DeFi defined: a guide to decentralized finance
January 26, 2022
DeFi leverages blockchain technology to challenge traditional banking and bring financial products to everyone with internet access
Decentralized finance (DeFi) incorporates a category of financial products and services built on blockchain technology. The benefits are significant:
Unlike traditional financial products and services, DeFi does not use intermediaries. This enables people from all social and geographical backgrounds to access financial systems.
Users can access DeFi services and stake their earnings to participate in networks whose tokens they hold.
Developers can build decentralized applications entirely on‐chain, using read/write infrastructure to interact with the network’s data.
By removing the intermediaries used in traditional financial products and services, DeFi makes financial systems accessible to a broader spectrum of users.
The DeFi ecosystem removes many of the traditional barriers to access for financial services, such as preferential terms, identity requirements, credit scores, and arduous pre‐qualification paperwork. This means anyone with an internet connection and access to crypto assets can participate.
Participation in DeFi is booming; DeFi Pulse data shows that the amount locked in to Ethereum‐based DeFi applications was $103 billion as of October 26, 2021, up from $65 billion on April 26, 2021. Over the course of 2020, the average Ethereum block size nearly doubled, from 22,415 bytes to 40,265 bytes. This was partly due to the boom in DeFi participation. Complex DeFi transactions became more common, prompting miners to set higher gas ceilings, which led to larger block sizes.
Why is DeFi important?
DeFi projects typically take the form of decentralized applications (referred to as dapps). How do they differ from established, centralized applications — and what are the benefits?
Centralized applications call data from a centralized server. So when Jane logs in to her bank’s online app on her smartphone, for example, the app checks the data server in the bank’s data center to ensure her password is correct. Then it loads her account balances. All of Jane’s information is controlled by that one entity. She must trust the bank to accurately maintain the record of her account balances and securely maintain any other personal data.
In contrast, a decentralized application calls its data from a blockchain (or other P2P network), normally via a combination of wallets and smart contracts. Because the application's data and business logic is stored in a blockchain, which is usually decentralized, the application itself is decentralized. No single entity controls a user’s data; smart contracts and cryptography ensure the information is shared around the network in a secure manner.
The basic features of dapps design highlight some of the reasons why people are excited about DeFi:
Trustless transfer of money Because DeFi products are decentralized, assets can be transferred and managed without users needing to trust intermediaries, such as banks or national settlement companies.
Logic embedded in smart contracts A smart contract is a self‐executing program on a blockchain that controls and/or documents events or actions according to preset terms. Smart contracts can execute the stipulations of an agreement, such as automatically distributing funds. They can also call data from a blockchain and serve as the business logic for decentralized applications. This means financial transactions — such as trading, lending, or even payroll — can happen automatically on preset terms, rather than requiring approval from a third party during their business hours. Some experts estimate banks could save up to $270 billion annually by leveraging smart contract technology to execute compliance functions such as know-your-customer (KYC) and anti-money laundering (AML) controls.
Minimal counterparties While a traditional asset exchange requires a buyer to be paired with an individual seller, decentralized exchanges use smart contracts, with supply and demand coded into the contract’s logic. This means buyers can purchase tokens from an overall pool, rather than relying on counterparties. Counterparty risk is removed because the collateral for the other side of the exchange is already in the dapps smart contract. The purchaser does not need to be paired to a specific seller.
Decentralized/"bankless" By removing a central authority from financial services, DeFi creates products that are censorship‐resistant. Being spread across a peer‐to‐peer network also makes them more resistant to manipulation.
Other highlights of DeFi include:
Speed: Most DeFi transactions take just a few seconds, regardless of the time of day or week, rather than being dependent on business hours. They are also available more quickly than those requiring an intermediary. DeFi functions according to programmed logic and mathematically provable values, rather than depending on email ping-pong or onerous settlement lines.
Flexible and composable Anyone wanting to trade digital asset pairs (such as ETH/USDC) that are not tradeable on any centralized exchange can create their own pair on a decentralized exchange, such as Uniswap. Other users can then trade that pair. Anyone wanting to build a new financial product can create a new smart contract to meet their exact needs. Token swaps and bridges enable broad ecosystem participation by heightening interoperability, and the composable elements of open‐source blockchain technologies break down data silos and encourage cross‐chain innovation.
Open and permissionless Traditional lending methods require potential borrowers to submit years of tax returns and other personal documentation, then subject them to background and employment checks, and more. With DeFi, anyone with the right technology and assets can participate. If you have enough funds in your connected wallet to use a DeFi product, you can.
Potential for financial independence