Decentralized Finance

Some of the most watershed moments in history involved changing what could be done in the palm of someone’s hand. From sparking a fire to Gutenberg’s printing press that brought reading to the masses, to the personal computer and smartphones. The purpose of technology is to facilitate ease of access and help individuals be more innovative, efficient, and productive. Accessibility to the masses facilitates technological change and advancement. 

Decentralized finance (DeFi) is here to shatter the functions of traditional finance. Currently, the traditional finance industry is “centralized.” In the United States, the Federal Reserve is the single central authority that controls the entire monetary policy. Traditional finance is antiquated, and we have seen several examples of how it is highly manipulated and full of inefficiencies, fraud, and corruption. The system is also isolated and inaccessible to the masses. 

DeFi and the onset of web 3.0 modernize the global financial system for the internet age. By adapting traditional finance to the capabilities of modern technology, we get transformative changes. DeFi open’s the door for all people to access a system impossible in traditional finance. It is a movement that creates a low-cost, fast, efficient, trustworthy, and transparent global financial ecosystem without a central authority. The system is also is highly accessible to anyone with a smartphone or internet.

The term DeFi has become a catch-all name for a growing list of financial products and services.  By using cryptography, decentralization, and blockchain, DeFi is able to provide an open, fully decentralized, and transparent financial system. The products and services open an entire ecosystem of versatile utility and, most of all… fun!  From names like UniSwap (Uni for Unicorn), PancakeSwap, BeefyFinance, AlpacaFinance, and so on, the potential for memes and fun is endless.  

How Does DeFi Work

The central technology of DeFi comes through blockchain and cryptocurrency. Blockchain technology is the cornerstone of decentralized finance and makes the decentralization aspect of DeFi possible. Blockchains like Bitcoin or Ethereum are a collection of transaction data strung together in a chain of blocks. 

Blockchains are decentralized, transparent, and immutable. The blockchain data is stored across different locations on a myriad of computers worldwide, making the chains decentralized. When it comes to transparency, blockchain data is permanently recorded on a public ledger, like BscScan, and anyone can verify the results. Imagine if the US Federal Reserve had a running ledger of how every tax dollar was allocated? Finally, cryptography and blockchain technology make each transaction fully immutable. The data cannot be changed, forged, or altered, and the chains cannot be unlinked. 

Common Use Cases of DeFi

Bitcoin (BTC), Ethereum, and Binance Smart Chain (BSC) are currently the big three of DeFi. Bitcoin is the original and started as a new digital asset. Bitcoin’s white paper from Satoshi Nakamoto came in 2009. BTC was the first-ever peer-to-peer digital money and the first financial application built on blockchain technology. However, it was Ethereum which changed the world of DeFi and the entire world of crypto. While Bitcoin is a store of value blockchain, Ethereum is programmable and allows for the creations of new products and services through smart contracts. BSC is somewhat of a newcomer and is a near copy of Ethereum, intended for faster transactions and cheaper fees. While Ethereum is the top dog in the DeFi world, Binance Smart Chain and other chains are growing in size and ability.

Ethereum allows for data and blocks of the chain to contain rules to create contracts. Smart contracts are an essential function that replaces the role of a traditional financial institution in all cryptocurrency transactions. The smart contract is recorded on the blockchain and can be used to verify nearly any digital asset. Cryptocurrencies and their accompanying smart contracts provide services that don't need intermediaries. Smart contracts authorize transactions and carry out contracts within a trusted environment, eliminating the requirement of a central authority like a government, bank, or legal body.

Web 3.0 is the next generation of applications and protocols that bridge users to the decentralized world wide web. Below is a list of common use cases for DeFi applications and protocols.

Common dApps and Protocols on DeFi

• E-Wallets - Digital or hardware wallets that connect cryptocurrency exchanges and allow assets to be used on third-party platforms and protocols. Examples TrustWallet, MetaMask
• Decentralized Exchanges - Commonly known as DEXes, use blockchain technology and a network of computers to complete and verify transactions. Examples PancakeSwap, UniSwap

• Stablecoins - coins pegged to fiat that still experience high yields and growth without the volatile swings of many crypto coins. Examples: USDC, Tether, USDT
• Non-Fungible Tokens (NFTs) - crypto-collectibles that cannot be divided. They are forever unique and characterize scarcity associated with cryptocurrencies. Examples: OpenSea, Binance Marketplace

• Flash Loans - an uncollateralized loan option that enables users to borrow instantly and efficiently based on certain rules. Example MakerDAO and Aave 
• Yield Farming - any blockchain protocol that enables any person with some holding of crypto tokens to ‘lock-up’ those holdings with a custodian(the protocol). In return, they distribute rewards. Examples: Compound, Beefy.Finance
  

Risks and Downsides to DeFi

With all the great upsides to DeFi, the phenomenon is still just beginning. Due to its early development, it is still vulnerable to several risks and downsides. 

First, the industry is still working on mainstream adoption and recognition. At this time, there are still few consumer protections for DeFi users. Some exchanges like Coinbase keep their funds in banks protected by Federal Deposit Insurance Corp. (FDIC), but there are no protections for crypto-assets and no reimbursements if an exchange fails. Moreover, many protocols are prone to hacks and exploits. Codes can be unfinished and leave holes for exploitation. With few protections and platforms prone to hacks, there are clear and present dangers to engaging in DeFi. 

Not all blockchains are created with the same degree of centralization. While not all DeFi apps are at the most decentralized, they work on teams gradually relinquishing control over their protocols. In the case of BSC, decentralization is negotiable, and the chain is proving that users may be willing to exchange some centralization for higher speeds and lower fees. Some users have also found strategies like yield farming to be highly skeptical but also prone to extreme volatility. 

Ultimately, DeFi users control their fate. Users should never, under any circumstance, share a private key. Many victims of perceived fraud come from a user sharing their private key unknowingly to the wrong person. There is also no way to recover a lost private key. Once it is lost, it is lost. This can be a perceived downside of decentralization.

Building A Better Future

Traditional finance, which has barely seen updates from the analog computer days, is ripe for improvement.  In today's world, central governments and financial institutions act as guarantors of transactions. This gives these institutions immense power over the money that flows through them. In a world where bankers and leaders of capital call the shots, DeFi products open up financial services to anyone with an internet connection. These protocols are also primarily owned and maintained by their users. This runs in stark contrast to a world where billions of people can't even access a bank account.

So far, tens of billions of dollars worth of crypto have flowed through DeFi applications, and it's growing every day. The platforms are permissionless and allow access to anyone with an internet connection. It has properties that can disenthrall citizens of the world. DeFi and the projects it has can become the unsung hero of a better financial future. Today, you might put your savings in an online savings account and earn an interest rate of less than 1% on your money. With DeFi, people lend their savings directly to others on a decentralized exchange, cut out the middleman and retain higher profits than ever imagined in centralized finance.

Blockchain and DeFi are ushering in the birth of a whole new economy. It is creating a path of least resistance to solve the world’s financial troubles.  After a pandemic that sped up the technological literacy of the world, we are at the cusp of the potential of blockchains and DeFi. Beyond Bitcoin, we have seen the enormous growth of DeFi blockchains like Ethereum and Binance Smart Chain. DeFi is proving to be the rising tide that capitalist thinkers have championed for decades. The dogmas of traditional finance are inadequate for the future of DeFi.