What is DeFi?

Main Points

• Decentralized Finance (DeFi) are financial services that operate without a central authority. 

• DeFi services are controlled entirely by blockchain technology rather than intermediaries like bankers. 

• DeFi works using smart contracts to facilitate trustless, peer-to-peer transactions for a wide range of financial services. 
  

Cryptocurrencies like Bitcoin were invented as a way to change the way we think about currency and payments. As the popularity of Bitcoin increases over the years, people are applying its principles and technology to other facets of the financial sector. These innovations are known as Decentralized Finance or DeFi. DeFi eliminates the need for banks, financial institutions, or intermediaries and allows people to conduct financial transactions directly with one another. 

What is DeFi exactly, and why is it so important? What will the future of DeFi look like? This guide will help you understand the basics of decentralized finance. 

What is DeFi? 

 Bitcoin is the first and most basic DeFi protocol. Rather than relying on the trust of intermediaries and banks, Bitcoin runs on a distributed ledger of millions of computers worldwide called nodes that use the mathematical principles of cryptography to verify transactions and eliminate the risk of "double-spend fraud," which is where money is spent then written back into the account to be spent again. But Bitcoin is limited in capabilities. It can only be used for just one small portion of the financial system - money transfers. 

The introduction of Ethereum and its innovation of Smart Contracts on the Solidity programming language allowed developers to create trustless and decentralized financial protocols. A smart contract is a software program that uses blockchain technology to create cryptographically secure self-executing contracts with the terms of agreement written directly into the code. The code controls the execution, and all transactions are trackable and irreversible. Smart contracts permit trustless transactions and agreements to be carried out among different, anonymous users without the need for a central authority. Although the idea of smart contracts existed since the 1990s, by around 2017 the Ethereum smart contract technology reached a level of sophistication and mass adoption that birthed a number of DeFi protocols that still exist today.

As an example, with the current state of the technology somebody can take out an insurance policy from a group of peers. All the terms for payout are predetermined, as well as the monthly payment, and the programming of the smart contract handles payment logistics without the need for human intervention. While this system is very niche and still a long way from widespread adoption, this type of DeFi can replace most of the insurance industry with a protocol, potentially saving policy holders a lot of money by cutting out middlemen and enabling regular people to gain wealth by contributing to financial services that were previously reserved for the wealthy.

Beyond creating a workable trustless system, DeFi is transparent and immutable because all terms and transactions are recorded on a blockchain, which means they cannot be changed or erased.

The Problem with Traditional Financial Services 

Traditional financial institutions like banks, lending companies, and insurance agencies are centralized, meaning a single CEO or a board of directors control everything from strategy to daily operations. Humans are generally pretty vulnerable to compromise, so institutions run by humans are subject to mismanagement, fraud, and corruption. 

Of course, financial malfeasance is not guaranteed to happen, but it has happened in the past. Remember the Great Recession of 2008? Much of the blame for that crisis is on the leaders of big banks and lending companies who used the deposits of their clients to make risky investments on toxic assets.

In addition to a flawed past, the present financial ecosystem is simply not accessible to many people. Traditional banking and lending firms are famous for high fees, slow transaction times, long waiting periods, and discriminatory practices. 

Modern technologies like blockchains and smart contracts can replace many flawed financial systems and can make the whole industry more efficient and accessible. 

Popular DeFi Protocols 

DeFi protocols seek to decentralize various functions of the financial ecosystem. Below, find four of DeFi’s most popular projects.

Decentralized Lending and Borrowing

DeFi lending platforms provide the ability to borrow and lend cryptocurrencies directly with one another. Aave is one of the most popular DeFi lending projects. Aave allows people to borrow money without oversight from banks, brokers, or intermediaries. 

Stablecoins

A stablecoin is a cryptocurrency that uses smart contracts to back up its value by a reserve asset like a government-issued currency or gold to offer price stability. Among the most popular stablecoins is USD Coin which is pegged to the United States dollar, so 1 USD Coin can always be redeemed for $1.00.

Stablecoins like USDC are very popular when using DeFi protocols because they provide the fast processing and privacy of cryptocurrencies while simultaneously offering the stability of fiat currencies like the US dollar, euro, or yuan. Many lending protocols prefer clients user stablecoins.  

Oracles

Oracles are a blockchain software used in DeFi that acts as an intermediary, translating off-chain (or real-world) data to smart contracts on the blockchain and back again. In other words, oracles provide reliable, tamper-resistant inputs and outputs for complex smart contracts. Oracles can be set up to monitor almost anything. Some oracles monitor weather, sports results, account balances, stocks' value, and so much more. 

Chainlink is one of the most popular oracle projects. It uses smart contracts to provide information from off-blockchain sources, like the real world, to on-blockchain smart contracts. 

Decentralized Exchanges

Decentralized Exchanges (DEXs) allow users to buy and sell crypto without centralized oversight. DEXs use smart contracts to match buyers with sellers to facilitate transactions directly, peer-to-peer. Popular DEXs include Uniswap, Pancakeswap, and Sushiswap. Note that this description applies to swap exchanges where no fiat funds are involved. Different protocols and degrees of centralization are involved when exchanging fiat currency for cryptocurrency.

The Future of DeFi

DeFi has begun to revolutionize many aspects of the financial services sector. Currently, the DeFi sector is worth hundreds of billions of dollars, but that's just a fraction of the wealth held by traditional financial entities.  

DeFi is still very much in its infancy, and the industry at large faces its share of risks. For starters, DeFi is largely unregulated, unlike the traditional financial sector, which is heavily regulated. Regulations are sure to come and, in many ways, are welcomed to bring clarity to the space. Laws that are too harsh, however, could stifle innovation and stop the industry from growing further. 

New projects are popping up all the time, and the coding behind the protocols isn't always perfect. There are plenty of malicious actors out there looking for any vulnerabilities in DeFi protocol code to exploit. Unfortunately, this has happened many times already, and users of certain protocols have lost a lot of money. To be clear, you can rest assured that the DeFi coins and tokens supported by CoinFlip (listed above) are already well established in the space. The risk of those projects being compromised is extremely low. 

Final Thoughts

DeFi protocols can make the financial ecosystem run more efficiently and provide new opportunities for those traditionally left behind from centralized finance. 

If you believe in the power of DeFi and want to invest in some DeFi cryptocurrencies, CoinFlip has you covered. Convert your cash to DeFi tokens like USDT, LINK, and USDC at a CoinFlip ATM near you or by bank transfer through CoinFlip Preferred!

Financial Advice Disclaimer: Nothing in this blog constitutes professional or financial advice, performance data or any recommendation that any specific cryptocurrency, portfolio, index, investment product, transaction or investment strategy is suitable for any specific person. You assume the sole responsibility of evaluating the merits and risks associated with all financial decisions and should seek the advice of a registered financial advisor when in doubt.