What Is DeFi?

DeFi stands for “Decentralized Finance”.

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What Is Decentralized Finance?

A decentralized system is when control is shared and distributed widely with no one entity in control. This is the opposite of traditional centralized systems, like banks, which concentrate power with a board of directors and shareholders.

“Fi” stands for Finance.

Defi is a distributed finance system run on blockchains.

What Is Wrong With The Existing Finance Structure?

The existing financial system is centralized.

This leads to inflexibility, interference by the state and high custody and service fees, which all adds to the cost. It can be opaque and relies heavily on the reputation of the entities involved.

It’s not all bad. It has various checks and balances to protect consumers.

DeFi eliminates middlemen as Defi is controlled by computer code in the form of “Smart Contracts”. The benefits are that costs are reduced, it is faster and transparency is increased. However, DeFi is largely unregulated. This means that there is little in the way of consumer protection should something go wrong.

What Is A Smart Contract?

A smart contract is a program stored on a blockchain that runs when predetermined conditions are met.

For example, if person X works on a project and delivers work item Z, then pay person X at the agreed rate Y.

Given the transparency,  and the immutable nature of the blockchain, the smart contracts are trusted by all parties as they can see the conditions outlined in the code. Once running, no one can stop the contract from executing.

In theory.

However, there have been instances where changes have been rolled back, the most notable being when a decentralized autonomous organization (DAO) was hacked. The Ethereum blockchain was eventually “hard forked”- meaning a major change was made to the system – in order to restore stolen funds.

Smart Contracts can also automate a workflow, triggering the next action when conditions are met.

What Are Examples Of DeFi Services?

Defi services mirror existing financial services.

These include:

  • Term deposits
  • Lending
  • Trading
  • Derivatives
  • Options
  • Payments
  • Wallets
  • Insurance

How Do I Use DeFi Services?

One of the main advantages of DeFi for those who hold cryptocurrency is the relatively high rates of interest being paid. DeFi services pay you significantly more than banks for holding your crypto, then lending it out to borrowers.

Here’s an example chart of lending and borrowing rates.

Sounds too good to be true?

There is a catch.

These services are largely unregulated, so you may have little comeback if these entities don’t meet their contractual obligations to you. The regulators are gunning for DeFi, which is not a bad thing from a consumers point of view.

Most legal experts expect government watchdogs to bring DeFi into their orbit. When it comes to Coinbase, Duke University law professor James Cox says the SEC’s assertiveness is actually overdue. Investors need a certain baseline of protection and disclosure, he says, and the threat to sue Coinbase is a message to crypto projects: Take a step back, because your activities likely aren’t exempt from oversight.

There is certainly significant potential for DeFi to reduce friction in financial markets.  Definitely an area to keep an eye on!

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