What is DeFi and How Does It Work?

2023.05.07

Key Takeaways

DeFi, short for “Decentralized Finance,” refers to financial services provided on public blockchains, especially Ethereum. This platform enables users to perform various activities similar to those offered by traditional banks, including borrowing, lending, earning interest, buying insurance, trading assets and derivatives, and more. Unlike traditional financial institutions, DeFi is faster, paperless, and does not require intermediaries.

Additionally, DeFi operates on a global, peer-to-peer basis, which means that transactions occur directly between two parties without the need for a centralized system. Furthermore, DeFi is pseudonymous and accessible to all, making it an inclusive platform.

How Does DeFi Work?

DeFi operates using smart contracts that eliminate the need for traditional financial institutions to act as intermediaries for transactions. Instead, participants directly transact with one another, with the use of blockchain technology for securing transactions. Unlike traditional finance systems, DeFi products do not take custody of your funds, so you remain in control of your assets.

To use DeFi, you need a secure digital wallet to access your funds or assets. When you want to transact, you can initiate transactions through smart contracts, which allow you and the other party to agree on specific conditions. For example, a smart contract can be created to send funds to a particular account regularly, and this will continue as long as sufficient funds are available. Once a smart contract is set up, it cannot be changed, so funds cannot be redirected to a different account.

While most DeFi applications are currently built on the Ethereum blockchain platform, other platforms such as Cardano, Binance, and Solana are quickly developing similar applications. Since DeFi is still in its infancy compared to centralized finance systems, new applications are being released continuously.

Advantages of DeFi

DeFi offers a range of benefits that make it an attractive alternative to traditional centralized finance. One of the biggest advantages is its open nature – users can access DeFi by simply creating a wallet, without the need to apply for an account. Additionally, DeFi is pseudonymous, meaning users don’t need to provide personal information such as their name or email address.

DeFi also offers more flexibility, allowing users to move their assets quickly and easily without the need for permission or expensive fees. Interest rates and rewards update rapidly, often every 15 seconds, and can be much higher than those offered by traditional finance. Plus, DeFi is transparent, with all transactions visible to everyone involved.

Disadvantages of DeFi

One downside of DeFi is that fluctuating transaction rates on the Ethereum blockchain can make active trading expensive. Additionally, depending on which dapps are used and how they are used, investments may experience high volatility. Finally, users are responsible for maintaining their own records for tax purposes, and regulations can vary from region to region.