Decentralized Finance, or DeFi, represents an open, global financial system built for the internet era. It serves as a transparent alternative to traditional systems that are often opaque, tightly controlled, and reliant on decades-old infrastructure. DeFi offers users greater control and visibility over their funds, provides exposure to global markets, and presents alternatives to local currency or banking options. DeFi products open financial services to anyone with an internet connection and are primarily owned and maintained by their users. To date, tens of billions of dollars in cryptocurrency have flowed into DeFi applications, and the ecosystem continues to grow daily.
Understanding DeFi
DeFi is a collective term for financial products and services accessible to anyone who can use Ethereum—essentially, anyone with an internet connection. In the world of DeFi, markets are always open, and there are no centralized authorities that can block payments or deny access to services. Operations that were once slow and prone to human error are now automated and more secure, managed by code that anyone can inspect and verify.
This expanding crypto economy enables users to borrow, lend, earn interest, and more. For example, crypto-savvy Argentinians have used DeFi to escape crippling inflation, and some companies have started streaming salaries to employees in real time. Individuals have even paid off multi-million dollar loans without disclosing any personal information.
DeFi vs. Traditional Finance
To appreciate the potential of DeFi, it helps to understand the limitations of today’s financial systems:
- Many people are unable to open a bank account or use financial services.
- Lack of access to financial services can prevent people from being employed.
- Financial services can block you from receiving payments.
- Privacy concerns: your personal data is often at risk.
- Governments and centralized institutions can shut down markets at will.
- Trading hours are usually limited to business hours in specific time zones.
- Money transfers can take days due to manual internal processes.
- High fees are common because intermediary institutions take a cut.
A Side-by-Side Comparison
| DeFi | Traditional Finance |
|---|---|
| You hold your own money. | Companies hold your money. |
| You control where your money goes and how it is spent. | You must trust companies not to mismanage your funds. |
| Transfers occur in minutes. | Payments can take days. |
| Transaction activity is pseudonymous. | Financial activity is tightly linked to your identity. |
| DeFi is open to everyone. | You must apply to use financial services. |
| Markets are always open. | Markets close when employees need breaks. |
| Built on transparency: anyone can inspect system data. | Financial institutions are closed books: you can’t review their loan history or managed asset records. |
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The Origins: Bitcoin and Beyond
Bitcoin is, in many ways, the first DeFi application. It allows you to truly own and control value, sending it anywhere in the world. Bitcoin provides a way for large numbers of people who don’t trust each other to agree on a ledger of accounts without a trusted intermediary. It is open to all, and no one has the authority to change its rules. Bitcoin’s rules, such as its scarcity and openness, are written into its technology. This contrasts with traditional finance, where governments can print money that devalues your savings, and companies can close markets.
Ethereum builds on this foundation. Like Bitcoin, its rules are immutable and accessible to everyone. But Ethereum also makes digital money programmable through smart contracts, enabling functionality beyond storing and sending value.
Programmable Money
Why would you want to program your money? This is essentially a default feature of tokens on Ethereum. Anyone can program logic into payments. This combines the control and security of Bitcoin with services typically offered by financial institutions. It enables activities with cryptocurrencies that aren’t possible with Bitcoin alone, such as borrowing, lending, scheduling payments, investing in index funds, and more.
What Can You Do with DeFi?
There is a decentralized alternative for most traditional financial services. Moreover, Ethereum creates opportunities for entirely new financial products. The following is a growing list of possibilities.
- Send money globally
- Stream money worldwide
- Access stablecoins
- Borrow funds with collateral
- Access unsecured flash loans
- Save using cryptocurrencies
- Swap tokens
- Grow your portfolio
- Fund your ideas
- Buy insurance
- Manage your portfolio
Send Money Globally
As a blockchain, Ethereum is designed to send transactions securely and globally. Like Bitcoin, it makes sending money worldwide as easy as sending an email. Just enter the recipient’s ENS name (like bob.eth) or account address from your wallet, and the payment will arrive directly, usually within minutes. To send or receive payments, you’ll need a wallet.
Stream Money Worldwide…
On Ethereum, you can also stream money. This allows you to pay someone’s salary by the second, giving them instant access to funds. Or, you could rent a storage unit or e-scooter instantly.
If you don’t want to send or stream volatile cryptocurrencies, Ethereum offers alternatives: stablecoins.
Access Stablecoins
The volatility of cryptocurrencies is a problem for many financial products and everyday expenses. The DeFi community has addressed this with stablecoins. Their value is pegged to another asset, usually a popular currency like the US dollar.
Coins like DAI or USDC have values that hover around one dollar. This makes them ideal for earning, spending, or retail use. Many people in Latin America have used them to protect their savings during periods of high uncertainty in their government-issued currencies.
Borrowing Money
Borrowing from decentralized providers comes in two main forms:
- Peer-to-peer: a borrower takes a loan directly from a specific lender.
- Pool-based: lenders provide funds (liquidity) to a pool from which borrowers can take loans.
There are many advantages to using a decentralized lender.
Borrow Anonymously
Today, borrowing and lending depend heavily on the individuals involved. Banks need to know whether you can repay a loan before lending to you.
Decentralized lending works without either party having to identify themselves. Instead, the borrower must provide collateral that the lender will automatically receive if the loan isn’t repaid. Some lenders even accept NFTs as collateral. NFTs are deeds for unique assets, like a painting.
This allows you to take a loan without credit checks or sharing private information.
Access Global Funds
When you use a decentralized lender, you access funds deposited from around the world, not just those held by your chosen bank or institution. This makes loans more accessible and improves interest rates.
Tax Efficiency
Borrowing can give you access to needed funds without having to sell your ETH (a taxable event). Instead, you can use ETH as collateral for a stablecoin loan. This provides cash flow while you retain your ETH. Stablecoins are more suitable when you need cash, as they don’t fluctuate in value like ETH.
Flash Loans
Flash loans are a more experimental form of decentralized lending that lets you borrow without collateral and without providing any personal information.
They are not yet widely accessible to non-technical users, but they hint at what might be possible for everyone in the future.
Flash loans rely on the fact that the loan is taken and repaid within the same transaction. If it can’t be repaid, the transaction reverts as if nothing happened.
The funds used are often held in liquidity pools (large pools of funds used for lending). If they are not being used at a given moment, it creates an opportunity for someone to borrow these funds, conduct business, and repay them almost instantaneously.
This means a lot of logic must be included in a single, custom transaction. A simple example might be using a flash loan to borrow an asset at a low price on one exchange to sell it on another where the price is higher.
In the traditional financial world, executing such a strategy would require a significant amount of capital. These profit-making strategies are often only accessible to the wealthy. Flash loans offer a glimpse into a future where having money isn’t necessarily a prerequisite for making money.
Start Saving with Cryptocurrencies
Lend Your Assets
You can earn interest on your cryptocurrencies by lending them and watching your funds grow in real time. Current interest rates are often much higher than those offered by local banks (if you can access them at all). Here’s an example:
- You lend 100 DAI, a stablecoin, to a product like Aave.
- You receive 100 Aave Dai (aDAI), a token representing your lent DAI.
- Your aDAI would increase based on the interest rates, and you could see your balance growing in your wallet. Depending on the APR, your wallet balance might be around 100.1234 after just a few days or even hours!
- You can withdraw an amount of regular DAI equal to your aDAI balance at any time.
No-Loss Lotteries
No-loss lotteries, like PoolTogether, offer a fun and innovative way to save money.
- You buy 100 tickets using 100 DAI tokens.
- You receive 100 plDAI, representing your 100 tickets.
- If one of your tickets is drawn as the winner, your plDAI balance increases by the prize amount.
- If you don’t win, your 100 plDAI are added to next week’s drawing.
- You can withdraw an amount of DAI equal to your plDAI balance at any time.
The prize pool consists of all the interest generated from lending the ticket deposits, similar to the lending example above.
Swap Tokens
There are thousands of tokens on Ethereum. Decentralized exchanges (DEXs) allow you to trade different tokens whenever you want. You never give up control of your assets. They work similarly to exchanging currency when you visit a foreign country. But the DeFi version never closes. Markets are open 24/7, 365 days a year, and the technology ensures there’s always someone to accept a trade.
For example, if you want to use PoolTogether’s no-loss lottery (described above), you’ll need a token like DAI or USDC. These DEXs allow you to swap your ETH for those tokens and back again when you’re done.
Advanced Trading
More advanced options exist for traders who prefer greater control. Limit orders, perpetual swaps, margin trading, and more are all possible. With decentralized trading, you get access to global liquidity, markets never close, and you always retain control of your assets.
When using a centralized exchange, you must deposit your assets before trading and trust the exchange to handle them. While your assets are deposited, they are at risk, as centralized exchanges are attractive targets for hackers.
Grow Your Portfolio
On Ethereum, there are fund management products that will try to grow your portfolio based on a strategy of your choice. This is automatic, open to anyone, and doesn’t require a human manager who takes a cut of your profits.
A good example is the DeFi Pulse Index (DPI). It’s a fund that automatically rebalances to ensure your portfolio includes the top DeFi tokens by market cap. You never have to manage any details and can withdraw from the fund at any time.
Fund Your Ideas
Ethereum is an ideal platform for crowdfunding:
- Potential backers can come from anywhere in the world: Ethereum and its tokens are open to everyone, globally.
- It’s transparent, so fundraisers can prove how much money has been raised. You can even track how funds are spent later.
- Backers can set up automatic refunds if, for example, specific deadlines aren’t met or a minimum amount isn’t raised.
Quadratic Funding
Ethereum is open-source software, and much of the work so far has been community-funded. This has led to the growth of an interesting new funding model: quadratic funding. It has the potential to improve how we fund all sorts of public goods in the future.
Quadratic funding ensures that the projects that receive the most funding are those with the most unique demand. In short, projects that improve the lives of the most people. Here’s how it works:
- There is a matching pool of donated funds.
- A round of public funding is initiated.
- People can signal their demand for a project by donating money.
- Once the round is over, the matching pool is distributed to the projects. Those with the most unique demand receive the largest amount from the matching pool.
This means Project A with 100 donations of $1 could receive more funding than Project B with a single donation of $10,000 (depending on the size of the matching pool).
Insurance
Decentralized insurance aims to make insurance cheaper, faster to pay out, and more transparent. With greater automation, coverage is more affordable, and payouts are much quicker. The data used to decide on your claims is completely transparent.
Ethereum products, like any software, can have bugs and exploits. So, currently, many insurance products in the space focus on protecting users from loss of funds. But there are projects beginning to offer coverage for all sorts of life events. A great example is Etherisc's crop insurance, which aims to protect small farmers in Kenya from drought and floods. Decentralized insurance can provide cheaper coverage for farmers who are often cut off from traditional insurance.
Aggregators and Portfolio Managers
With so much going on, you need a way to track all your investments, loans, and trades. Many products allow you to coordinate all your DeFi activities from a single place. This is the beauty of DeFi’s open architecture. Teams can build interfaces where you can not only view your balances across various products but also use their features. You might find this useful as you explore more of DeFi.
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How Does DeFi Work?
DeFi uses cryptocurrencies and smart contracts to provide services that don’t need intermediaries. In today’s financial world, institutions act as guarantors of transactions. This gives them immense power, as money flows through them. Furthermore, billions of people worldwide cannot even access a bank account.
In DeFi, a smart contract replaces the financial institution in the transaction. A smart contract is a type of Ethereum account that can hold funds and send or refund them based on certain conditions. No one can alter a live smart contract; it will execute exactly as programmed.
A contract designed to deliver an allowance or salary could be programmed to send money from Account A to Account B every Friday. It will do so as long as Account A has the necessary funds. No one can change the contract to add Account C as a recipient to steal funds.
Contracts are public for anyone to inspect and audit. This means malicious contracts come under community scrutiny very quickly.
Currently, this means users must rely on the more technical members of the Ethereum community who can read code. The open-source community helps keep developers in check, but this need will diminish over time as it becomes easier to read smart contracts and as other methods for proving code reliability are developed.
Ethereum and DeFi
Ethereum is the perfect foundation for DeFi for several reasons:
- No one owns Ethereum or the smart contracts on it: this gives everyone an opportunity to use DeFi. It also means no one can change the rules.
- DeFi products all speak the same language behind the scenes: Ethereum. This means many products work together seamlessly. You can lend tokens on one platform and exchange the interest-bearing token in another market on a completely different application.
- Tokens and cryptocurrencies are built on Ethereum, a shared ledger: tracking transactions and ownership is Ethereum’s specialty.
- Ethereum offers full financial freedom: most products never take custody of your funds, leaving you in full control.
You can think of DeFi in terms of layers:
- The blockchain: Ethereum contains the transaction history and state of accounts.
- The assets: ETH and other tokens (currencies).
- The protocols: these provide the functionality, e.g., a service that enables the decentralized lending of assets.
- The applications: the products we use to manage and access the protocols.
Note: DeFi makes significant use of the ERC-20 token standard. Applications in DeFi often use the "wrapped" version of ETH, called Wrapped Ether (WETH).
Building DeFi
DeFi is an open-source movement. DeFi protocols and applications are all open for inspection, forking, and innovation by anyone. Because of this layered stack (all sharing the same base blockchain and assets), protocols can be mixed and matched to offer unique combinations and opportunities.
Frequently Asked Questions
What does DeFi stand for?
DeFi stands for Decentralized Finance. It refers to a ecosystem of financial applications built on blockchain networks, primarily Ethereum, that operate without central intermediaries like banks. These applications offer services like lending, borrowing, and trading in a open, permissionless manner.
Is DeFi safe to use?
DeFi carries risks like any emerging technology. Smart contract bugs and market volatility are potential concerns. However, the transparent nature of open-source code allows for community auditing, and users always retain custody of their funds, reducing counterparty risk. It's essential to research projects thoroughly and start with small amounts.
How do I start using DeFi?
To start using DeFi, you'll need a Web3 wallet, some cryptocurrency (usually ETH for Ethereum-based DeFi), and an internet connection. From there, you can connect your wallet to various DeFi applications to lend, borrow, or trade assets. 👉 Get started with DeFi basics
What are the main benefits of DeFi over traditional finance?
Key benefits include global access, no need for permission or trust in a central authority, full control over your assets, transparency of operations, and often higher potential yields on savings. Markets are open 24/7, and transactions can settle in minutes.
Can I really earn interest on my crypto?
Yes. Through DeFi lending protocols, you can deposit your cryptocurrencies into liquidity pools and earn interest. The rates are typically determined algorithmically by supply and demand and can often be higher than traditional savings accounts. Your earnings accrue in real-time and are visible in your wallet.
What is a smart contract?
A smart contract is a self-executing program stored on a blockchain. It automatically executes the terms of an agreement when predefined conditions are met. In DeFi, they replace the role of traditional financial intermediaries, managing everything from loans to complex trades without human intervention.