What is DeFi and why is it becoming the future of finance?

Decentralized Finance (DeFi) is not just a technical concept but a revolution in how we manage, trade, and create financial value. Completely different from traditional banking systems, DeFi is a network of peer-to-peer (P2P) financial applications built on blockchain technology, allowing anyone to access financial services without intermediaries.

The DeFi ecosystem is developed based on fundamental financial principles such as lending, payments, derivatives, and asset exchanges. What’s special is that DeFi platforms are designed to provide everyone with fair and transparent access to financial services. By the end of 2021, the total value locked (TVL) in DeFi protocols exceeded $256 billion—a figure demonstrating nearly fourfold growth within a year.

Problems of Traditional Finance That DeFi Is Solving

Traditional finance has operated for centuries but presents fundamental issues that cannot be ignored. First, centralization creates risks: financial crises and hyperinflation have affected billions worldwide because people must trust decisions made by central institutions. Second, accessibility is a major barrier—statistically, 1.7 billion adults worldwide still lack bank accounts, cut off from basic financial tools.

DeFi addresses these issues by removing intermediaries and opening access to all. With DeFi, you can borrow money in less than 3 minutes, open a savings account almost instantly, send cross-border payments at lightning speed, and invest in projects regardless of your location. Blockchain technology has taken money out of central bank control, and DeFi is doing the same for the entire traditional financial system.

Smart Contracts: The Technical Foundation Behind DeFi

To understand what DeFi is at a deeper level, we need to learn about smart contracts. These are programs stored on the blockchain that automatically execute when predefined conditions are met. For example, a contract can automatically disburse a loan to a specified address after the borrower provides sufficient collateral.

Ethereum blockchain introduced smart contracts along with the Ethereum Virtual Machine (EVM)—a virtual computer that allows writing and running these programs. Developers write code in languages like Solidity and Vyper, which are compiled into EVM bytecode. Solidity has become the most popular language for blockchain programming, and thanks to this flexibility, Ethereum has become the second-largest cryptocurrency after Bitcoin.

However, Ethereum is not the only platform supporting smart contracts. Other blockchains like Solana, Cardano, Polkadot, TRON, EOS, and Cosmos also support smart contracts, each offering new approaches to address issues like scalability and transaction throughput. Nonetheless, due to network effects and first-mover advantages, Ethereum remains dominant—according to State of the DApps, approximately 67.5% of smart contracts are deployed on Ethereum, and over 88% of DeFi projects operate on this platform.

How DeFi Differs from Centralized Finance (CeFi)

Traditional finance (CeFi) relies on intermediaries like banks and financial institutions to provide services, whereas DeFi builds a decentralized, peer-to-peer, flatter, and less hierarchical structure. This difference offers clear advantages.

Greater transparency and security: DeFi applications operate on P2P mechanisms and eliminate centralized intermediaries, creating a new level of transparency. Processes and rates are defined within transparent models, with user participation rather than decisions made by an opaque entity. Additionally, removing intermediaries reduces a single point of failure that hackers or manipulators could target.

Faster and cheaper transactions: Bypassing intermediaries makes transaction processing in DeFi much quicker. No need for interbank communication across regions, a cross-border transaction can be completed in minutes instead of days, at very low costs.

Better control: DeFi users have full control over their assets and are responsible for security. This prevents central authorities from becoming attack targets and reduces costs associated with insurance and complex asset protection systems typical of traditional finance.

24/7 operation: Traditional financial markets only open during banking hours, but DeFi, built on digital technology, is always active. You can access it anytime, anywhere, ensuring more stable liquidity compared to traditional markets, where liquidity can thin out when markets are closed.

Blockchain-based security: Built on robust blockchain technology, DeFi uses smart contracts to store and process data in tamper-resistant ways. The P2P transaction model allows all participants to have full visibility, helping prevent manipulation from inside or outside actors.

Main Practical Applications of DeFi

What are DeFi applications? They include three core financial principles converted into smart contracts: decentralized exchanges (DEX), stablecoins, and lending (borrowing and lending).

Decentralized Exchanges (DEX): Enable users to trade cryptocurrencies trustlessly, without KYC verification, and without regional restrictions. DEXs have attracted over $26 billion in total value locked. There are two main types: order book-based and liquidity pool-based. The latter uses automated market maker (AMM) tools to facilitate trading without intermediaries.

Stablecoins: Digital assets pegged to a stable external asset (like USD) or a basket of assets to limit volatility. Stablecoins are the backbone of DeFi, with a total market cap exceeding $146 billion. The main types include fiat-backed (USDT, USDC, PAX, BUSD), crypto-backed (DAI, sUSD, aDAI), commodity-backed (PAXG, DGX, XAUT, GLC), and algorithm-backed (AMPL, ESD, YAM). Today, many stablecoins use hybrid models combining these types, such as RSV.

Lending Markets: Borrowing and lending are the largest DeFi segments, with over $39.25 billion locked, accounting for more than 50% of total DeFi TVL. Unlike traditional finance, you don’t need extensive documentation or credit scores—just sufficient collateral and a wallet address. DeFi also opens up a large P2P lending market for those wanting to lend out their crypto and earn interest.

Ways to Earn Money in the DeFi Ecosystem

DeFi offers many opportunities to profit from your crypto holdings.

Staking: Earning rewards by holding cryptocurrencies that use Proof of Stake (PoS). Staking pools act like savings accounts, allowing you to deposit crypto into pools to earn interest over time.

Yield Farming: A more advanced strategy, this is a popular method to generate higher yields. DeFi protocols use yield farming to maintain platform liquidity, supplied by AMM tools. AMMs are smart contracts that use algorithms to facilitate digital asset trading on DEXs.

Liquidity Mining: Similar to yield farming but involves direct use of smart contracts and liquidity providers. Instead of fixed APY rewards, you receive LP tokens or governance tokens as rewards.

Community Fundraising: DeFi has made raising capital more accessible. Users can invest crypto into projects seeking funding in exchange for rewards or equity. This method also enables transparent fundraising for social causes, with users raising funds from each other.

Risks You Should Know Before Participating in DeFi

While DeFi offers many opportunities, it also involves significant risks that you must understand.

Software vulnerabilities: DeFi protocols run on smart contracts, which can have exploitable bugs. According to ImmuneFi, over $3.2 billion in crypto was stolen from DeFi projects in 2021, and over $1 billion in just the first three months of 2022. These attacks are due to hackers exploiting critical software vulnerabilities.

Fraud and scams: High anonymity and lack of KYC procedures make it easier for malicious actors to launch fraudulent projects. Market manipulation schemes like rug pulls and pump-and-dump have been common in 2020-2021, causing substantial losses for investors. Recent scam projects have also stolen funds from leading DeFi protocols.

Temporary losses: Due to crypto price volatility, token prices in liquidity pools can fluctuate significantly. If one token’s price surges while another remains stable, your earnings can decrease or even turn negative. While analyzing historical prices before adding liquidity can mitigate this risk, it cannot be eliminated entirely due to high market volatility.

High leverage: Some DeFi derivatives applications offer leverage up to 100x. While attractive for winning trades, losses can be severe, especially during sharp price swings. Trustworthy DEXs typically offer reasonable leverage levels.

Token risks: Most users do not perform thorough due diligence before investing in new tokens, rushing to follow trends. Investing in tokens without reputable developers can lead to significant losses.

Legal risks: Although DeFi’s TVL reaches billions, regulatory authorities have yet to oversee the sector. Most users are unaware that this space is largely unregulated, meaning if fraud occurs, you have no legal recourse and must rely solely on the DeFi protocol to protect your funds.

The Future of DeFi: Prospects and Challenges

DeFi has enormous potential to make financial products more accessible worldwide. The field has evolved from a handful of applications to providing infrastructure for new, more open, trustless, borderless financial services. Current applications (DEX, stablecoins, lending) serve as a foundation for building more complex tools like derivatives, asset management, and insurance.

Ethereum clearly dominates the DeFi ecosystem due to network effects and flexibility, but other platforms are also showing strengths to compete. The ETH 2.0 upgrade promises improvements with sharding and PoS mechanisms, and we will also witness fierce competition among Ethereum and other blockchains to capture market share in the emerging DeFi landscape.

Conclusion: What Is DeFi?

Decentralized Finance (DeFi) is not just a concept but a global movement to democratize access to financial services. It is a system built on blockchain technology that removes intermediaries, offers transparency, speed, better control, and operates 24/7. DeFi provides opportunities to earn through staking, yield farming, liquidity mining, and community fundraising.

However, users must be aware of risks: software bugs, scams, temporary losses, high leverage, and regulatory uncertainty. The outlook for DeFi is highly promising, with continuous growth and innovation expected in the coming years. Success will depend on risk management and creating a safe, transparent ecosystem for everyone involved.