What is decentralized finance (DeFi)?
Decentralized finance (DeFi) is an emerging model for organizing and enabling cryptocurrency-based transactions, exchanges and financial services.
DeFi's core premise is that there is no centralized authority to dictate or control operations. It's a different approach than the traditional models of finance for fiat currency or centralized finance (CeFi) within the cryptocurrency markets. With centralized models, there is a core foundational authority that can influence and control the flow of transactions. The central authority often is also responsible for custody of assets.
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.
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The DeFi model also includes the notion of decentralized exchanges (DEXs) that operate with the purpose of helping to connect and enable individuals looking 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, 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.
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.
Instead of a central authority enabling a transaction to occur, a smart contract is programmatically enabled to perform the financial transaction that is specified in the contract. A smart contract can hold 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 as code, which means they are viewable by others to audit and analyze. There is no need for a central authority to enable a smart contract with DeFi as the system works in a P2P model. As such, if two peers can agree to execute a transaction, it can be done without the need for a third-party central authority.
Within the DeFi model and its usage of smart contracts, there is an emphasis on empowering the individual user. Cryptocurrency asset custody relies on control of both private and public encryption keys. With the decentralized approach, custody in the form of the private cryptographic encryption keys are held by the individual.
CeFi vs. DeFi
With cryptocurrency-related financial services, there are two prevailing models in use today with CeFi and DeFi. When comparing CeFi vs. DeFi, it's important to note that there are similarities and differences between the two approaches.
Both models enable traders to buy, sell and loan cryptocurrency assets and have a concept of an exchange that can help to facilitate transactions. Blockchain-based technologies are also central to both CeFi and DeFi models.
The two approaches differ with dramatic results in organization and management. The CeFi model relies on a central authority to govern transactions. The central authority also holds custody over assets.
In contrast, the DeFi approach relies on smart contracts and a P2P decentralized approach to enable financial services. Instead of asset custody being the responsibility of the centralized exchanges, it is the individual users that hold custody of their own cryptocurrency assets.
Benefits of DeFi
DeFi offers users a number of benefits that can help to improve confidence, security and trust in cryptocurrency-based transactions and applications, including the following:
- Decentralized. Because it's decentralized, DeFi is not subject to the inherent risks with CeFi, where the failure of an exchange can lead to a complete collapse and loss of user funds and accounts.
- Permissionless. As a decentralized model, there is no need for a central authority to approve or enable a transaction. Instead, the model is permissionless as the programmatic logic of smart contracts defines what is possible.
- Transparency. The smart contract model can enable users to understand the terms and logic of a transaction in a transparent model without 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, Know Your Client requirements, which are common with 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, in which users can benefit from financial services applications and other use cases, such as gaming and social media.
- Fees. Without a central authority, DeFi provides users with 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 likely the model's biggest challenge. DeFi works in a P2P model, with smart contracts and sophisticated algorithms that can be difficult to fully understand for the uninitiated. That 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 a challenge.
- Volatility. There can potentially be more volatility in DeFi approaches as there is no moderating central authority to control or limit transaction or market momentum.
- Security. In recent years, DeFi platforms have increasingly been targeted by attackers. A Federal Bureau of Investigation alert issued in August 2022 warned that over $1 billion in assets had been stolen in just a three-month period.
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Uses of DeFi
There are a broad range of use cases where DeFi is being implemented today, including the following:
- Payments. DeFi can enable P2P payments without the need for a central authority.
- Lending. The ability to lend and borrow cryptocurrency assets is a common use case for DeFi.
- NFTs. Non-fungible tokens enable users to own tokens that can be traded.
- Stablecoins. An increasingly common use of DeFi is stablecoins. The purpose of a stablecoin is to help limit the volatility of 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 enables individuals to gain interest income on cryptocurrency assets.
- DApps. DApps run on DeFi and enable multiple types of use cases, including financial services and gaming.
There are multiple DeFi services and platforms available today, including the following:
- Avalanche. Avalanche is a proof of stake blockchain for supporting 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 provides several capabilities, including the DeFi Pulse Index, which tracks the performance of DeFi assets and cryptocurrencies.
- MakerDAO. MakerDAO is a decentralized autonomous organization for governing cryptocurrency operations and created the Dai stablecoin, which is linked to the U.S. dollar.
- TrueFi. TrueFi provides a lending credit protocol, as well as the TRU token.