DeFi: What is it and how does it work in the cryptocurrency world

Decentralized Finance, or DeFi, represents a revolutionary approach to financial services in the digital age. It is not just another trend in the cryptocurrency sector — it is a reimagining of how people interact with money and financial instruments. What is DeFi really? It is an ecosystem of financial applications built on blockchain technology that allows users to perform financial transactions without intermediaries.

Unlike traditional banking systems, where central financial institutions control all processes, decentralized finance is based on the peer-to-peer interaction principle. Specialized financial primitives—lending, payments, asset trading, and their derivatives—are developed on blockchain technology. These tools are integrated into a single ecosystem, providing equal access to all users regardless of their location.

Why Decentralized Finance Changed the Perspective on Traditional Banking

The traditional financial system has developed over centuries but has retained fundamental issues that have become even more apparent in the digital era. The main problem is the centralization of power in the hands of banks and financial institutions. History is full of examples of financial crises and hyperinflation events where citizens lost savings due to decisions made by centralized authorities.

A second major problem is lack of access. According to data, 1.7 billion adults worldwide remain outside the traditional banking system. They lack access even to basic tools: savings accounts, the ability to get a loan, or send remittances internationally without huge fees.

DeFi addresses both problems simultaneously. Blockchain technology has freed currency from central bank control, and decentralized finance applies this same principle across the entire financial sector. Now, with just an internet connection and a crypto wallet, a person can get a loan in 3 minutes, open a savings account instantly, send a payment worldwide in minutes, and invest in assets regardless of where they live.

Smart Contracts: The Technological Foundation of Decentralized Finance

Understanding what DeFi is impossible without delving into how it works on a technical level. All DeFi applications operate on smart contracts—programs stored on the blockchain that automatically execute the terms of agreements when certain conditions are met.

Imagine a smart contract as a computer-coded agreement. If a condition is fulfilled (for example, collateral is deposited into an account), the program automatically performs an action (such as issuing a loan). No human intervention is required—the process is fully automated and transparent to all participants.

A key moment in the history of digital finance occurred when Ethereum introduced its own virtual machine (EVM—Ethereum Virtual Machine). This is a computing environment that compiles and executes smart contracts written in specialized programming languages like Solidity and Vyper. Solidity has become the industry standard for developing smart contracts on Ethereum.

Ethereum quickly dominated this niche due to its flexibility and network effect. Today, it is the second-largest cryptocurrency after Bitcoin. However, alternative blockchain platforms are gradually gaining market share. Cardano, Polkadot, TRON, EOS, Solana, and Cosmos offer unique approaches to architecture, addressing issues such as scalability, interoperability, and transaction throughput.

According to DeFiPrime, there are 202 projects in the DeFi ecosystem, of which 178 are built on Ethereum. This demonstrates the advantage of being a pioneer and the strong network effect.

How Decentralized Finance Differs from Traditional and Centralized Systems

Understanding what DeFi is is helped by comparing it to alternatives. Traditional finance (TradFi) and centralized crypto platforms (CeFi) operate on fundamentally different principles than DeFi.

Transparency: An Open Book Instead of a Black Box

In traditional banks, processes are hidden from clients. You don’t know the terms under which the bank uses your money or what fees you actually pay. In DeFi applications, everything is open: algorithms that determine interest rates are visible to everyone. Users have full access to information about how the system works.

The absence of intermediaries also eliminates a single point of failure. Hackers cannot attack one central server and access all funds. DeFi is based on consensus—manipulating the system is impossible without the knowledge of the entire user base.

Speed: Minutes Instead of Days

When you send an international transfer through a bank, it takes several days because it involves multiple financial institutions in different countries, each subject to its own regulations.

In DeFi, cross-border transactions are processed in minutes and cost much less. Records are immediately recorded, resistant to changes, and accessible to all network participants.

More Control for the User

In traditional systems, the bank controls your money and is responsible for its security. If the bank is hacked, you rely on its insurance. In DeFi, you have full control over your assets via your private key. Security is your responsibility.

This may sound intimidating, but it actually offers huge advantages. Financial institutions spend enormous sums on protecting client assets and insuring against losses. DeFi does not require these expenses, making services cheaper.

24/7 Operation: Always Available

Traditional financial markets operate during business hours on certain days. On weekends or at night, transactions are impossible. DeFi markets operate 24/7, without holidays or breaks.

This means liquidity in DeFi markets can be maintained more stably. In traditional finance, liquidity often drops when exchanges close.

Privacy at a New Level

DeFi uses smart contracts that store and process data in a tamper-proof manner. While traditional financial organizations can be hacked or manipulated by employees or external attackers, DeFi employs a P2P transaction model where all participants have full access to information. This prevents manipulation.

The Three Pillars of the DeFi Ecosystem: Exchanges, Stability, and Lending

DeFi is built on three financial primitives that act as “money Legos.” Properly combining them can create an alternative decentralized financial services system.

Decentralized Exchanges: Trading Without Trust

DEXs (decentralized exchanges) allow users to trade crypto assets completely trustlessly. They do not require KYC (Know Your Customer) procedures and have no geographical restrictions.

Unlike traditional exchanges, DEXs do not work with fiat currencies and only support crypto-to-crypto trades. In recent years, they have locked over $26 billion.

There are two main types of DEXs:

Order Book-Based DEXs: They operate on a model used by almost all centralized exchanges. Price is determined by supply and demand between buyers and sellers.

Liquidity Pool-Based DEXs: These platforms use an innovative approach. Instead of an order book mechanism, they use liquidity pools, allowing token swaps for one pair of assets at a time. These pools are provided by liquidity providers—ordinary users who earn fees for supplying assets.

Stablecoins: The Island of Stability in a Volatile Ocean

Stablecoins solve one of the main problems of cryptocurrencies—extreme volatility. They are digital assets pegged to a stable external asset (e.g., US dollar) or a basket of assets, limiting price fluctuations.

Over five years, stablecoins have reached a market capitalization of $146 billion. They are the backbone of DeFi, enabling financial operations without worrying about sharp price swings.

There are four types of stablecoins:

Fiat-Collateralized Stablecoins: Pegged to fiat currency, usually USD. Examples: USDT, USDC, PAX, BUSD. Current USDC price is $1.00.

Crypto-Collateralized Stablecoins: Backed by over-collateralized crypto assets due to high volatility (e.g., ETH at $1.97K or BTC at $67.98K). Examples: DAI (current price $1.00), sUSD, aDAI, aUSD.

Commodity-Backed Stablecoins: Pegged to real assets, typically gold. Examples: PAXG (current price $5.11K), DGX, XAUT, GLC.

Algorithmic Stablecoins: Maintained by algorithms that automatically control the price. They do not require collateral. Examples: AMPL, ESD, YAM.

Many modern stablecoins use a hybrid model, combining several types to achieve stability. RSV, for example, combines crypto-backed and fiat-backed assets, including USDC and DAI.

A unique property of stablecoins is their “chain-agnosticism.” Since they are pegged to external assets, they can exist on multiple blockchains. Tether, for example, operates on Ethereum, TRON, OMNI, and several other platforms.

Lending: Borrowing and Earning Interest Without a Banker

Lending markets are the second DeFi primitive. The entire traditional banking sector is based on lending and borrowing principles. In DeFi, it works completely differently.

The lending segment is the largest part of DeFi, with over $38 billion locked in various protocols. With a total of $89.12 billion locked in DeFi (as of May 2023), lending protocols account for nearly half of the entire market.

To get a loan in DeFi, you don’t need years of credit history or a bunch of documents. Just two things: sufficient collateral in crypto assets and your wallet address. The process takes minutes instead of weeks.

DeFi also opens the P2P lending market for those who want to lend money. You can issue a loan for interest and earn additional income. Lending protocols profit through net interest margin (NIM), similar to traditional banks.

Income Sources in DeFi: How to Earn on Crypto Assets

DeFi has opened new opportunities for investors seeking additional income from their cryptocurrencies beyond simple holding.

Staking: Passive Income for Holding

Staking is a process that allows users to earn rewards just for holding cryptocurrencies that use the Proof of Stake (PoS) consensus mechanism. DeFi staking pools work like savings accounts in a bank.

You add your assets to a special pool in a specific cryptocurrency and earn rewards over time. The protocol uses your assets to support network operation, and rewards are distributed among participants.

Yield Farming: An Active Investment Strategy

Yield farming is a more complex strategy compared to staking but potentially more profitable. It is one of the most popular methods to increase income, offering a good stream of passive earnings.

DeFi protocols use yield farming to maintain liquidity on their platforms. They pay rewards to liquidity providers who add their assets to pools.

Yield farming is carried out via AMMs (automated market makers)—smart contracts that use mathematical algorithms to facilitate trading of digital assets. AMMs provide liquidity without intermediaries, using liquidity pools.

Liquidity Mining: How It Differs from Farming

Although liquidity mining and yield farming are often used interchangeably, there is a difference. Both help maintain liquidity for trading in DeFi protocols.

Liquidity mining uses smart contracts and liquidity providers, while yield farming relies on AMMs. In yield farming, users earn APY rewards for a fixed period by locking assets for liquidity. In liquidity mining, rewards are paid in LP tokens (liquidity provider tokens) or governance tokens.

Crowdfunding in DeFi: Funding the Future

Crowdfunding has existed for a long time, but DeFi has made it simpler and more accessible. Decentralization allows projects to raise funds directly from the community.

Users can invest their crypto assets in exchange for rewards or shares in future projects. Crowdfunding also enables donations for social initiatives. Additionally, P2P crowdfunding allows transparent, permissionless fundraising without intermediaries.

Real Challenges of DeFi: Risks That Cannot Be Ignored

DeFi has enormous potential, but that doesn’t mean there are no challenges. Investors need to understand the risks before participating.

Software Vulnerabilities: The Code Bomb

DeFi protocols run on smart contracts, which can have vulnerabilities. According to Hacken, hacker attacks on DeFi resulted in losses exceeding $4.75 billion in 2022, up from about $3 billion in 2021.

These attacks occurred when hackers identified and exploited critical vulnerabilities in smart contract code. One reason is that smart contracts are often deployed without thorough security audits.

Fraud and Scams: The Wild West of Finance

High anonymity and lack of KYC requirements make DeFi an attractive platform for scammers. “Rug pull” schemes (where developers suddenly disappear with investors’ funds) and pump-and-dump strategies frequently make headlines.

Recent data shows that fraudulent projects regularly steal investor funds through popular DeFi protocols. This is one of the main reasons large institutional investors hesitate to enter the market—they simply do not trust the security and regulatory environment.

Temporary Loss Risk: Price Volatility

Due to high crypto volatility, token prices in liquidity pools can change rapidly. If one token’s price spikes sharply while another remains stable, your returns can decrease significantly or even turn into losses.

While analyzing historical price data can partially mitigate this risk, it cannot be completely avoided. The crypto market is too volatile and unpredictable.

Leverage Risk: A Double-Edged Sword

Some DeFi applications in derivatives and futures sectors offer very high leverage—up to 100x. This can be attractive for successful trades, but losses can be catastrophic in volatile market conditions.

Fortunately, reliable DEXs set acceptable leverage levels to prevent excessive borrowing.

Token Risk: Blind Investing

Every token you invest in via DeFi protocols requires careful research, but many users do not do this. Rushing to join new trends, most do not conduct proper due diligence.

The risk of investing in new tokens is extremely high. Investing in tokens without reputable developers can lead to total loss of funds.

Regulatory Risk: An Unknown Future

DeFi has a total value locked (TVL) of several billion dollars, but regulators have yet to establish clear frameworks. Many countries and governments are still figuring out how to regulate this sector.

Most users are unaware of the lack of regulation. If you lose funds due to fraud, you have no legal recourse. You depend on the security of the protocol itself.

The Future of Decentralized Finance

DeFi has the potential to make financial products accessible to billions worldwide. The sector has grown from a handful of applications to a full-fledged alternative financial infrastructure that is open, trustless, borderless, and censorship-resistant.

Existing DeFi applications lay the groundwork for more complex instruments: derivatives, asset management, insurance, and other services.

Ethereum clearly dominates the DeFi ecosystem due to network effects and being a pioneer. But alternative platforms are gradually gaining strength, attracting talented developers. The ETH 2.0 upgrade is expected to improve many aspects of Ethereum through sharding and a transition to PoS consensus. This could lead to intense competition between Ethereum and other smart contract platforms for a share of the growing DeFi ecosystem.

Key Takeaways About DeFi

1. DeFi is a blockchain-based financial system that democratizes finance by removing intermediaries and expanding access.

2. The importance of DeFi lies in solving trust issues with centralized systems and providing financial access to everyone, regardless of location.

3. DeFi operates through smart contracts—self-executing programs with conditions written in code that automate processes and ensure decentralization.

4. Advantages of DeFi over traditional finance include greater transparency, faster transactions, more user control, 24/7 operation, and enhanced privacy.

5. Main DeFi applications are DEXs, stablecoins, and lending services.

6. Income in DeFi can be earned through staking, yield farming, liquidity mining, and crowdfunding.

7. DeFi carries risks: code vulnerabilities, scams, temporary loss, leverage dangers, token risks, and regulatory uncertainty.

8. The future of DeFi looks promising: further growth, innovation, and competition among blockchain platforms are expected.

Decentralized finance offers an innovative approach to financial services aimed at creating a more inclusive and transparent system. As technology advances, DeFi has the potential to transform the financial landscape and provide broader access to financial tools worldwide. Understanding what DeFi is and how it works is becoming increasingly important for anyone wanting to participate in the future financial system.