What is Decentralized Finance (DeFi)?

Decentralized finance (DeFi) describes the broad concept of blockchain-powered financial services free from the intermediaries of traditional banking. Although it didn't go by the name "DeFi" at the time, Bitcoin introduced the idea of electronic peer-to-peer money to the world in 2009. As a simple medium of exchange and store of value, Bitcoin pioneered the idea of digital assets as money. The trustless nature of the network removed third-party institutions like central banks from this new idea.

With the creation of Ethereum came smart contract functionality. Digital assets can not only be transferred but, through immutable code, developers can also simulate more features of the traditional finance system without the need to use traditional intermediaries. This opened the doors to the use of cryptocurrencies for financial services like lending and borrowing, trading, insurance, venture funding, and participating in derivatives markets. Other smart contract platforms soon saw similar growth in their DeFi ecosystems after their respective launches.

DeFi's alternative financial system offers users the ability to have full control over their assets and how they interact with other parties, making it a core element of Web3. It has seen an exponential rise in popularity due to its aim to remove many impediments and frictions of traditional finance.

Take, for instance, the process of borrowing from a traditional bank. First, you need to apply and be approved for a loan. The rate is set by the bank, and they charge a fee to manage the loan for you. If they want to transfer your loan to another servicer, you are not in a position to change their decision.

This one example highlights only a few of the potential differences provided by the decentralization of finance. There is no traditional "gatekeeping" in DeFi; its services are generally open, and there is no application process requirement to use its decentralized applications (dapps). Rates are set by market factors such as supply and demand.

The fees needed to run dapps are used to support the network rather than a traditional third party. Further, users have the freedom to move their funds from one platform to another. Lastly, while a bank typically operates for set hours on business days, DeFi is always open.

Since its inception, DeFi has grown to offer a wide selection of services.

Some of the most popular examples include:

These give crypto holders an asset with a constant value so they don't have to trade back and forth to fiat currency through centralized exchanges. For example, MakerDAO introduced the idea of a decentralized, overcollateralized stablecoin in 2017. This token (DAI) was backed by other cryptocurrencies and designed to maintain a stable value of $1.

Just like taking a loan from a bank, some platforms provide opportunities for users to borrow assets to be used in alternative DeFi applications or for other investments. Users can also lend their own assets through smart contracts and collect interest and rewards, also known as yield farming. Aave is a well-known lending and borrowing platform.

Trading stocks requires a buyer and a seller, and traditionally large investors or institutions act as "market makers" that provide liquidity to asset markets. Many decentralized exchanges (DEX) use an automated market maker (AMM) smart contract that sees users combine their assets into liquidity pools. Those wishing to swap tokens trade into the pool, and liquidity providers collect a swap fee for their service. Uniswap and Curve Finance are prominent examples of these platforms.

Traditional markets for securities and commodities include not only the trading of fundamental assets but also derivatives of those assets. There are similar crypto-based DeFi markets that allow for trading in these derivatives, such as perpetual futures contracts.

Because of the inherent risks that come with DeFi, such as hacks and smart contract exploits, decentralized insurance has become a way to attempt to protect funds. By paying a premium, users can submit claims to recover assets lost in DeFi protocols.

Venture funding: Crowdfunding efforts have become ways to help ensure projects have support. For example, Parachain crowdloans are used to build support behind blockchain projects that must bid on parachain slots to be included in the Polkadot network.

First, it is worth noting that not all platforms that claim decentralization are truly decentralized. In some cases, the stakes or governance in a platform may be heavily weighted toward the founding team or a small group of participants.

Another major risk is the susceptibility to hacks. Any weakness in the back-end programming of a DeFi platform can be exploited by a bad actor, in which case funds can be irreversibly drained from the protocol. This can also happen on the front-end of a platform.

Because it is based on blockchain technology, decentralized finance is governed by different mechanisms than traditional finance. Users must be aware of these when they participate in its offerings, and it is important to conduct thorough research before using any platform.

Disclosures:

Content provided for educational purposes only. Not investment advice or a recommendation. Trading and owning digital assets involves significant risk, including the risk of substantial loss. Cryptocurrency services are offered through an account with Robinhood Crypto, LLC (NMLS ID 1702840). Robinhood Crypto is licensed to engage in virtual currency business activity by the New York State Department of Financial Services. Cryptocurrency held through Robinhood Crypto is not FDIC insured or SIPC protected.