Tech Corner

What is Decentralized Finance? How does DeFi work?

Jeremy DSouza
.
Apr 19
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5-6 mins

Table of contents

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Decentralized Finance

Some consider Decentralized Finance to be an evolved version of the traditional, centralized financial system. Others look at it as a fad or a scam. But what is it, really?

What is Decentralized Finance (DeFi)?

Decentralized Finance or DeFi is a system that makes it possible for anyone to get access to financial products and services on a blockchain network like Ethereum without requiring middlemen and intermediaries like banks and brokerages to get involved. Essentially, anyone who can use a blockchain network (so, anyone who has access to the internet) can use DeFi. 

DeFi gets rid of the need for centralized institutions and authorities who could traditionally block your payments or deny access to certain things. It replaces them with direct, peer-to-peer relationships over the blockchain network.

These services are now more transparent because they are handled by code that anyone can inspect. DeFi creates an alternative system, not just another way to get into the traditional finance systems. 

How does Decentralised finance work?

Decentralized finance makes use of cryptocurrency and smart contracts (don’t worry, we’ll explain what those are) to enable financial services without the involvement of middlemen and intermediaries. 

There are several open-source protocols that are being made alongside blockchains. These are essentially creating the structure upon which DeFi functions.

For decentralized finance to work, it needs infrastructure and a currency. The infrastructure could come from the Ethereum platform which allows you to write decentralized programs and create smart contracts. You could even build dapps to establish financial services on the Ethereum blockchain. The currency used here could be cryptocurrency, but most cryptocurrencies are highly volatile. That’s where stable currencies (stablecoins) come into the picture.

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Smart contracts and dapps

Smart contracts are programs that are written and run on the Ethereum blockchain. They are a kind of Ethereum account. They have a balance and have the ability to send transactions over the blockchain network. But they aren’t controlled by a user. They get deployed to the network and run as programmed. They can’t be deleted by default and once they’re live, they can’t be altered either. Interactions with smart contracts are essentially irreversible.

You can use smart contracts to build and decentralized apps or dapps on the blockchain. These dapps can be built to establish financial services and smart contracts can autonomously manage them.


What are smart contracts?
Smart contracts (Source: iMi Blockchain)

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Stable currencies

The volatility of cryptocurrencies can be quite an issue for financial products and regular spending. But there’s a way around it - stablecoins.

Stablecoins are stable currencies that have their value pegged to another asset, usually a fiat currency. Let’s take the example of DAI. This is a decentralized stablecoin with its value pegged against the United States Dollar. It uses smart contracts on the Ethereum blockchain to keep the value of 1 DAI as close to 1 United States Dollar as possible.


types of stablecoins and examples of stablecoins
Stablecoin classification (Source: Footprint Analytics)

The governance of DeFi

Governance and decision-making at DeFi organizations is generally meant to be decentralized. They generally become independent of their developers as the project grows and eventually are governed by the community that makes use of it. 

The transition could be via it becoming a decentralized autonomous organization (DAO) that has rules and regulations embedded in programming code and could issue governance tokens, the holders of which get a voice in decisions.

Decentralized financial services

Online payments is just a small part of decentralized finance. DeFi also includes exchanges and has decentralized loans, insurance, and savings plans. These decentralized financial services can exist and operate in a fair and secure manner because of smart contracts and dapps on Ethereum. 

Some of the decentralized financial services supported by Ethereum are:

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Decentralized borrowing and lending

You can get a loan from decentralized lenders in two ways:

  • Peer-to-peerThis would involve borrowing directly from a specific lender.
  • Pool-basedHere lenders provide funds (liquidity) to a pool that you could borrow from.

With traditional, centralized finance, if you want a loan, the bank needs to know that you are likely to pay the loan back. With decentralized lending, however, neither party has to reveal themselves. The borrower just has to put up collateral to borrow the loan, and if the loan is not repaid, the lender will automatically receive ownership of the collateral. This is carried out through smart contracts. This makes it possible for you to borrow money without sharing private information. Some lenders even accept NFTs as collateral. 

A more interesting part of decentralized lending is ‘flash loans’. Here loans are taken and repaid in the same transaction, basically at the same time. If you want a basic example of this, picture someone borrowing a certain amount of an asset at one price and selling it on another exchange where the price is higher and then paying off the loan in a single transaction. The person taking the flash loan would then get to keep the profit minus the transaction fee. If the loan can’t be paid back, the transaction is reverted and it’s like nothing happened at all. 


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Decentralized exchange

There’s a wide range of cryptocurrencies and tokens available on Ethereum. You can use Decentralized exchanges (DEXs) to buy, sell, and trade these tokens whenever you want to. You won’t have to go through an exchange operator, there’s no need for ID verification. The markets are open 24/7, 365 days a year. The trades get executed autonomously and the terms and process are guided by smart contracts.


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Decentralized insurance

Smart contracts also enable peer-to-peer, decentralized insurance. Using the decentralized system you can get connected to anyone around the world who is ready to insure your assets. You can also choose to insure other people’s assets at a premium without needing to go via the route of insurance companies and agents. Smart contracts let this happen autonomously and make sure there is a fair, secure, and trustworthy process. 

What are the Advantages and disadvantages of DeFi?

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The advantages of DeFi

  • With cryptography and consensus algorithms, blockchains have achieved immutability. It’s not possible for anyone to manipulate any record on the blockchain network.
  • There is more transparency involved thanks to the distributed ledger and the fact that transactions and ownership can be easily verified.
  • It helps you get access to financial services without needing permission from centralized institutions.
  • It also makes peer-to-peer lending and borrowing easier and facilitates faster transaction settlement.


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The disadvantages of DeFi

  • There are software risks like bugs that could cause the software to malfunction and security vulnerabilities that could make it possible for hackers to steal funds from the protocol.
  • There is also the shared responsibility that comes when you don’t have intermediaries involved and users have to take responsibility for their funds and assets. This could work negatively for users. Decentralized Finance projects do not take responsibility for any of the mistakes that their users might make.
  • Decentralized Finance wallets need to be secured with private keys. But if you lose your private key, you can’t recover your funds at all.


Is DeFi a good investment?

DeFi could potentially be a lucrative investment, but there are risks involved. Obviously, there is the risk associated with the high volatility of cryptocurrencies, but there are also security and fraud risks involved. The smart contracts upon which DeFi protocols are reliant could also have vulnerabilities which some parties might exploit. 

Basically, even though DeFi might seem attractive, you need to be aware of the risks involved before you decide whether you want to invest in it.

Note: This article is not intended as financial advice or investment advice. 

Jeremy DSouza

Jeremy is a marketer at Engati with an interest in marketing psychology and consumer neuroscience. Over the last year he has interviewed many of the world's brightest CX, AI, Marketing, and Tech thought leaders for Engati CX.

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