What Is Decentralized Finance and Why Does It Matter?

Decentralized finance (DeFi) is an emerging alternative ecosystem of financial products. It builds on blockchain technology, the underpinning of cryptocurrencies, and relies on networks of computers around the world. Many DeFi projects aim to replicate or replace existing financial services, such as lending and borrowing money or keeping savings in an interest-earning account. 

Centralized finance (CeFi) or traditional finance (TradFi) rely on intermediaries such as banks, exchanges, and brokerages. In contrast, DeFi is built on so-called smart contract platforms, most notably Ethereum and Cardano. They are not operated or owned by a single or central organization, and anyone with an internet connection may be able to use them.

Key components of DeFi

The DeFi space is rapidly evolving. Here are some of the key concepts and commonly used terms that can be important for understanding DeFi:

• Cryptocurrency (“Crypto”).

  This is an umbrella shorthand term used to describe types of digital currency that use blockchain technology: a digital public ledger that uses complex cryptography to record every transaction.
  

• Permissionless.

  DeFi products and services may require people to have a crypto wallet and internet connection. However, users don’t necessarily need to apply for an account or get permission from a centralized organization, such as a bank. People can use DeFi without sharing their name, address, Social Security number, or other identifiers. The transactions are public and can be traced, but users can remain pseudonymous.
  
  

• Composability.

  The permissionless nature also applies to the programs that are part of DeFi. Composability describes the ability of DeFi applications and rules (protocols) to easily interact with one another.
  

• Smart contracts.

  Smart contracts are the self-executing pieces of code (i.e., programs) that live on a blockchain. Developers can use smart contracts to create new applications; smart contracts can’t be changed or removed once they’re on a blockchain. Ethereum is one smart contract platform. (Although the name Ethereum is used synonymously with its native cryptocurrency, it’s more accurate to think of Ethereum as a supercomputer that’s powered by computers around the world than a currency. Ether is the native cryptocurrency built on the Ethereum platform, but other cryptocurrencies are built on this platform as well.)
  
  

• dApps.

  Decentralized apps (dApps) are programs created and run using a smart contract platform, such as Ethereum. One could think of smart contracts as the backend or building blocks of the program, while the dApp is the front-end user interface. Unlike traditional software, no single company or person controls a dApp once it’s launched.
  
  

• Gas fees.

  This refers to a fee users pay for transactions. On the Ethereum network, gas fees are paid in Ethereum’s native cryptocurrency, ether (ETH), and denominated in gwei, with each gwei equaling 0.000000001 ETH. Congestion in the network can lead to rising gas fees, which could make DeFi services less affordable.
  
  

• Stablecoins.

  Stablecoins are cryptocurrencies that are pegged to another asset, such as the US dollar. For example, one of the first widely adopted stablecoins, DAI, token is supposed to always equal $1. Stablecoins are often collateralized with another cryptocurrency, commodities, or fiat (government-issued) currency. They are an important part of the DeFi ecosystem because stablecoins can provide price stability when there’s volatility in the cryptocurrency market.
  
  

• Overcollateralization.

  Stablecoins and loans are often “overcollateralized.” In dollar terms, an example would be using $150 as collateral for a $100 loan. Overcollateralization can help mitigate some of the risk that comes from cryptocurrencies’ volatility.
  

The DeFi infrastructure

The DeFi ecosystem relies on hierarchical layers of infrastructure. These include:

• Settlement layer.

  The underlying blockchain network, such as Ethereum. These set the baseline rules, or protocols, for everything built on the blockchain.
  

• Asset layer.

  The asset layer is made up of the digital assets that are created based on the settlement layer. One example is Ethereum’s native cryptocurrency ether, or ETH. Fungible tokens, such as stablecoins, are also part of the asset layer, as are non-fungible tokens (NFTs), digital assets linked to art, music, videos, and other types of entertainment.
  
  

• Protocol layer.

  Protocols are standards, principles, or sets of rules. Developers can create smart contracts with protocols for specific uses, such as lending or borrowing money. In turn, other developers and dApps can reuse or build on these protocols.
  
  

• Application layer.

  The application layer is where dApps translate the underlying protocols into user-friendly systems. Generally, people interact with DeFi through the application layer.
  
  

• Aggregation layer.

  Aggregators are also user-facing systems, but they can connect or combine multiple dApps to enable more intricate use cases, like flash loans.
  

How does decentralized finance work?

DeFi projects generally have a mandate from their founders to create permissionless financial services that run on a decentralized platform.

The backend uses smart contracts to make decisions, while the project creators and developers build dApps for people to use. DeFi dApps allow users to conduct financial transactions without relying on a centralized intermediary—for instance, exchanging one type of coin for another without having to create an account with a brokerage or exchange.  

dApps and protocol can also be used as building blocks in various DeFi projects: They may be swapped out or combined to create new projects, which is why they’re sometimes called “money Legos.” Seeing someone use these building blocks to create new projects is a potentially exciting part of the DeFi ecosystem.  

For example, someone could compare exchange rates on different decentralized exchanges, trade ETH for a stablecoin on whichever exchange has the best rate, and then keep the stablecoin on whichever platform offers the best interest rate. A new dApp might take this one step further by combining the entire transaction chain. Rather than making each move on its own, someone could use the dApp to automate the process.

5 ways DeFi is used today

Here are some examples of common categories of DeFi projects and popular projects that fit within each category:

1. Asset management

Cryptocurrency wallets, including MetaMask, Ledger, and Coinbase Wallet let people own and control their funds without centralized intermediaries or custodians.

2. Decentralized exchanges

Decentralized exchanges (DEXs) such as Balancer, Curve Finance, Sushiswap, and Uniswap let people buy, sell, and trade cryptocurrencies. Users don’t need to create an account, signup or verify their identity to use a DEX. Users also don’t necessarily need to deposit funds into an account before using a DEX, like they would with a centralized exchange or brokerage.

3. Borrowing and lending

Money market services such as Aave, Compound, InstaDApp, and Maker let people lend and borrow cryptocurrencies without requiring applications, credit scores, accounts, or identifying information. Smart contracts govern the movement of money, and borrowers often need to overcollateralize their loans with cryptocurrency assets that get locked up.

Similar to earning interest in a checking or savings account, lenders can earn interest by keeping their cryptocurrency on the platform. Staking or lending cryptocurrencies to earn rewards (such as interest in the same or a different token) is known as yield farming.

4. NFT marketplaces

While many DEXs let people exchange fungible tokens, such as ETH, there are also decentralized exchanges for non-fungible tokens (NFTs), like OpenSea and Rarible. There have been many attention-grabbing headlines about the latest multimillion dollar NFT sale. But the DeFi-NFT overlap could also become more complex. For instance, some projects, like NFTfi, let people use NFTs as collateral for a loan.

5. Flash loans

Flash loans are unsecured loans that must be repaid in the same transaction. They’re available on some DeFi lending platforms, including Aave and dYdX, but not through a traditional lender. It’s possible to create and use flash loans to make multiple moves within the same transaction.

For example, someone might notice that the same token has different prices on two exchanges. Using a flash loan, they could buy the token at the lower price, sell it on the second exchange at the higher price, return the loan in the same transaction, and pocket the difference.

DeFi vs. traditional finance

DeFi and TradFi share some similar products, goals, and services. However, there are distinct differences between the two.

DeFi

• Permissionless systems don’t require users to share personal information
• Public ledgers allow anyone with the knowhow to review transactions
• Users can hold and control their funds
• A federal regulatory framework is being established
• Accessible at any time

TradFi

• Require sharing personal information to meet know your customer (KYC) requirements
• Financial institutions generally keep transactions private
• Financial institutions hold the funds on customers’ behalf
• Must comply with state and federal regulations

The future of DeFi

The future of DeFi is largely unknown. As institutional, venture capital, and retail investors pour money into the space, there may be an explosion of new ideas and applications. But no one knows which ones will succeed—or if the entire system will fail or evolve into something else entirely.