Whether you’ve long invested in cryptocurrency or have recently opened your first crypto wallet, you’ve likely stumbled across the term “decentralized finance” while researching the blockchain or emerging coins. Also referred to as DeFi, decentralized finance is a technology that’s at the heart of the cryptocurrency movement. And while it’s a foundational element in that sphere, its potential goes far beyond that.
DeFi’s appeal also lies in the fact that it removes the need for intermediaries like banks from certain financial transactions. This can make certain financial products more accessible to a wider variety of consumers, but it can also make DeFi transactions risky. If you’re curious to learn more about these and other basics of decentralized finance before you get involved, here’s what you need to know.
Decentralized finance refers to financial services or applications that operate independently of traditional banks or similar entities. Generally speaking, the most common DeFi approach involves blockchain, the digital ledger technology behind most leading cryptocurrencies.
Bitcoin is an example of DeFi. Transactions people make with Bitcoin aren’t managed by a bank or even a single institution. Instead, the approach is peer-to-peer, allowing anyone to create, verify or review related records or store the broader database that tracks the transactions.
The Ethereum network takes DeFi further. Instead of solely supporting a native token, the Ethereum network creates a landscape. Its blockchain can host programs designed by developers without applying any controls that prevent the decentralized nature of the network.
However, DeFi isn’t inherently relegated to crypto or blockchain. Instead, it potentially describes any financial activities that can occur without tapping into traditional payment-processing and money-handling institutions.
How Decentralized Finance Works
DeFi organizations operate using a direct democracy-style approach. This means no one person or entity has control over the related application or cryptocurrency. Instead, as projects grow and more users participate, the community has an increasingly stronger say.
Generally, participation rights are based on ownership of native tokens. When you hold a token, you get a voice when it’s time to make various decisions about the future of a project. Precisely what that involves varies depending on the app or cryptocurrency and on any other rules associated with the project.
However, across all DeFi projects, you have a lack of traditional banking processes and oversight. Instead, transactions are typically peer-to-peer, often relying on peer-based verification methods to ensure they’re legitimate. Since that’s the case, no one entity or individual gets to dictate whether a transaction is valid or a change is approved. Instead, majority consensus always plays a role.
Additionally, DeFi generally limits the ability of governments to interfere in a project. The peer-to-peer system and distributed ledgers aren’t based in a single location or an individual platform. Instead, a network of systems is involved, most with unique owners. Even if some of the computers or servers are taken offline, the rest continue the work, making these systems difficult to shut down.
Different Types of DeFi Projects
In many ways, decentralized finance is a concept, not a physical thing. Often, it serves as an underlying project principle. It guides various choices, with the goal of ensuring decentralized approaches remain part of the project’s development and resulting applications, systems or assets.
Generally speaking, cryptocurrency is a DeFi project. It’s designed without the need for traditional banks. Plus, no single person or entity controls the destiny of any given token; anyone engaging with the cryptocurrency typically has a say. However, cryptocurrency isn’t the only potential application for DeFi concepts.
Decentralized autonomous organizations (DAOs) are another example of DeFi-oriented projects. These online entities – of which there are approximately 4,000 – bring groups together to support a common goal. While their purposes vary, they embrace flat hierarchical structures and often have DAO-specific tokens.
DeFi exchanges (DEXs) are another outcome of the movement. These aim to support peer-to-peer cryptocurrency and NFT trading. They do this by allowing users to eliminate their reliance on the middleman exchanges you find with traditional brokerages or any crypto exchange that limits cryptocurrency storage to built-in wallets. Additionally, it typically reduces or eliminates many transaction fees.
The Pros and Cons of DeFi
While decentralized finance brings a lot to the table in regards to long-term viability and functional potential, there are also plenty of challenges related to DeFi projects. In some cases, something that’s a benefit from one perspective is a drawback from another, too. Here’s a look at the pros and cons of DeFi.
One of the main benefits of DeFi is that it’s hard to eliminate, censor or eradicate. Since a network of computers is involved, shutting it down is practically impossible. Similarly, confiscating all of the associated assets isn’t too realistic either.
The peer-to-peer approach also reduces physical limitations and fees. Users can complete international transactions with the same ease as trades occurring on the same neighborhood block, which is something you don’t see with most centralized transactions.
With DeFi, it may also be easier to access certain financial services. Typically, DeFi doesn’t rely on traditional forms of identification or current metrics for creditworthiness. This means DeFi projects can give people access to systems that they can’t tap into using traditional banking methods.
Certain related technologies, like smart contracts, can simplify some transactions or agreements. Plus, they’re inherently unalterable, which can provide some peace of mind in the security of these systems.
When it comes to downsides, DeFi typically needs a significant amount of computing power to operate correctly. Transaction verifications usually involve solving complex equations — a process referred to as mining.
Cumulatively, Bitcoin mining consumes around 91 terawatt-hours of electricity per year. That’s more than the country of Finland – a nation with a population of about 5.5 million – uses on an annual basis. That’s just for one cryptocurrency — and that’s a lot of energy potentially contributing to climate change.
Without a central authority, there are fewer safeguards in place. In many cases, individuals are entirely responsible for safeguarding their assets. If you lose your passcode to a crypto wallet or it gets stolen, there’s little recourse to regain your associated assets.
While smart contracts provide some assurance, there are also issues with the approach. Since the code is open-source, it could become a viable attack vector for hackers. Additionally, the sheer volume of code can be problematic, particularly when it comes to bug and glitch management.
Finally, while regulations are limited currently, they’re likely on the horizon. As a result, today’s DeFi likely won’t resemble the DeFi ecosystem that exists years from now; changes to laws could make specific approaches impossible or, at least, illegal, depending on regulations that are enacted in the future.