To put it simply, DeFi simply refers to the complete range of financial services including lending, borrowing, insurance, earning interest, etc. being decentralized. This is where DeFi gets its name—decentralized finance.
But this raises a couple of questions: What does decentralization mean and what does it mean for finance to be decentralized?
To properly explain what DeFi is, it helps to compare it to centralized finance (CeFi). And to do that, let’s take a step back and consider how Bitcoin is decentralized.
What is decentralization?
Unlike traditional fiat currencies issued and controlled by governments and central banks, Bitcoin is a cryptocurrency where no person, organization or government controls the amount of Bitcoin in circulation, can issue Bitcoin or control it otherwise.
In the case of US dollars, there is one central authority (the US Federal Reserve) that prints US dollars and sets interest rates, among other things. This makes the US dollar a centralized currency.
The absence of any such authority for Bitcoin is what makes it a decentralized currency.
It instead works through a set of self-governing protocols that no organization, or central authority, controls. You can learn more about how Bitcoin works here.
How DeFi decentralizes the entire financial system
Bitcoin enables people to transfer money around the world free of governmental interference or being blacklisted by financial institutions. But being able to move money is only one part of the broader financial system.
And just like fiat currencies such as the US dollar or the Euro are centralized, today our entire financial system and all of its services are completely centralized.
Whether you want to take out a loan, insurance, invest in stocks or invest your savings to earn interest, up until recently you have had to go through a centralized authority, usually a bank.
DeFi, however, decentralizes financial services in a similar way to how Bitcoin decentralizes money—by removing middlemen and having no central authority or organization in charge. All with the help of blockchains and smart contracts.
Why do we need DeFi?
Traditional finance, or CeFi, has plenty of downsides.
First there’s mismanagement. Banks and other financial institutions have far from a spotless record when it comes to properly managing the money people deposit with them. In the most severe cases, this has led to people losing their hard-earned savings.
Worse still, there’s outright fraud and corruption. This is an unavoidable possibility whenever you introduce a middleman as is required with traditional financial institutions.
DeFi, on the other hand, presents a number of benefits:
Everything is open
Because DeFi operates on pre-established and immutable protocols based on blockchains and smart contracts, you don’t need to go through an approval process to access financial services. You also don’t need to reside in a particular country, make an arbitrary amount of money a year or go through background checks. Everything is truly open to everyone.
While everything is open and transparent, you don’t have to hand over any personal information like your name, phone number or even email address. This gives you a good degree of anonymity when accessing financial services.
It is important to note, however, that it’s not completely anonymous.
All transactions that occur on the blockchain are publicly verifiable. This means that people can view balances in different wallets they don’t own and see where the funds are coming from and where they’re going.
That said, there is nothing personally identifiable with your public wallet, which makes it pseudonymous.
This is actually one of the biggest strengths of DeFi over traditional finance – that everything is publicly verifiable including the smart contracts underpinning DeFi services.
This further reduces the risk of fraud as everyone has the ability to verify that DeFi services are operating how they should.
There are no middlemen
Middlemen not only open up the possibility of fraud and corruption, they also charge fees for the services they provide. By eliminating middlemen such as banks and other financial institutions, DeFi also removes many of the fees associated with accessing financial services.
In addition to removing service fees, DeFi also lets savers earn higher interest rates on their deposits as well as borrowers access credit at lower interest rates.
This is again thanks to there being no middlemen to take a cut of these transactions as profit. Meaning that the savings are realized by the people accessing the services in the form of more favorable interest rates.
In comparison to large banks which have hundreds of thousands of employees facilitating saving and borrowing, DeFi protocols completely automate the process with smart contracts.
Services you can access with DeFi
Through the use of software known as dapps (short for decentralized applications) that typically run on the Ethereum blockchain, you can access a number of financial services including:
- Obtaining a loan
- Lending out your assets to earn interest
- Trading crypto assets
- Buying derivatives
- Depositing funds into a savings account to earn interest
In all of these cases, with DeFi you’ll enjoy much more favorable terms than you would with a traditional bank or financial institution. Including accessing better interest rates, no brokerage fees and not having to fill out paperwork or waiting to be approved.
Why DeFi is the future of finance
The open and flexible nature of DeFi democratizes the financial system so that everyone has equal access to financial services regardless of who they are or where they live.
This puts unprecedented power into the hands of individuals to control their financial future and puts the power traditional financial institutions have in check.
Regular people are now able to earn decent interest on their savings.
This is particularly attractive with current inflation levels and the next-to-zero interest rates banks are offering on savings accounts. Now DeFi presents people with an option other than going backward in real terms with their savings.
DeFi, with the help of stablecoins, also makes it possible for people to secure their funds in a stable currency when their national currency is losing value.
For a lot of people, this is much easier than the arduous process of trying to open a bank account in US dollars or another relatively stable currency like the Euro.
All of these opportunities DeFi unlocks for people and how it levels the playing field is why DeFi is growing in popularity and is around to stay.