If you’re interested in cryptocurrencies, NFTs, and other digital assets, you may find yourself wanting to take advantage of decentralized finance (DeFi) opportunities in the future. These open alternatives to traditional banking have taken off at a rapid rate in recent years, with more than $60 billion worth of cryptocurrencies invested into them so far, according to the latest data from Statista. At its peak in October 2021, DeFi held more than $100 billion in assets.
In this AAG Academy guide, we’ll look at what decentralized finance is, how it works, and why it’s so important.
DeFi is short for decentralized finance, the term used to describe a financial system based on secure distributed ledgers, much like those used for cryptocurrency. The use of the term DeFi dates back to 2018 when a group of software developers came up with an alternative to traditional financial services that is automated and built on the blockchain.
DeFi can be a little like a bank, providing a way to invest your money and earn returns, and borrow money when you need it. However, it is also free (for now, at least) from the laws and regulations that govern traditional banking and financial systems. It is also free from the control normal banks possess. DeFi is decentralized and powered by the blockchain — the same technology used by cryptocurrency — so no single person or entity has control over it.
This brings some significant advantages, like the ability to use DeFi options without a traditional bank account, and without the credit status required to use many of today’s financial services. However, there are some disadvantages, too. Without regulation, DeFi misses out on many of the protections traditional financial systems provide in most countries.
What is a DeFi wallet?
To be able to access DeFi applications and services, you need a DeFi wallet. Luckily for us, a DeFi wallet is actually the same thing as a decentralized cryptocurrency wallet, such as MetaMask, Trust Wallet, or the new AAG MetaOne Wallet. These provide access to digital assets — including cryptocurrencies and NFTs — and allow us to connect to DeFi applications.
The principal benefits of DeFi, which is also often referred to as “open finance,” are accessibility, reduction in friction, potentially higher returns, and lower fees.
DeFi shares many of the same advantages that we’ve come to expect from cryptocurrencies. One of the biggest is that anyone can access it, so long as they have an internet connection. It doesn’t matter where you live, who you are, or what socioeconomic position you’re in. You don’t have to prove how much you earn, you don’t need a good credit rating, and you don’t even need a fixed address. DeFi is open to everyone.
Another big advantage is that DeFi is, by definition, decentralized. It’s powered entirely by the blockchain and allows users to do away with the third parties that are typically involved when dealing with traditional banks and lenders. It’s also entirely open-source, so anyone can build DeFi products, which typically means a wider range of lenders to choose from — and greater flexibility.
While it’s not clear how much longer this will last, one of the additional advantages of DeFi is the potential to realize gains without taxation — in several countries at least.
How does DeFi work?
DeFi is enabled by blockchain technology, and most DeFi services use Ethereum. This allows the services, or decentralized applications (DApps), to be powered by smart contracts, which are essentially computer programs that run on the blockchain network. What’s unique about these programs is that, unlike most computer programs, they are entirely autonomous.
When certain conditions are met, the smart contract automatically executes the commands that have been programmed — be it for the transfer of tokens between addresses, or for other functions. This not only takes out any middlemen to reduce costs, but it also makes DeFi incredibly secure. No one can tamper with a DeFi transaction.
Furthermore, because all smart contracts are completely transparent and viewable on the blockchain, anyone can examine their code before using them to find out exactly how they work. That means there can be no surprises.
Today, many DeFi services allow you to invest cryptocurrency assets, earn interest, take out loans, obtain insurance, and lots more. To use them, you simply need a decentralized cryptocurrency wallet and some cryptocurrency assets to get you started. You can then connect your wallet to a DeFi DApp and start taking advantage of its services.
What are some examples of DeFi in use?
Here are a list of financial services that have been enabled by decentralized finance:
Decentralized exchange (DEX)
A decentralized exchange or DEX is an application that can be used to obtain, trade, and swap cryptocurrencies. They use smart contracts on the blockchain to automate these facilities, and they are open to everyone, unlike centralized exchanges. Some of the most popular DEXs are PancakeSwap, Uniswap, and SushiSwap.
AAVE and Compound are both DeFi lending platforms, which give users the ability to borrow cryptocurrency assets, or lend their own assets to others. AAVE and Compound can be used by anyone on the condition that the user must have an Ethereum wallet containing some funds.
Yearn Finance allows its users to earn interest or returns on the cryptocurrency assets they invest into it. The app is a yield aggregator that runs on top of Ethereum’s blockchain, and its users can deposit assets they don’t need right away into a Yearn Finance “vault” which uses a variety of strategies to generate interest on those assets.
Yes and no. Although there are some security benefits to using DeFi services — such as no middlemen and no centralized networks — there are also some disadvantages. For instance, if something goes wrong when using DeFi services, it’s very difficult to get help, and there are no financial regulations to protect you.
Although DeFi is still in its infancy, usage of it has been growing since 2018. It’s likely that will continue, assuming there are no significant changes to the way DeFi services operate — such as forced regulation — especially given the rise of Web3. But it is still too early to tell whether DeFi will become mainstream like traditional financial services.
DeFi is famous for its open lending protocol, which gives users the ability to borrow money in cryptocurrency assets. It is completely decentralized and powered by the blockchain, so it is transparent and typically more affordable. There’s also no need for a bank account or credit checks, so it’s much more accessible.
DeFi can also be used for other financial services, like obtaining insurance and even mortgages. And while cryptocurrencies are highly volatile, decentralized stablecoins can be a perfect alternative to traditional cash.
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About the author
Senior content writer
Senior copywriter for AAG Marketing team with the focus of educating our community on all things web3, blockchain and Metaverse.
This article is intended to provide generalized information designed to educate a broad segment of the public; it does not give personalized investment, legal, or other business and professional advice. Before taking any action, you should always consult with your own financial, legal, tax, investment, or other professional for advice on matters that affect you and/or your business.