Discover Decentralized Finance (Decentralized Finance - DeFi)

Decentralized finance, or DeFi, is a new financial ecosystem built on blockchain technology that provides equal and transparent access to financial services for everyone. Completely different from traditional finance, DeFi leverages smart contracts to eliminate intermediaries, creating a peer-to-peer (P2P) financial system without control from centralized organizations.

What Is Decentralized Finance and Why Is It Important?

The DeFi ecosystem is developed based on fundamental financial principles such as lending, payments, derivatives, and asset trading, but implemented via blockchain instead of centralized agencies. At its peak in 2021, the total value locked (TVL) in DeFi protocols across leading blockchains exceeded $256 billion, nearly quadrupling in one year, demonstrating strong growth in this field.

The importance of decentralized finance lies in addressing two core issues of traditional financial systems. First is lack of trust and transparency. Throughout history, financial crises and hyperinflation caused by centralized authorities have affected billions worldwide. Second is access. Notably, 1.7 billion adults globally still lack bank accounts, unable to access basic financial tools like savings accounts or loans.

DeFi offers solutions to both challenges. Blockchain technology has taken money out of the control of central banks and governments, and DeFi is doing the same for the entire financial sector. Now, you can borrow money in under 3 minutes, open a savings account almost instantly, send cross-border payments at lightning speed, and invest in favorite companies via tokenized securities, regardless of where you are in the world.

How Decentralized Finance Works

DeFi operates on blockchain technology through smart contracts—programs stored and executed automatically on the blockchain. Think of smart contracts as a set of digitally encoded agreements 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 the concept of smart contracts along with the Ethereum Virtual Machine (EVM), a near-complete Turing-complete state machine. EVM is a computational tool that allows writing and running smart contracts. Developers code using languages like Solidity and Vyper, with Solidity being the most popular for coding smart contracts on Ethereum.

Ethereum has gained significant momentum and is the second-largest cryptocurrency after Bitcoin, thanks to the flexibility provided by EVM and smart contracts. However, Ethereum is not the only smart contract platform. Many other blockchains—often called “Ethereum alternatives”—also support smart contracts, including Cardano, Polkadot, TRON, EOS, Solana, and Cosmos.

These platforms offer new approaches and architectures to address issues like scalability, interoperability, and transaction throughput. While some platforms are technologically superior, none match Ethereum’s real-world adoption. Thanks to network effects and being a pioneer, Ethereum maintains a dominant position in user base. As of 2022, there are 7,250 deployed smart contracts across all platforms, with 4,900 on Ethereum, accounting for 67.5% market share. In the DeFi space specifically, there are 202 projects, with 178 operating on Ethereum.

Comparing Decentralized Finance and Traditional Finance: Key Differences

Traditional finance—also called CeFi (centralized finance)—relies on intermediaries like banks and financial institutions. In contrast, DeFi uses blockchain technology to implement a decentralized, peer-to-peer, flatter, and less hierarchical structure focused on higher accessibility.

Transparency in DeFi

DeFi applications introduce a new level of transparency thanks to their peer-to-peer nature. Processes and rates are determined within a transparent model, with user participation instead of being managed by a central entity. As a result, DeFi operations are more transparent than their CeFi counterparts.

Furthermore, removing intermediaries in the P2P model eliminates a single point of failure, which could be targeted for attacks or manipulation. Unlike CeFi, DeFi relies on consensus mechanisms and cannot be manipulated by user groups without their awareness.

Speed and Cost Efficiency

Eliminating intermediaries streamlining transactions significantly speeds up processes in DeFi applications. Transactions are processed faster, records are maintained transparently, and fraud is harder. Besides speed, the decentralized model also reduces transaction costs considerably.

In CeFi, cross-border transactions must go through interbank communications across regions, often slowed by national regulations. Conversely, a cross-border transaction using DeFi can be completed in minutes instead of days, at much lower costs.

Control and Security

DeFi users have full control over their assets, with security being their own responsibility. This prevents central authorities from becoming lucrative targets for attacks aimed at stealing user funds. The model also offers higher cost efficiency since traditional financial institutions spend large sums on safeguarding assets. DeFi does not require such expenses.

Built on advanced blockchain technology, DeFi applications use smart contracts to store and process data in tamper-proof ways. While traditional financial institutions are vulnerable to internal or external attacks and manipulation, DeFi leverages a P2P transaction model—allowing all participants to have full visibility, which helps prevent malicious behaviors.

24/7 Operation Without Interruptions

Traditional financial markets operate only five days a week during bank hours. DeFi, based on digital technology, is always active, keeping markets open and accessible from anywhere at any time. DeFi markets do not close, allowing liquidity to remain more stable compared to traditional markets, where liquidity can thin out when markets are closed.

Main Applications of Decentralized Finance

Financial principles are the building blocks—like “financial Lego”—that underpin today’s financial services industry. DeFi offers a complete alternative financial system by integrating these principles into smart contracts.

Decentralized Exchanges (DEX)

DEXs are a key financial principle for the DeFi ecosystem. They enable users to trade cryptocurrencies in a trustless, decentralized manner. DEXs do not require KYC verification and have no geographical restrictions.

Decentralized exchanges have gained significant momentum, with over $26 billion locked across all DEXs. Unlike centralized exchanges, DEXs do not deal in fiat currency and only support cryptocurrency trading.

The two most common types of DEXs are:

• Order book-based DEXs—operate on an order book model used by most centralized exchanges
• Liquidity pool-based DEXs—also called “swap platforms,” use liquidity pools to facilitate trading of a single pair at a time

Stablecoins – Stable Digital Assets

Stablecoins are digital assets with stable prices. They are cryptocurrencies pegged to external stable assets (like USD) or a basket of assets to limit volatility. Stablecoins are the backbone of DeFi—within five years, their market cap exceeded $146 billion.

There are four main types:

• Fiat-backed—pegged to fiat currencies like USD, including USDT, USDC, PAX, and BUSD
• Crypto-backed—collateralized by over-collateralized crypto assets, including DAI, sUSD, aDAI, and sUSD
• Commodity-backed—pegged to commodities like gold or silver, including PAXG, DGX, XAUT, and GLC
• Algorithm-backed—stabilized by algorithmic mechanisms, including AMPL, ESD, and YAM

Today, many stablecoins use hybrid models combining these types to achieve greater stability. A unique feature of stablecoins is their “chain-agnostic” nature—they are pegged to external assets, allowing them to exist across multiple blockchains.

Lending and Borrowing Markets

The lending and borrowing market is the third core principle of DeFi. The entire global banking sector operates based on this credit market.

Lending is the largest DeFi segment, with over $39.25 billion locked in various lending protocols. To compare, the total TVL in DeFi is $77.32 billion, meaning lending protocols account for over 50% of the total market share.

DeFi lending and borrowing differ significantly from traditional mechanisms. You don’t need extensive 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.

Ways to Earn Money Through DeFi

DeFi can be an exciting way for investors to generate additional profits from their crypto holdings.

Staking – Holding to Earn Rewards

Staking allows users to earn rewards by holding cryptocurrencies that use Proof of Stake (PoS) consensus mechanisms. Staking pools in DeFi work like savings accounts, enabling users to add cryptocurrencies to earn interest over time.

Yield Farming – Advanced Strategy

Yield farming is a more advanced investment strategy. It’s the most common way to generate passive income from holding cryptocurrencies, providing attractive returns. DeFi protocols use yield farming to maintain liquidity on their platforms.

Yield farming is often facilitated by Automated Market Makers (AMMs)—smart contracts that use algorithms to support digital asset trading on DEXs.

Liquidity Mining – Providing Liquidity

While yield farming and liquidity mining are often used interchangeably, there are subtle differences. Both help maintain liquidity, but liquidity mining rewards liquidity providers with tokens, such as LP tokens or governance tokens, often with fixed APY.

Community Fundraising

Community fundraising has been around for years, but DeFi has accelerated this approach by making it more accessible. The power of decentralization combined with the collective nature of fundraising creates one of the most exciting ways to generate revenue from DeFi.

DeFi projects allow users to invest their crypto assets in exchange for rewards or equity in promising projects. Peer-to-peer fundraising also enables users to raise funds from each other transparently and permissionlessly.

Risks to Know When Participating in DeFi

While DeFi has huge potential, it also involves significant risks and challenges.

Software Vulnerabilities in Smart Contracts

DeFi protocols running on smart contracts may have vulnerabilities exploitable by attackers. According to ImmuneFi, over $3.2 billion in crypto was stolen from DeFi projects in 2021, and over $1 billion in the first three months of 2022.

Fraud and Scams

High anonymity and lack of KYC procedures make it easier for some to launch fraudulent projects in DeFi. Rug pulls and pump-and-dump schemes are common, making investors cautious.

Temporary Loss Risks

Due to high volatility in crypto prices, token prices in DEX liquidity pools can fluctuate. If one token’s price surges while another remains stable, user earnings can be significantly affected, sometimes resulting in losses.

Leverage Risks

Some DeFi applications offer extremely high leverage—up to 100x. While attractive for winning trades, losses can be severe, especially given the volatile nature of crypto markets.

Token Risks

Every token you invest in via DeFi should be thoroughly researched. However, many users do not do this in their rush to follow trends. Investing in new tokens carries high risk, though potential rewards are also greater.

Regulatory Uncertainty

Despite the TVL reaching billions of dollars, DeFi markets are largely unregulated. Some countries are trying to understand how the market operates and consider implementing regulations. However, most DeFi investors are unaware of the lack of regulation. Investors can lose funds due to scams with no legal recourse, relying solely on protocols’ security.

The Future of Decentralized Finance

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

DeFi applications enable building more complex tools like derivatives, asset management, and insurance. Ethereum clearly dominates the DeFi ecosystem thanks to network effects and flexibility. However, other platforms are also showing strength to compete with Ethereum.

The ETH 2.0 upgrade aims to improve Ethereum through sharding and Proof of Stake consensus. Meanwhile, fierce competition among Ethereum and other smart contract platforms is expected to shape the emerging ecosystem.

Key Takeaways About Decentralized Finance

1. DeFi is a blockchain-based financial system aimed at democratizing finance by removing intermediaries and increasing access.

2. Its importance lies in addressing distrust in centralized systems and making financial services more accessible.

3. DeFi operates via smart contracts—self-executing agreements enabling automation and decentralization.

4. DeFi differs from traditional finance in transparency, transaction speed, user control, 24/7 availability, and security.

5. Main applications include decentralized exchanges (DEX), stablecoins, and lending/borrowing services.

6. Opportunities to earn include staking, yield farming, liquidity mining, and community fundraising.

7. Despite its potential, DeFi carries significant risks—from software bugs to scams and regulatory uncertainties.

8. The future of DeFi looks promising, with continuous growth expected.

Decentralized finance offers a new, innovative approach to financial services, aiming to create a more inclusive and transparent system. As technology advances, DeFi has the potential to reshape the global financial landscape and provide broader access to financial tools for everyone.