Decentralized Finance (DeFi) refers to the wide variety of financial products and services available without a centralized authority like a bank. This decentralization—made possible by blockchains and smart contracts—is core to Web3.
For example, consider a company like Chase or PayPal that helps you trade currencies, take out a loan, or send payments. In each case, you’re relying on some centralized authority like a bank or broker to offer these services. DeFi is all about coordinating the same (and better) financial services with publicly verifiable transparency, through automated smart contracts…but between peers.
The common thread among the wide variety of DeFi tools is that they don’t rely on intermediaries like banks. This is made possible with decentralized (or Web3) tech like blockchain networks. Much like Web3 itself, DeFi is:
- Trust-minimized: It relies on blockchain tech instead of centralized databases, meaning users don’t have to blindly trust big organizations with opaque rules.
- Permissionless: Anyone with a crypto wallet can participate, without needing financial qualification or approval from an authority like a government.
Introduction to DeFi
DeFi is an invention of the crypto era, built on decentralized networks powered by blockchain technology and cryptocurrency. The term “DeFi” itself was coined in 2018.
Some consider Bitcoin (the first widely adopted cryptocurrency) to be the originator of DeFi because it enabled global, peer-to-peer transactions. But while Bitcoin made peer-to-peer payments possible, it’s only one small part of the world of DeFi. Really, DeFi as we know it today began on the Ethereum blockchain.
The technology that powers DeFi: smart contracts and DApps
In 2015, the Ethereum network launched and famously debuted “smart contracts,” which are like specialized programs that live on a blockchain. With this innovation, Ethereum became the first “programmable” blockchain, capable of doing much more than just peer-to-peer transactions. By layering and combining smart contracts (sort of like stacking Lego blocks), developers could build entire decentralized apps ("DApps") that live on a blockchain rather than on a company-owned server.
With this innovation, developers began to build all kinds of DeFi DApps and protocols to provide financial services like lending, borrowing, trading, derivatives, and more to the crypto market. In the following years, DeFi exploded in popularity on the Ethereum network. Users could finally take direct control of their finances without relying on governments or banks. Following in Ethereum’s footsteps, there are now many blockchains with similar programmability and their own flourishing DeFi ecosystems.
Problems with traditional finance
You might be wondering why someone would want to use DeFi tools over what’s available in traditional finance—after all, traditional finance has more rules, regulations, and customer protections, right? In reality, traditional financial infrastructure can make it harder for people to access financial services, and requires them to place trust in institutions that (often) aren’t very trustworthy.
Lack of access to traditional financial services
Financial institutions set their own rules and regulations in the name of “safety.” But the red tape and bureaucracy of banks and intermediaries will often disadvantage people rather than help them. Traditional finance is full of economic and geographic restrictions that keep people from using financial services.
Think of savings accounts that reward higher account balances with better interest rates, charge fees for dropping below a minimum bank balance, or require minimum transaction amounts. Many regions are plagued by predatory lending models that exploit people looking to borrow money. Even sending money from one bank account to another can incur service charges. Try sending remittances abroad, and you’ll find even more restrictions—and fees—set in place by intermediaries.
Traditional finance is centralized, with powerful institutions that make money by charging users for services—without many viable alternatives. But it’s not all just about fees.
Access to financial markets like stocks and derivatives is shrinking, and becoming dominated by the wealthy. In the US, for example, the top 10% of households by net worth own more than 85% of equities; the bottom 50% of households own less than 1%. In many countries, people don’t even have access to stock markets. This all demonstrates just how “closed” the global economy really is.
Traditional finance forces you to trust Big Banks
Traditional finance also relies on trust. When you deposit money in a bank, for example, you’re trusting that institution to keep your assets safe and available to withdraw at your discretion. Once you deposit, though, banks will use that money in ways you might not like. Really, your account balance is just a number on a screen—at any given time, some percentage of that balance is loaned out to other customers, invested, etc. And in times of emergency, it’s not uncommon for customers to withdraw funds en masse, a phenomenon known as a “bank run” (which can deplete a bank’s entire cash reserves).
Traditional finance is old, slow, and built on a system of centralized control and unequal access that most benefits the rich. It’s an industry that’s ripe for the benefits of decentralization.
Advantages of DeFi: speed, open access, and reduced costs
Just like Web3 is a rejection of Big Tech that dominates the Internet, DeFi is a rejection of Big Banks that have come to dominate the financial markets.
DeFi relies on smart contracts, not intermediaries. It’s fast and automated. It greatly reduces overhead costs and the potential for human error. It cuts out the institutions and intermediaries that charge users fees for performing basic financial services. There aren’t any central authorities, underwriters, governing agencies, or even KYC (or Know Your Customer, a technical method of verifying your identity). It’s a streamlined financial system operated by—and for—everyday people.
The associated risks of DeFi
But with great power comes great responsibility. DeFi users are responsible for managing their own assets, and doing good diligence before using DeFi DApps. There’s always the risk of bad actors trying to steal your assets, or faulty smart contracts that give hackers an opportunity to exploit. If something goes wrong in DeFi, there’s no central authority to complain to, and no government guarantors; there’s no DeFi equivalent of the US Government’s FDIC (or Federal Deposit Insurance Corporation). But the popularity of DeFi (and the billions of dollars invested in DeFi protocols) shows that many users would rather place their trust in code than Big Banks.
To access all the benefits of DeFi, users have to assume some risk, too. The good news, though, is that DeFi protocols are getting easier to use and safer by the day.
What can you do with DeFi?
DeFi enables users to take advantage of the same products a bank or financial institution might offer, only directly between peers. These include:
- Global payments
- Trading
- Borrowing
- Lending
- Derivatives
As you can imagine, these services look a bit different without a central authority like a bank overseeing the whole process. Take lending, for example. In traditional finance, you’d walk into a bank and ask for a loan. The bank would ask for some financial data (like your income and credit score) before deciding to approve or deny your request; the process can take months.
In DeFi, however, taking out a loan can be as simple as visiting a DeFi DApp, depositing some crypto as collateral, and borrowing against it instantly. And instead of the borrowed assets coming from a bank, they’d come from other users who are participating in the ecosystem by lending their assets…and earning interest payments for doing so.
Similarly, peer-to-peer trading on decentralized exchanges (DEXs) is facilitated by users, too. People supply trading liquidity to earn rewards. Then traders can take advantage of the crowdsourced liquidity to swap between assets. On a DEX, trades are carried out via smart contracts.
These are just a few examples of how people can participate in DeFi not only by using financial services, but also by owning and providing them—something typically reserved for banks and financial institutions.
Note: DEXs shouldn’t be confused with centralized crypto exchanges (CEXs), where a central authority oversees transactions, facilitates trades, and has the final say in what happens to users’ assets. These can be susceptible to the same issues (like bank runs) as traditional finance. Trading on a DEX enables users to retain sole control over their private keys, and therefore self-custody of their assets.
Explore DeFi with Brave Wallet
DeFi stands to make financial services cheaper, easier, and more accessible for everyone. And while there are many paths in DeFi, you only need one tool to get started: a self-custody crypto wallet.
There’s an open, permissionless, trustless world of financial products out there. Start exploring them today, with Brave Wallet.
