What is DeFi: A Journey to Discover the Next Generation of Decentralized Finance

What is DeFi? That’s the question increasingly asked by investors and those interested in blockchain technology. Decentralized Finance (DeFi) represents a revolution in how people manage, exchange, and utilize financial assets. Unlike traditional finance, which relies on banks and financial institutions as intermediaries, DeFi builds an open, transparent system that doesn’t require trust in any organization, all operated by blockchain technology and smart contracts that execute automatically.

What is DeFi – Core Concepts and Its Mission

When asking “What is DeFi,” it’s important to understand that this isn’t just a specific application or protocol, but an entire financial ecosystem built entirely on blockchain platforms. What is DeFi in essence? It’s peer-to-peer (P2P) financial applications that enable users to perform financial transactions without intermediaries.

At its peak in late 2021, the total value locked (TVL) in DeFi protocols exceeded $256 billion, nearly quadrupling in just one year. This figure demonstrates rapid market acceptance of a completely new financial paradigm. Interestingly, DeFi not only addresses current issues but also opens up entirely new possibilities for accessing financial services.

Why is DeFi Important: Restructuring Finance

The need to understand “What is DeFi” stems from clear limitations in the current financial system. First, traditional finance relies on centralized control by central banks and large financial organizations, which has led to financial crises and hyperinflation affecting billions worldwide. Users must trust these institutions to manage their money, but history shows that such trust isn’t always justified.

Second, access to basic financial services remains limited. About 1.7 billion adults worldwide lack bank accounts and cannot access savings tools or credit. That’s why “What is DeFi” becomes crucial—it offers open access to financial services for everyone, regardless of location or financial status.

Blockchain technology has taken money out of central banks’ control, and DeFi is doing the same for traditional finance. With DeFi products, you can borrow funds in under 3 minutes, open a savings account almost instantly, send international payments at lightning speed, and invest in your favorite projects without geographical or conditional restrictions.

What is DeFi in Practice: Smart Contracts and Blockchain Technology

To truly understand “What is DeFi,” grasping the role of smart contracts is essential. Smart contracts are programs stored on the blockchain that automatically execute when predefined conditions are met. For example, a smart contract can automatically disburse a loan to a specified address once the borrower deposits sufficient collateral.

Ethereum’s blockchain ushered in a new era by introducing the Ethereum Virtual Machine (EVM), a computational platform that allows writing and running smart contracts. Developers code in languages like Solidity and Vyper, which are then compiled into EVM bytecode. Solidity remains the most popular language for developing contracts on Ethereum.

Thanks to this flexibility, Ethereum has become the second-largest cryptocurrency after Bitcoin. However, Ethereum isn’t the only platform supporting smart contracts. Alternatives like Solana, Cardano, Polkadot, TRON, EOS, and Cosmos offer different approaches and architectures to address scalability, interoperability, and throughput issues.

While some of these platforms have technical advantages, Ethereum maintains dominance due to network effects and being a pioneer. According to State of the DApps, as of November 2022, there were 7,250 smart contracts deployed across various platforms, with 4,900 (67.5%) on Ethereum. For specific DeFi applications, DeFiPrime reports 202 DeFi projects, with 178 operating on Ethereum.

How DeFi Differs from Traditional Finance: Key Differences

Traditional finance, or centralized finance (CeFi), depends on intermediaries like banks and financial institutions. In contrast, DeFi leverages blockchain technology to create a decentralized, peer-to-peer, less hierarchical structure focused on equal access.

Transparency: By removing intermediaries, DeFi applications offer higher transparency. All processes and rates are clearly defined and involve user participation. This also eliminates a single point of failure—an attack vector or manipulation target. DeFi relies on consensus mechanisms that cannot be tampered with without community awareness.

Transaction Speed: Without intermediaries controlling transactions, processing is significantly faster. Records are maintained transparently, tamper-proof, and visible to all participants. Cross-border transactions via DeFi can be completed in minutes instead of days, at much lower costs.

User Control: DeFi users have full oversight of their assets, with security becoming their own responsibility. This prevents central authorities from becoming targets for attacks. Additionally, DeFi apps are cost-efficient since they don’t require large expenses for asset protection like traditional financial institutions.

24/7 Operation: Traditional markets are open only five days a week during business hours. DeFi operates 24/7 via digital technology, allowing users to access services anytime. Liquidity in DeFi markets tends to be more stable compared to traditional markets.

Security: Built on blockchain, DeFi applications use smart contracts to store data in tamper-resistant ways. The P2P model enables all participants to verify transactions, preventing internal or external manipulation.

Main DeFi Applications: DEX, Stablecoins, and Lending

What is DeFi in practical terms? It integrates core financial principles into smart contracts, forming a comprehensive financial system. The three main pillars are: decentralized exchanges (DEX), stablecoins, and lending markets.

Decentralized Exchanges (DEX): DEXs allow users to trade cryptocurrencies trustlessly, without KYC verification or regional restrictions. DEXs have gained significant momentum recently, with over $26 billion in TVL across all DEXs. Unlike centralized exchanges, DEXs do not support fiat currency trading, only crypto-to-crypto.

There are two common types of DEXs: order book-based (similar to centralized exchanges) and liquidity pool-based (also called “swap platforms”). These use liquidity pools to facilitate trading of token pairs at any given time.

Stablecoins: Stablecoins provide a digital asset with stable value. They are pegged to external assets or baskets of assets to limit volatility. In just five years, stablecoins surpassed a total market cap of $146 billion, becoming the backbone of DeFi.

There are four types: fiat-backed (collateralized by fiat currency like USD, e.g., USDT, USDC, PAX, BUSD); crypto-backed (over-collateralized by crypto assets, e.g., DAI); commodity-backed (collateralized by commodities like gold, e.g., PAXG); and algorithm-backed (controlled by algorithms, e.g., AMPL).

Many stablecoins now use hybrid models, combining multiple types for stability. A unique feature is “chain-agnostic” stablecoins, which can exist across multiple blockchains. For example, Tether (USDT) exists on Ethereum, TRON, OMNI, and others.

Lending Markets (Lending/Borrowing): The lending segment is the largest in DeFi, with over $39.25 billion in TVL across various lending protocols. DeFi lending and borrowing differ fundamentally from traditional mechanisms—you don’t need complex documentation or credit scores, just sufficient collateral and a wallet address.

DeFi also opens up a broader peer-to-peer lending market, allowing users to lend their crypto assets and earn interest. This market operates similarly to traditional banks or P2P lending organizations, earning profit from net interest margins (NIM).

How to Earn Income from DeFi

DeFi can be an exciting way for investors to generate additional returns. Here are some common methods:

Staking: Staking lets users earn rewards by holding cryptocurrencies that use Proof of Stake (PoS). Staking pools function like savings accounts, allowing users to lock up crypto to earn interest over time.

Yield Farming: A more advanced investment strategy, yield farming is one of the most popular ways to generate passive income from crypto. DeFi protocols use yield farming to maintain liquidity. It’s provided by Automated Market Makers (AMMs), smart contracts that use algorithms to facilitate trading on DEXs.

Liquidity Mining: While often used interchangeably with yield farming, there are differences. Liquidity mining involves providing assets to liquidity pools and earning rewards in the form of LP tokens or governance tokens.

Community Fundraising: DeFi has made this approach more accessible. Projects allow users to invest their crypto in exchange for rewards or equity stakes. Peer-to-peer fundraising enables transparent, permissionless crowdfunding among users.

Risks in DeFi You Should Know

While DeFi offers many opportunities, it also involves significant risks.

Smart Contract Risks: DeFi protocols run on smart contracts, which may contain vulnerabilities exploitable by hackers. According to ImmuneFi, over $3.2 billion in crypto was stolen from DeFi projects in 2021, with more than $1 billion in the first three months of 2022 alone.

Fraud and Scams: High anonymity and lack of KYC procedures make it easier for malicious projects to launch. Rug pulls and pump-and-dump schemes became common in 2020–2021.

Loss Risks: Crypto prices are volatile, and token prices within liquidity pools fluctuate accordingly. Rapid increases in one token’s value while others remain stable can impact earnings and lead to losses.

Leverage: Some DeFi apps offer leverage up to 100x. While attractive for winning trades, losses can be equally severe.

Token Risks: Many users do not perform thorough due diligence before investing. Investing in tokens from unverified developers can result in significant losses.

Legal Risks: Despite TVL reaching several billion dollars, DeFi remains largely unregulated. Investors may lose money due to scams with no legal recourse.

Future Outlook of DeFi

DeFi has the potential to make financial products more accessible. The sector has evolved from a handful of applications into an infrastructure for alternative financial services—more open, trustless, and borderless.

Current applications provide a foundation for building more complex tools like derivatives, asset management, and insurance. Ethereum clearly dominates the DeFi ecosystem, but other platforms are also showing strengths to compete.

Ethereum 2.0 upgrades, including sharding and proof-of-stake, are expected to improve many aspects of Ethereum, while competition among smart contract platforms will intensify as they vie for market share in the rapidly growing DeFi landscape.

Key Takeaways: What is DeFi and Why It Matters

1. What is DeFi: A blockchain-based financial system aimed at democratizing finance by removing intermediaries and providing open access to financial services.

2. Its importance: DeFi addresses trust issues inherent in centralized systems and makes financial services more accessible to everyone, regardless of location or financial background.

3. How it works: DeFi operates via smart contracts—self-executing agreements written in code.

4. Advantages over CeFi: Increased transparency, faster transactions, greater control, 24/7 availability, and enhanced security.

5. Main applications: DEX, stablecoins, and lending markets.

6. Income opportunities: Staking, yield farming, liquidity mining, and community fundraising.

7. Risks: Software vulnerabilities, scams, losses, leverage, token risks, and regulatory uncertainty.

8. Future prospects: DeFi continues to grow with more complex applications and increasing platform competition.

In summary, answering “What is DeFi” isn’t just about a new technology but about a fundamental shift in how finance is approached. DeFi offers transparency, efficiency, and accessibility that traditional systems cannot match. As technology advances, DeFi has the potential to reshape the global financial landscape and provide financial tools to everyone worldwide, regardless of their location or wealth.