Decentralized Finance (DeFi) Definition

What Is Decentralized Finance (DeFi)?

Decentralized finance (DeFi) is an emerging financial technology based on secure distributed ledgers similar to those used by cryptocurrencies. The system removes the control banks and institutions have on money, financial products, and financial services.

Some of the key attractions of DeFi for many consumers are:

  • It eliminates the fees that banks and other financial companies charge for using their services.
  • You hold your money in a secure digital wallet instead of keeping it in a bank.
  • Anyone with an internet connection can use it without needing approval.
  • You can transfer funds in seconds and minutes.

Key Takeaways

  • Decentralized finance, or DeFi, uses emerging technology to remove third parties in financial transactions.
  • The components of DeFi are stablecoins, software, and hardware that enables the development of applications.
  • The infrastructure for DeFi and its regulation are still under development and debate.
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Understanding Decentralized Finance (DeFi)

To understand decentralized finance and how it works, it helps to understand how centralized finance differs from DeFi.

Centralized Finance

In centralized finance, your money is held by banks, corporations whose overarching goal is to make money. The financial system is full of third parties who facilitate money movement between parties, with each one charging fees for using their services. For example, say you purchase a gallon of milk using your credit card. The charge goes from the merchant to an acquiring bank, which forwards the card details to the credit card network.

The network clears the charge and requests a payment from your bank. Your bank approves the charge and sends the approval to the network, through the acquiring bank, back to the merchant. Each entity in the chain receives payment for its services, generally because merchants must pay for your ability to use credit and debit cards.

All other financial transactions cost money; loan applications can take days to be approved; you might not even be able to use a bank's services if you're traveling.

Two of DeFi's goals are to reduce transaction times and increase access to financial services.

Decentralized Finance

Decentralized finance eliminates intermediaries by allowing people, merchants, and businesses to conduct financial transactions through emerging technology. This is accomplished through peer-to-peer financial networks that use security protocols, connectivity, software, and hardware advancements.

From anywhere you have an internet connection, you can lend, trade, and borrow using software that records and verifies financial actions in distributed financial databases. A distributed database is accessible across various locations; it collects and aggregates data from all users and uses a consensus mechanism to verify it.

Decentralized finance uses this technology to eliminate centralized finance models by enabling anyone to use financial services anywhere regardless of who or where they are.

DeFi applications give users more control over their money through personal wallets and trading services that cater to individuals.

While taking control away from third parties, decentralized finance does not provide anonymity. Your transactions may not have your name, but they are traceable by the entities that have access. These entities might be governments, law enforcement, or other entities that exist to protect people's financial interests.

How Does DeFi Work?

Decentralized finance uses the blockchain technology that cryptocurrencies use. A blockchain is a distributed and secured database or ledger. Applications called dApps are used to handle transactions and run the blockchain.

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.

The blocks are "chained" together through the information in each proceeding block, giving it the name blockchain. Information in previous blocks cannot be changed without affecting the following blocks, so there is no way to alter a blockchain. This concept, along with other security protocols, provides the secure nature of a blockchain.

DeFi Financial Products

Peer-to-peer (P2P) financial transactions are one of the core premises behind DeFi. A P2P DeFi transaction is where two parties agree to exchange cryptocurrency for goods or services without a third party involved.

To fully understand this, consider how you get a loan in centralized finance. You'd need to go to your bank or another lender and apply for one. If you were approved, you'd pay interest and service fees for the privilege of using that lender's services.

Peer-to-peer lending under DeFi doesn't mean there won't be any interest and fees. However, it does mean that you'll have many more options since the lender can be anywhere in the world.

In DeFi, you'd use your decentralized finance application (dApp) to enter your loan needs, and an algorithm would match you up with peers that meet your needs. You'd then need to agree to one of the lender's terms and receive your loan.

The transaction is recorded in the blockchain; you receive your loan after the consensus mechanism verifies it. Then, the lender can begin collecting payments from you at the agreed-upon intervals. When you make a payment via your dApp, it follows the same process in the blockchain; then, the funds are transferred to the lender.

DeFi Currency

DeFi is designed to use cryptocurrency for transactions. The technology is still developing, so it is difficult to determine precisely how existing cryptocurrencies will be implemented, if at all. Much of the concept revolves around stablecoin, a cryptocurrency backed by an entity or pegged to fiat currency like the dollar.

The Future of DeFi

Decentralized finance is still in the beginning stages of its evolution. For starters, it is unregulated, which means the ecosystem is still riddled with infrastructural mishaps, hacks, and scams.

Current laws were crafted based on the idea of separate financial jurisdictions, each with its own set of laws and rules. DeFi’s borderless transaction ability presents essential questions for this type of regulation. For example, who is responsible for investigating a financial crime that occurs across borders, protocols, and DeFi apps? Who would enforce the regulations, and how would they enforce them?

The decentralized finance ecosystem's open and distributed nature might also pose problems to existing financial regulation.

Other concerns are system stability, energy requirements, carbon footprint, system upgrades, system maintenance, and hardware failures.

Many questions must be answered and advancements made before DeFi becomes safe to use. Financial institutions are not going to let go of one of their primary means of making money—if DeFi succeeds, it's more than likely that banks and corporations will find ways to get into the system; if not to control how you access your money, then at least to make money from the system.

What Does Decentralized Finance Do?

The goal of DeFi is to get rid of the third parties that are involved in all financial transactions.

Is Bitcoin a Decentralized Finance?

Bitcoin is a cryptocurrency. DeFi is being designed to use cryptocurrency in its ecosystem, so Bitcoin isn't DeFi as much as it is a part of it.

What Is Total Value Locked in DeFi?

Total value locked (TVL) is the sum of all cryptocurrencies staked, loaned, deposited in a pool, or used for other financial actions across all of DeFi. It can also represent the sum of specific cryptocurrencies used for financial activities, such as ether or bitcoin.

Investing in cryptocurrencies and other Initial Coin Offerings (“ICOs”) is highly risky and speculative, and this article is not a recommendation by Investopedia or the writer to invest in cryptocurrencies or other ICOs. Since each individual's situation is unique, a qualified professional should always be consulted before making any financial decisions. Investopedia makes no representations or warranties as to the accuracy or timeliness of the information contained herein.

Article Sources

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  1. ethereum.org. "Decentralized Finance (DeFi)."

  2. Wharton, University of Pennsylvania. "DeFi Beyond the Hype, The Emerging World of Decentralized Finance," Pages 4-5.

  3. Wharton, University of Pennsylvania. "DeFi Beyond the Hype, The Emerging World of Decentralized Finance," Pages 2-3.

  4. National Institute of Standards and Technology. "Blockchain."

  5. ethereum.org. "Introduction to Smart Contracts."

  6. ethereum.org. "Introduction to dapps."

  7. Wharton, University of Pennsylvania. "DeFi Beyond the Hype, The Emerging World of Decentralized Finance," Pages 3, 8.

  8. Wharton, University of Pennsylvania. "DeFi Beyond the Hype, The Emerging World of Decentralized Finance," Page 7.

  9. Coindesk. "Total Value Locked (TVL)."

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