What is DeFi? A comprehensive understanding of the core logic of decentralized finance

Decentralized Finance, abbreviated as DeFi, represents a fundamental shift in the financial system. Unlike traditional finance that relies on intermediaries such as banks and brokerages, DeFi is built on blockchain technology and utilizes smart contracts to enable peer-to-peer financial interactions, allowing users to lend, trade, invest, and perform other financial activities without passing through any third parties.

It may sound complex, but its core logic is quite elegant: DeFi transforms financial primitives (credit, liquidity, asset exchange) into code that executes automatically. By the end of 2021, the total value locked (TVL) in the DeFi ecosystem surpassed $256 billion, growing nearly fourfold in just one year, demonstrating its explosive growth.

From Traditional Finance to DeFi—A Financial Revolution

The evolution of finance has paralleled human economic development. From barter to the emergence of money, then to credit transactions and banking systems, each step addressed the economic challenges of its time. However, this process also introduced new issues.

Challenges of Traditional Finance

Multiple financial crises and hyperinflations in history stem from the vulnerabilities of centralization—power concentrated in a few institutions, which, if mismanaged, can impact billions worldwide. More seriously, there are still 1.7 billion adults globally without access to basic financial accounts, excluded from the financial system.

Another major problem with traditional finance is inefficiency. Cross-border remittances require coordination among multiple banks, are limited by operating hours and regional regulations, and are costly and time-consuming.

How DeFi Changes the Game

DeFi breaks these constraints. Through blockchain transparency and the automatic execution of smart contracts, DeFi creates a permissionless, 24/7 operational financial system. Users can get loans in under three minutes, open savings accounts almost instantly, and complete cross-border payments at minimal cost. Geography is no longer a barrier—an internet connection is all that’s needed.

Core Advantages of DeFi: Why It Is Changing Finance

Transparency Breakthrough

Every transaction and fee in DeFi applications is recorded on a public blockchain. Users don’t need to blindly trust a financial institution; they can verify transactions directly. This peer-to-peer transparency eliminates information asymmetry common in traditional finance.

In contrast, centralized finance (CeFi) operates as a black box—users must trust banks or exchanges’ integrity, which has been betrayed multiple times. DeFi is entirely different: driven by consensus, it cannot be manipulated without users’ knowledge.

Speed and Cost Revolution

Removing intermediaries significantly increases transaction speed. Processes that once required coordination among banks and compliance with multiple regulations can now be completed in minutes. Transaction costs are reduced to a fraction of traditional methods.

DeFi markets operate 24/7, year-round, with stable and reliable liquidity, unlike traditional markets that dry up after hours.

User Control Returns

In DeFi, users have full custody of their assets and are responsible for their security. While this increases responsibility, it fundamentally eliminates single points of failure—financial institutions are no longer prime targets for hackers. Additionally, the huge costs that institutions previously invested in safeguarding user assets are eliminated, ultimately benefiting all users.

Redefining Privacy

Thanks to smart contract tamper-proof features and P2P transaction modes, DeFi offers stronger privacy protections than traditional finance. All participants have full transparency, which also creates effective oversight mechanisms, reducing the risk of insider manipulation.

How DeFi Works: The Power of Smart Contracts

All the magic of DeFi comes from a core technology: smart contracts. These are code stored on the blockchain that automatically executes once predefined conditions are met, without any manual intervention.

Imagine a lending scenario: after a borrower collateralizes sufficient crypto assets, the smart contract automatically verifies the collateral’s value and transfers the corresponding loan amount. The entire process is transparent, automated, and tamper-proof.

Ethereum’s Leading Role

Ethereum launched the EVM (Ethereum Virtual Machine) in 2015, a Turing-complete computing engine. Developers can write smart contracts using languages like Solidity or Vyper, which are then compiled into EVM-executable instructions.

This flexibility has made Ethereum the preferred platform for DeFi development and the second-largest cryptocurrency by market cap after Bitcoin. According to DeFiPrime, out of 202 existing DeFi projects, 178 are deployed on Ethereum.

Rise of Competitors

Of course, Ethereum is not the only platform. Blockchains like Cardano, Polkadot, TRON, EOS, Solana, and Cosmos also support smart contracts, each introducing innovative designs to address scalability, interoperability, or transaction throughput issues.

However, network effects are powerful. As the pioneer, Ethereum has accumulated the most developers, liquidity, and users, making it difficult to displace in the short term.

DeFi Application Landscape: How Financial Primitives Combine

Financial primitives are the basic units of a financial system—lending, asset exchange, value storage. DeFi re-implements these primitives via smart contracts, leading to a rich ecosystem of applications.

Rise of Decentralized Exchanges (DEXs)

DEXs enable users to trade crypto assets trustlessly, without KYC, and without regional restrictions. Unlike centralized exchanges, DEXs feature peer-to-peer direct trading, with assets always under user control.

Total value locked in DEXs exceeds $26 billion. Mainstream DEXs fall into two categories: order book-based models (like centralized exchanges) and liquidity pool-based models (called “token swap platforms”), where users can exchange trading pairs with a single transaction.

Stablecoins as the Foundation

Stablecoins are the backbone of DeFi. Their value is pegged to stable assets (usually USD) or baskets of assets, aiming to limit volatility. In just five years, the total market cap of stablecoins has surged past $146 billion.

Main types of stablecoins include:

Fiat-backed: The most common, such as USDT, USDC, PAX, BUSD, directly pegged to USD.

Crypto-backed: Over-collateralized digital assets like DAI and aUSD, designed to stay stable amid crypto market volatility.

Commodity-backed: Pegged to physical assets like gold or silver, e.g., PAXG.

Algorithmic: Fully governed by algorithms without collateral, such as AMPL and YAM.

Many stablecoins now adopt hybrid models, like RSV, which integrates multiple asset types for more robust price stability. They are “chain-agnostic,” meaning they can circulate across multiple blockchains, e.g., Tether exists on Ethereum, TRON, and others.

Explosive Growth of Lending Markets

Lending is the largest segment within DeFi. As of May 2023, various DeFi lending protocols have locked over $38 billion, accounting for about 50% of the total DeFi TVL of $89.12 billion.

DeFi lending’s appeal lies in its simplicity—no need for extensive paperwork or credit checks, just collateral and a wallet address. It opens new avenues for peer-to-peer lending, where lenders earn interest spreads, creating mutual incentives.

Earning in DeFi: Diversified Profit Channels

DeFi offers multiple ways for investors to earn extra returns from crypto assets.

Staking: The Most Passive Income

Staking leverages proof-of-stake (PoS) consensus mechanisms. Users deposit crypto into staking pools, similar to opening a savings account, earning rewards over time. The staked assets are used by DeFi protocols for operations, and the generated rewards are distributed to the community of investors.

Yield Farming: Advanced Strategies

Yield farming is a more complex investment approach. DeFi protocols incentivize platform liquidity, and users provide liquidity to earn yields. Automated Market Makers (AMMs) play a central role—they are smart contracts that match trades via mathematical algorithms instead of traditional order books, allowing liquidity providers (LPs) to participate and earn rewards.

Liquidity Mining: Incentivizing Providers

While often confused with yield farming, liquidity mining has subtle differences. It also maintains protocol liquidity but rewards providers with LP tokens or governance tokens rather than direct APY.

Crowdfunding: New Investment Opportunities

DeFi makes crowdfunding more accessible. Users can invest in new projects with crypto assets in exchange for rewards or future equity. This decentralized approach also supports social donations, turning peer-to-peer funding into a reality.

Risks in DeFi: Opportunities and Hidden Dangers

Despite its potential, DeFi carries real risks that investors must be aware of.

Software Vulnerabilities

DeFi protocols depend on smart contracts, which may contain exploitable bugs. According to Hacken, in 2022, DeFi hacks caused losses exceeding $4.75 billion, much higher than the approximately $3 billion in 2021. These attacks often exploit critical vulnerabilities in code.

Fraud and Scams

High anonymity and lack of KYC make it easier for bad actors to launch scams. Between 2020-2021, “rug pulls” and “pump-and-dump” schemes frequently made headlines, deterring institutional investors. Many of these scams have stolen large sums from mainstream DeFi protocols, posing significant risks to newcomers.

Impermanent Loss

In liquidity pools, price fluctuations of different tokens can cause significant impermanent loss. If one token surges while the other remains stable, liquidity providers may suffer losses. Although historical data analysis can mitigate some risks, the high volatility of crypto markets means this risk can never be fully eliminated.

Leverage Risks

Some DeFi applications offer leverage up to 100x in derivatives trading. While high leverage can amplify profits, it can also lead to catastrophic losses during market swings. Responsible platforms provide reasonable leverage levels to prevent over-borrowing.

Token Selection Risks

Every DeFi investment requires thorough research, but many users chase new trends without proper due diligence. High potential returns come with high risks—investing in tokens lacking solid development support can result in devastating losses.

Regulatory Uncertainty

Although DeFi’s TVL has reached billions of dollars, global regulators have yet to establish comprehensive oversight. Many countries are still exploring how to regulate this market, and new rules could be introduced. Investors affected by scams or losses may find it difficult to recover funds legally, relying instead on protocol protections.

The Future of DeFi: New Opportunities and Challenges

DeFi has evolved from a handful of applications into a comprehensive financial infrastructure, laying the groundwork for derivatives, asset management, insurance, and more complex services. Its potential lies in bringing financial products to every corner of the globe, achieving true financial inclusion.

Ethereum continues to lead due to its network effects and smart contract flexibility, but alternative platforms are emerging. Ethereum 2.0’s upgrades, including sharding and proof-of-stake, aim to improve performance and could spark fierce competition for DeFi market share.

The ecosystem is at a critical juncture—full of innovative opportunities but also facing technological, risk, and regulatory challenges. Users should understand DeFi’s potential and pitfalls thoroughly, conducting in-depth research before making investment decisions.

Key Takeaways

1. DeFi Definition: A blockchain-based decentralized financial system that eliminates intermediaries, democratizing access to financial tools for everyone.

2. Core Problems Addressed: Tackles trust issues, inefficiency, and inaccessibility in traditional finance, opening doors for the 1.7 billion excluded adults.

3. Technological Backbone: Smart contracts automate financial agreements, removing the need for manual intervention or third-party trust.

4. Competitive Advantages: Compared to CeFi, DeFi offers higher transparency, faster transactions, greater user control, 24/7 operation, and enhanced privacy.

5. Three Pillars of Application: Decentralized exchanges (DEXs) for asset swapping, stablecoins for value storage, and lending markets for credit services.

6. Diversified Earnings: Staking, yield farming, liquidity mining, and crowdfunding provide passive income streams.

7. Risks: Software bugs, scams, impermanent loss, leverage dangers, token risks, and regulatory uncertainties.

8. Future Outlook: Continued growth with Ethereum’s leadership, but increasing competition and evolving regulations will shape the industry’s trajectory.

DeFi signifies a transformative shift in finance—breaking down traditional barriers and creating borderless, transparent, and efficient financial services worldwide. As the ecosystem matures through technological advances and broader adoption, DeFi has the potential to reshape the global financial landscape. However, investors should approach with caution, understanding both the opportunities and the risks involved.