What Is Decentralized Finance (DeFi) and How Does It Work?

Decentralized Finance (DeFi) Definition

Investopedia / Joules Garcia

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.

DeFi eliminates the fees that banks and other financial companies charge for using their services. Individuals hold money in a secure digital wallet, can transfer funds in minutes, and anyone with an internet connection can use DeFi.

Key Takeaways

  • Decentralized finance, or DeFi, uses emerging technology to remove third parties and centralized institutions from 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 constantly evolving.
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Centralized Finance vs. Decentralized Finance (DeFi)

Decentralized finance differs from traditional, centralized financial institutions and banking.

Centralized Finance

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.

All financial transactions are overseen in centralized finance, from loan applications to a local bank's services.

Two of DeFi's goals include reducing transaction times and increasing access to financial services.

Decentralized Finance

Decentralized finance eliminates intermediaries by allowing people, merchants, and businesses to conduct financial transactions through emerging technology. Through peer-to-peer financial networks, DeFi uses security protocols, connectivity, software, and hardware advancements.

Wherever there is an internet connection, individuals 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 as it collects and aggregates data from all users and uses a consensus mechanism to verify it.

Decentralized finance eliminates the need for a centralized finance model 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.

Decentralized finance does not provide full anonymity. Transactions do not include an individual's name but are traceable by the entities that have access, including governments, and law to protect an individual'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.

Uses of DeFi

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.

In DeFi, P2P can meet an individual's loan needs, and an algorithm would matches peers that agree on the lender's terms, and a loan is issued. Payments from P2P are made via a decentralized application, or dApp, and follow the same process in the blockchain. Using DeFi allows for:

• Accessibility: Anyone with an internet connection can access a DeFi platform and transactions occur without any geographic restriction.

• Low fees and high-interest rates: DeFi enables any two parties to directly negotiate interest rates and lend money via DeFi networks.

• Security and Transparency: Smart contracts published on a blockchain and records of completed transactions are available for anyone to review but do not reveal your identity. Blockchains are immutable, meaning they cannot be changed.

• Autonomy: DeFi platforms don't rely on any centralized financial institutions and are not subject to adversity or bankruptcy. The decentralized nature of DeFi protocols mitigates much of this risk.

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.

Advantages and Disadvantages of DeFi

Pros
  • Decentralized applications allow individuals to transfer capital around the world

  • Investor's ability to generate income

  • High level of security

Cons
  • Participation in DeFi is complex and not easily understood

  • High risk of fraud and scams

  • High level of volatility

The Future of DeFi

Decentralized finance is constantly evolving. It is unregulated and its ecosystem is 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.

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?

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

What Does Decentralized Finance Do?

The goal of DeFi is to challenge the use of centralized financial institutions and 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.

The Bottom Line

Decentralized finance (DeFi) is an emerging financial technology that challenges the current centralized banking system. DeFi eliminates the fees that banks and other financial companies charge for using their services and promotes the use of peer-to-peer, or P2P, transactions.

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

  2. Nasdaq. “Understanding DeFi and Its Importance in the Crypto Economy.”

  3. Financial Industry Regulatory Authority. “Blockchain Technology.”

  4. Cornell University arXiv. “DeFi vs. DeFi – Comparing Centralized to Decentralized Finance.”

  5. Financial Industry Regulatory Authority. “What Is a Blockchain, and Why Should I Care?

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

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

  8. Federal Reserve Bank of St. Louis. Decentralized Finance: On Blockchain- and Smart Contract-Based Financial Markets.”

  9. World Economic Forum. “Decentralized Finance (DeFi) Policy-Maker Toolkit,” Page 10.

  10. Tennessee Department of Commerce and Insurance. “Bank to the Future: Decentralized Finance (DeFi) Defined,” Pages 1-2.

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

  12. World Economic Forum. “Decentralized Finance (DeFi) Policy-Maker Toolkit,” Pages 21-24.

  13. U.S. Securities and Exchange Commission. “Funds Trading in Bitcoin Futures – Investor Bulletin.”

  14. Nasdaq. “What Is Total Value Locked?

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