What Is Decentralized Finance (DeFi)?

What Is Decentralized Finance (DeFi)? article image.

Decentralized finance (DeFi) is the general name for an alternative financial ecosystem in the cryptocurrency world. Traditional financial products and services are offered and controlled by central authorities, such as banks, stock market exchanges and regulators. But DeFi apps run—sometimes on autopilot—without a single or central authority governing them.

How Does Decentralized Finance Work?

DeFi apps run on a cryptocurrency platform and rely on the same underlying blockchain technology.

Ethereum is one of the most popular DeFi platforms, and it can be helpful (and accurate) to think of Ethereum as a supercomputer that's powered by individual computers around the world. In turn, decentralized apps, including DeFi apps, can be built and run on the Ethereum supercomputer.

In part, decentralization refers to the fact that no single person or organization controls the computers running the network. The arrangement helps keep the platform running, and it also means that no central authority, such as a government, can necessarily shut down the system.

Additionally, decentralized apps use smart contracts—basically, small programs that are added to the blockchain and run automatically. For example, a company or person might create a smart contract that automatically transfers cryptocurrencies between two parties, and then potentially receive financial benefits when others use it. But they give up control once the smart contract is uploaded to a blockchain.

Decentralized finance also distinguishes itself from centralized finance because it's "permissionless," meaning you don't need permission to use the apps. For example, you might be able to use a DeFi app to borrow or lend cryptocurrencies without having to apply for an account or verify your identity. All you may need is a cryptocurrency wallet and an internet connection.

In contrast, centralized financial institutions such as banks control and own their products and services, and choose who they want to do business with.

How Do People Use DeFi?

In large part, DeFi apps aim to replicate the products and services that exist within traditional financial services, such as borrowing and lending money and trading investments. Right now, the most popular DeFi services are:

  • Cryptocurrency exchanges: Decentralized exchanges (DEXs) let you trade cryptocurrencies based on the DEX's exchange rate. There are different types of DEXs, and some may charge you a fee for each transaction. People can also earn cryptos by adding liquidity to a DEX (in other words, keeping their funds on the DEX) and earning a share of the fees.
  • Cryptocurrency borrowing and lending: There are also DeFi apps that let you borrow cryptocurrencies, or lend your cryptocurrency to earn a return—these are sometimes called cryptocurrency savings accounts. Because there's no identity or credit check required, borrowers may need to offer excess crypto collateral for the loan. It could make sense for borrowers who want to use funds right now, but don't want to sell their cryptocurrency holdings and pay taxes on the earnings.

As DeFi projects aim to replicate and expand on existing financial systems, new products and services may become more popular, such as insurance or payment systems. And we may even see offerings that don't have equivalents within traditional centralized finance.

Is Using DeFi Risky?

Investing in DeFi, either by adding liquidity to a DEX or lending your cryptos, can offer relatively high returns. But as with all cryptocurrency investing, it comes with risk.

Traditional savings accounts might give you less than 1% annual percentage yield (APY) on your savings. And even high-yield accounts might only offer a few percent. But there are options on DeFi that could lead to much higher APYs—such as over 10% APY with stablecoins, which are relatively safer than other types of cryptocurrencies.

Near anonymity and cutting-edge tech can be appealing for many reasons. Some people might want to break away from centralized financial institutions, or live somewhere that doesn't have trustworthy or stable financial systems. But it can also appeal to criminals, and cryptocurrency scams are prevalent. Remember, even "earning" 100,000% APY can lead to a loss if the cryptocurrency you receive winds up being worthless.

The Bottom Line

If you want to try out the DeFi ecosystem, it's best to do a lot of homework first and not to use money you can't afford to lose. You can also explore the crypto world by buying and trading cryptocurrencies through a centralized exchange, such as Coinbase, Binance.US or Gemini.

These companies may be more proactive about complying with government regulations and putting guides in place to help keep your money safe. However, even if you avoid scams, investing in cryptocurrencies can still be risky.