Understanding What DeFi Is: Decentralized Finance and the Future of the Financial Services Industry

DeFi, short for Decentralized Finance, is not just a new concept but a revolution in how we access financial services. To answer “What is DeFi?”, we need to understand that it is a peer-to-peer (P2P) financial system built on blockchain technology, allowing individuals to conduct financial transactions without intermediaries like banks or traditional financial institutions.

The essence of DeFi is entirely different from traditional finance. Instead of relying on centralized organizations to manage money and assets, DeFi uses fundamental financial principles such as credit, payments, derivatives, and asset swaps, but implements them through smart contracts on blockchain. These platforms are designed to ensure fair access for everyone, regardless of geographic location or financial status.

A New Financial Foundation Powered by Blockchain Technology

To understand “What is DeFi?”, we first need to review the history of money and financial tools. Throughout history, money has taken many forms, but its primary purpose has always been to facilitate the exchange of goods and services. As economies developed, people needed more complex financial tools to meet increasing demands.

One of the earliest tools was credit—allowing individuals and businesses to borrow money at a set interest rate. Later, banks and financial organizations emerged offering a variety of services. However, this centralized model introduced two fundamental issues.

First is lack of trust. Global financial history has seen numerous crises and hyperinflation affecting billions. When power is concentrated in a few organizations, the risk of systemic collapse increases significantly.

Second is limited access. Alarmingly, 1.7 billion adults worldwide still lack bank accounts and cannot access basic financial services like savings or loans. Blockchain technology has changed this landscape by freeing money from government and central bank control. DeFi is doing the same for the entire financial system, providing open access to modern financial tools for everyone.

Today, through DeFi applications, you can borrow money in minutes, open a savings account almost instantly, make international payments quickly, or invest in companies via tokenized securities—regardless of your location.

How Does DeFi Work? Exploring the Core Mechanisms

To truly understand “What is DeFi?”, we need to examine how it operates at a technical level. DeFi applications run on blockchain networks supported by smart contracts—programs stored on the blockchain that automatically execute when certain conditions are met. Smart contracts can be viewed as digital agreements that do not require third-party intervention.

For example, a smart contract can automatically disburse a loan to a specific wallet address when the borrower provides sufficient collateral. Ethereum’s blockchain is a pioneer platform introducing smart contracts along with the Ethereum Virtual Machine (EVM), a nearly complete computing environment. Developers use programming languages like Solidity or Vyper to write smart contracts on Ethereum. Solidity is the most popular language for this purpose.

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

These platforms offer entirely new approaches and architectures aimed at solving issues like scalability, interoperability, and transaction throughput. Despite technical advantages some may have, no platform matches Ethereum’s real-world adoption. Thanks to network effects and being a pioneer, Ethereum remains dominant.

According to State of the DApps, there are a total of 7,250 smart contracts deployed across various platforms, with 4,900 on Ethereum—accounting for 67.5% market share. For DeFi projects specifically, DeFiPrime reports 202 projects, with 178 operating on Ethereum. This explains why most popular DeFi applications are built on Ethereum.

Differences Between Decentralized Finance and Traditional Systems

DeFi and traditional finance (CeFi—Centralized Finance) operate on two completely different models. Traditional finance relies on intermediaries like banks and financial firms to provide services. In contrast, DeFi leverages blockchain technology to create a decentralized, peer-to-peer, less hierarchical structure focused on expanding access.

Increased Transparency and Security

By bypassing intermediaries, DeFi applications offer unprecedented transparency. Processes and rates are determined transparently, with user participation rather than centralized decision-making. As a result, DeFi activities are more transparent than their CeFi counterparts. Additionally, removing intermediaries eliminates a single point of failure—reducing vulnerability to attacks or manipulation. DeFi relies on consensus mechanisms and is resistant to tampering without community awareness.

Built on blockchain, DeFi applications use smart contracts to store and process data in a tamper-proof manner. Traditional financial institutions are more vulnerable to internal or external attacks. DeFi’s P2P model allows participants to fully monitor transactions, helping prevent fraud.

Faster Transactions and Cost Savings

Eliminating a middleman accelerates transaction processing significantly. Transaction histories are transparent, tamper-proof, and accessible to all participants. Besides speed, the decentralized model is much cheaper.

In CeFi, basic transactions like transfers depend on interbank communication across regions and are slowed by varying regulations. Conversely, cross-border DeFi transactions can be completed in minutes at a fraction of the cost.

User Control and 24/7 Availability

DeFi users have full control over their assets, but security is their responsibility. This prevents centralized entities from becoming lucrative targets for attacks. The model is also more cost-efficient since traditional financial institutions spend large sums on safeguarding assets and insurance. DeFi does not require such expenses.

Traditional markets operate only five days a week during banking hours. DeFi, powered by digital technology, is always open, providing 24/7 access. Users can connect from anywhere at any time, maintaining higher liquidity compared to traditional markets, where liquidity can thin out when markets are closed.

Practical DeFi Applications Today

The most common DeFi applications revolve around fundamental financial principles—building blocks for the financial services industry. DeFi creates a comprehensive financial system by integrating these principles into smart contracts:

Decentralized Exchanges (DEXs)

DEXs are the first principle of DeFi. They enable users to trade cryptocurrencies in a trustless, fully decentralized manner. DEXs do not require KYC verification and are borderless. Recently, DEXs have gained strong momentum, with over $26 billion USD locked across all DEX platforms.

Unlike centralized exchanges, DEXs do not deal in fiat currency and only support crypto-to-crypto trading. There are two main types: order book-based DEXs—similar to traditional exchanges—and liquidity pool-based DEXs, also called “swap platforms,” which use liquidity pools to facilitate trading of a single pair at a time.

Stablecoins—Stable Digital Currencies

Stablecoins are digital assets with stable value. They are pegged to external assets like USD or a basket of assets to limit volatility. Stablecoins are the backbone of DeFi. In just five years, stablecoins have reached a total market cap of $146 billion, reflecting rapid growth of the top nine stablecoins.

Four main types:

• Fiat-backed: Collateralized by fiat currency (e.g., USDT, USDC, PAX, BUSD).
• Crypto-backed: Collateralized by over-collateralized crypto assets (e.g., DAI, sUSD, aDAI).
• Commodity-backed: Collateralized by commodities like gold or silver (e.g., PAXG, DGX, XAUT, GLC).
• Algorithm-backed: Price-controlled by algorithms without collateral (e.g., AMPL, ESD, YAM).

Many stablecoins now use hybrid models for greater stability. A unique feature is “chain-agnostic” stablecoins—pegged to external assets and existing across multiple blockchains (e.g., Tether on Ethereum, TRON, Omni, etc.).

Lending and Borrowing Markets

The third core principle of DeFi is lending and borrowing. The global banking sector relies heavily on credit markets. Lending protocols are the largest DeFi segment, with over $39.25 billion locked in various lending platforms. Compared to the total DeFi TVL of $77.32 billion, lending protocols account for over 50%.

DeFi lending and borrowing differ greatly from traditional banking. No extensive documentation or credit checks are needed—just sufficient collateral and a wallet address. DeFi opens a vast peer-to-peer lending market, allowing users to lend their crypto assets and earn interest. The entire DeFi ecosystem is built on these three principles, forming an open, transparent, trustless, and borderless alternative financial service industry.

Earning Income in DeFi: Main Strategies

DeFi offers attractive opportunities for investors to generate yields from their crypto holdings. Here are various ways to earn passive income through DeFi applications.

Staking—Earning Rewards by Holding

Staking involves locking certain cryptocurrencies to earn rewards via Proof of Stake (PoS) consensus mechanisms. DeFi staking pools function like savings accounts, allowing users to deposit specific tokens to earn rewards over time. Staked tokens are actively used by the protocol, and rewards are distributed among participants.

Yield Farming—Advanced Investment Strategy

Yield farming is a more advanced DeFi investment method, one of the most popular ways to generate higher returns from crypto holdings, providing good passive income. DeFi protocols use yield farming to maintain liquidity on their platforms, supplying liquidity to DEXs.

Yield farming is often facilitated by Automated Market Makers (AMMs)—smart contracts that use algorithms to support digital asset trading on DEXs. Yield farmers provide liquidity to AMMs, which enables decentralized trading without intermediaries, leveraging liquidity pools and liquidity providers.

Liquidity Mining—Managing Liquidity

While yield farming and liquidity mining are often used interchangeably, there are subtle differences. Like yield farming, liquidity mining helps maintain sufficient liquidity for trading. However, liquidity mining specifically involves smart contracts and liquidity providers, whereas yield farming relies on AMMs. Unlike fixed APY rewards in yield farming, liquidity mining rewards are often paid in LP tokens or governance tokens.

Community Fundraising—Creating Collective Incentives

Although community fundraising has existed for years, DeFi has made it more accessible. The power of decentralization combined with collective funding creates exciting opportunities. DeFi projects allow users to invest their crypto assets in exchange for rewards or stakes in promising projects. It also enables transparent, permissionless fundraising for social causes, where members can raise funds among themselves.

Challenges and Risks to Watch Out For

While DeFi offers significant potential, it also involves risks and challenges. Here are the major risks participants should be aware of.

Smart Contract Vulnerabilities and Security

DeFi protocols run on smart contracts, which may contain exploitable bugs. According to ImmuneFi, over $3.2 billion in crypto was stolen from DeFi projects in 2021, and over $1 billion in the first quarter of 2022 alone. These attacks are due to hackers discovering and exploiting critical vulnerabilities in code.

Fraud and Scams

High anonymity and lack of KYC procedures make it easier for malicious actors to launch fraudulent projects. Rug pulls and pump-and-dump schemes are common, raising investor caution. Scammers have stolen funds from top DeFi protocols, representing a significant risk.

Impermanent Loss

Due to high volatility, token prices in liquidity pools fluctuate. When one token’s price surges while another remains stable, liquidity providers may experience impermanent loss—potentially leading to losses. While historical data analysis can mitigate this risk, it cannot be eliminated entirely due to market volatility.

High Leverage—Amplified Risks

Some DeFi derivatives platforms offer leverage up to 100x. While high leverage can amplify gains, it also significantly increases the risk of large losses, especially during volatile price swings. Reputable DEXs typically offer reasonable leverage to protect users.

Token Risks—Careful Selection Needed

All tokens invested via DeFi protocols should be thoroughly researched, but many users skip due diligence. Investing in new tokens carries high risk but also high potential returns. Tokens without reputable developers or backing can lead to substantial losses.

Legal and Regulatory Uncertainty

Despite DeFi’s TVL reaching billions, regulators have yet to fully oversee the space. Some countries are studying the market and considering regulations. However, most users are unaware of the lack of regulation, and investors may lose funds due to scams without legal recourse.

The Future of DeFi: Trends and Outlook

Decentralized finance has enormous potential to make financial products more accessible. From a few basic applications, DeFi has evolved into a comprehensive infrastructure for alternative financial services—open, trustless, borderless, and free from centralized control.

Platforms built on DeFi provide the foundation for developing more complex and sophisticated applications like derivatives, asset management, and insurance. Ethereum continues to dominate the DeFi ecosystem thanks to network effects and flexibility. However, other platforms are also showing strengths to compete.

Ethereum 2.0 upgrades, including sharding and Proof of Stake, are expected to improve scalability and performance. We may also witness fierce competition among Ethereum and other smart contract platforms to capture market share in the growing DeFi landscape.

Summary: Key Points About DeFi

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

2. Its importance lies in addressing trust issues in centralized systems and making financial services more accessible globally, regardless of location or financial status.

3. DeFi operates through smart contracts—self-executing agreements written in code, enabling automation and full decentralization.

4. Compared to CeFi, DeFi offers increased transparency, faster transactions, better user control, 24/7 availability, and enhanced security.

5. Popular DeFi applications include decentralized exchanges (DEXs), stablecoins, and lending/borrowing services.

6. Income opportunities in DeFi include staking, yield farming, liquidity mining, and community fundraising.

7. Risks to consider include smart contract bugs, scams, impermanent loss, high leverage, token risks, and regulatory uncertainties.

8. The future of DeFi looks promising with continued growth, but users should be aware of risks and conduct thorough research before participating.

In conclusion, decentralized finance offers a novel and innovative approach to financial services, aiming to build a more inclusive, transparent, and resilient financial system. As technology advances, DeFi has the potential to reshape the global financial landscape and provide broader access to financial tools worldwide.