Lo-fi, hi-fi, DeFi? If you’ve followed the world of NFTs, blockchain, or cryptocurrency even a little bit, you’ve probably come across the term “DeFi.” It stands for “decentralized finance,” and it may just be the future of the financial system as we know it.
DeFi is still in its relative infancy. Similar to how the early days of the internet had a “Wild West” feel of basic chat rooms, rudimentary websites, and early online service providers, crypto enthusiasts say a growing number of blockchain networks, decentralized exchanges, and DeFi protocols are paving the way for the future.
But are they really creating the future of finance? And what does it mean for today’s crypto investors? Here’s what the experts say.
Decentralized Finance (DeFi) Defined
Decentralized finance refers to a financial system that is not built on or around a central figure or institution, and instead is powered by a number of distributed actors and organizations often working independently or in tandem.
For instance, the traditional financial industry (CeFi, or “centralized finance”) revolves around big key institutions such as the Federal Reserve, payments processors, and large banks. The DeFi space aims to sidestep those big players, allowing individual projects and teams to take on those roles.
“In the DeFi space, there’s no central authority to report to,” says Shirin Bucknam, co-founder of Crypto Witch Club, a Brooklyn-based online education community dedicated to blockchain and web3. “It’s really a radical new way of doing things.”
In reality, cryptocurrency and decentralized finance is drawing more and more scrutiny and attention from lawmakers and government regulators as public interest and adoption grows. Nevertheless, these decentralized ideals continue to inspire new crypto and other DeFi projects.
In the DeFi world, the incumbent intermediaries that make the financial system work are all replaced by software or code, called “smart contracts.” So when you execute a transaction, a smart contract handles the heavy lifting, connecting the correct parties and ensuring the transaction goes through. This is, by and large, how the cryptocurrency ecosystem functions, and one of the reasons DeFi continues to grow in prominence and importance.
“DeFi allows for applications, which are built using smart contracts — the idea behind DeFi is that all the products and services that are in the economy today can be self-executed using an automated code,” says Dr. Merav Ozair, blockchain expert and a fintech professor at Rutgers Business School.
To sum it up, DeFi is, in all, a collection of lending platforms, exchanges, and many other institutions that were designed and created apart from the traditional financial system, and are operating on their own, without a central authority or vision steering it.
DeFi vs. CeFi (Centralized Finance)
While an unregulated financial system may sound pretty cool, there are also some obvious drawbacks. The most obvious is that the DeFi ecosystem lacks the consumer protections of the traditional system — things like deposit protection or the guardrails provided by the rigorous IPO process stocks go through before being traded on public markets, which help investors get a clear idea of what they’re investing in.
Perhaps the biggest issue with DeFi, currently, is that it’s rife with bad actors looking to make a quick buck. That is one of the reasons for the prevalence of scammers and pump-and-dump schemes in the crypto markets, for instance.
There’s also the chance that DeFi projects can have issues with the foundational smart contracts, says Ozair. “Any application can have bugs,” she says. “You have to be careful because sometimes the algorithm can go haywire. Codes [smart contracts] are just rules. It’s not really smart — it’s as smart as the person who wrote it.”
Ozair adds that without a central authority checking the numerous algorithms and DeFi projects for issues before they become publicly available, there’s always a chance that consumers could bear the brunt of an algorithm gone wild.
With that in mind, experts and crypto enthusiasts believe DeFi can offer some advantages over the traditional system. Bucknam says that for people who want “full control over everything” in regard to their finances, DeFi is a godsend, for example. She also says people can earn higher interest rates by staking their crypto holdings than they’re likely to get using a savings account at a bank.
With one online savings account, Bucknam says she only earns 0.5% per year in interest. But “through staking on DeFi with stablecoins, I can get 8% APY,” she adds.
Of course, the higher potential reward of staking crypto comes with a good amount of extra risk compared to a classic high-yield savings account. For starters, you won’t benefit from FDIC insurance when staking your crypto. FDIC insurance guarantees your money in the unlikely event of a bank failure. With crypto, a similar institutional failure offers no such assurance that you’ll be able to recover your funds.
What’s more, online savings accounts and even conventional savings accounts are steadily increasing rates lately as the cost of borrowing increases amid the Fed’s efforts to slow down inflation. And a smart conventional investing strategy can easily earn returns of 8% or more over the long-term. So while it may be possible to earn greater rewards by staking crypto than by storing it in a savings account, it’s not such a favorable comparison to conventional investing.
It’s still early for DeFi, so if you’re comparing conventional financial products to crypto networks, it’s smart to weight the risks against the potential rewards. Experts say it’s best to have no more than 5% of your overall portfolio tied up in crypto, and only to go that far after you’ve built up an emergency fund and paid off any high-interest debt.
What Does DeFi Do?
Another key question: What is the point of DeFi? What does it actually do? You’re likely to get different answers depending on who you ask, but it usually boils down to a central aim: giving more control to individuals over both their own finances and, to a degree, the financial system.
In a word, DeFi is all about freedom. Depending on the individual, it’s possible to use the DeFi space to have full and total control over your assets (be they in crypto, or a fiat-backed stablecoin, etc.). Blockchain technology acts as a permanent record for transactions and ownership data, and transactions can often be executed faster than they would in the CeFi system.
But again, that freedom and control come at a cost — there are fewer guardrails to keep consumers or DeFi participants, and their assets, safe. It’s truly a “wild west” feel, where if you lose your assets to hackers or through other means, there may be no recourse for getting them back.
How Does DeFi Work?
The DeFi system works on the back of smart contracts. And smart contracts are, in layman’s terms, bits of computer code. They’re basically instructions that tell a software program what to do under certain circumstances.
“Smart contracts are just codes. They are instructions to run an application,” says Ozair. “Everything is rule-based.”
That means that when you execute a transaction in the DeFi ecosystem, the specifics of the request are read by smart contracts, and those smart contracts follow a series of protocols to push the transaction through the system. For example, if you press the “F” key on your computer’s keyboard, it sends instructions through the computer’s system to present the “F” on your screen. Smart contracts work in a similar way, Ozair says.
In the CeFi system, a number of players are involved, which can create some serious delays in the transaction going through. If you execute a transaction, for instance, the bank needs to work with another bank, and often other intermediaries, in swapping funds and instructions. Even a simple transaction can involve numerous companies or institutions.
DeFi, effectively, smooths that all out, making things easier, faster, and cheaper — if it all goes to plan.
The DeFi space is largely unregulated, and while that means users have more freedom and control over their assets, there are few, if any, guardrails to keep them and their possessions safe.
What Is DeFi Built On?
You’re likely familiar with the foundational tools that DeFi projects are built on: specifically, the ethereum blockchain networks and smart contracts. Essentially, projects or applications (often called “dApps”) are commonly, but not exclusively, being built on the ethereum blockchain and then being automated using smart contract protocols.
Blockchains are basically distributed public ledgers, and are commonly used in the crypto space for recording transaction information. Combined with smart contract technology, dApps can execute transactions on their own, with no intermediaries (banks, etc.) needed. It’s automated, which can be a good thing, but again, there’s always room for error.
“It’s good that there are no intermediaries or biases, but it’s not good if the application isn’t written correctly,” says Ozair.
How to Participate in DeFi, and What It Means for Crypto Investors
If you’re interested in participating in the DeFi space, there are several ways to get involved. But perhaps the simplest is to start buying cryptocurrencies or other digital assets using an exchange.
That would first involve setting up a crypto wallet, giving you a place to store and transact your assets. Then, choose an exchange to work with, or even which specific coins or cryptocurrencies you’d like to engage with. Since some work on certain blockchains and not others, this might require a little research.
You can then look at your options for getting involved, be it trading crypto, or lending it out to get rewards. Of course, you’ll need to be careful since the space is unregulated and rife with risk.
For investors, the idea is relatively simple: The more sophisticated, practical, and useful the application of DeFi networks and products, the more people will be compelled to engage in and adopt new ways of doing things. And to do things in DeFi, new participants will first need to buy crypto for access, which remains the clearest path toward increasing value for cryptocurrencies.
Is Bitcoin Considered Decentralized?
Bitcoin, the granddaddy of all cryptocurrencies, is a good example of a DeFi project. There is no central bitcoin authority — it’s not issued by a central bank or managed by any central institution. And, naturally, it’s powered by a blockchain network, rather than stored on a central server.
If you already knew that, then you already had a basic understanding of how DeFi works. But it’s important to know that DeFi projects aren’t built on the bitcoin blockchain, but typically, ethereum. Bucknam says that’s because the ethereum blockchain is faster and more efficient, which is essential for dApp developers.
“Bitcoin [blockchain] is like the Netscape of the crypto world, it’s like a [version 1], it’s slower than the others,” she says. And, most importantly, she says that the DeFi space is rapidly evolving in a way that resembles the early world wide web. “Right now, DeFi is sort of like when Google came out in the early 2000s,” she says.
Ozair agrees. “Blockchain tech today is very much in its early stages, and similar to what the internet was like in the early 2000s,” she says. With that in mind, there are going to be some bumps and bruises along the way, she says, but with time, there “could be an Amazon or Google of the future in the DeFi space.”
As for what’s next for DeFi? Further refinement, Ozair says. “The next step is figuring out how to make good code and kick everything up a notch.”