DeFi Meaning: How Decentralized Finance Works

“DeFi” is an acronym for “decentralized finance.” It refers to the growing array of platforms, cryptocurrencies, and protocols enabling average people and investors to engage in financial services without central authorities and intermediaries. As an example, most Bitcoin (or BTC) trades and purchases happen between two individuals or entities with access to the same blockchain. This is in contrast to traditional finance, in which many transactions require a third party bank or lender.

DeFi works by allowing providers and consumers to interact with each other via blockchain technology. Rather than use a bank as an intermediary, people conduct transactions with each other by trading their NFT or crypto assets on open-source blockchain platforms.

For example, suppose someone wants to purchase a new item with their cryptocurrency. These users would then verify this transaction as part of the same blockchain ledger. Once they do so, algorithms encrypt both the transaction itself and the currency the individual used to purchase it.

To increase the security of these transactions, many platforms offer smart contracts to ensure everyone walks away from a deal with what the other person promised them. Crypto staking—or verification—provides another level of safety and validation.

DeFi is revolutionizing the financial system one day at a time. Here are just some of the advantages you can expect from utilizing the technology:

• Direct connection: DeFi applications allow anyone with an internet connection to conduct financial transactions with another interested party. Rather than rely on a bank to facilitate these exchanges, both individuals and institutions can directly buy, trade, and sell from each other.
• Increased flexibility: Since anyone in the world can use DeFi technology, it offers users a far greater amount of choice than is common in traditional finance. For instance, you could reach out to vendors and lenders in different continents and countries to conduct direct transactions via cryptocurrency. In other words, your own national borders (and currency) need not prevent you from doing business with people internationally.
• More control: Banks can set interest rates and stipulations to control your money—with DeFi, you have the freedom to control your own currency. For instance, many DeFi enthusiasts engage in yield farming, a practice by which people rapidly transfer and exchange their assets to compound and increase their returns.

DeFi comes with a much higher degree of risk than traditional finance. Consider these disadvantages before jumping into the technology headfirst:

• Greater volatility: The financial products and assets people use in the world of decentralized finance are subject to a great degree of volatility. The total value of your cryptocurrency, as well as your access to liquidity, can plummet at a staggeringly fast rate. Proponents might say great risk comes with the potential of great reward, but critics insist great loss looms on the horizon for most DeFi enthusiasts as well.
• Lack of regulation: The DeFi ecosystem has yet to come heavily under the sway of regulators and watchdogs. For some, the lack of strict DeFi protocols and laws are a selling point to use the technology for financial transactions. For others, this lack of regulation makes the technology too much of a risk.
• Less security: Hackers might have an easier time stealing your decentralized digital assets than they would robbing a bank (either in person or online). Some blockchains are as secure as traditional financial institutions, while others will leave your derivatives and holdings exceptionally vulnerable.

DeFi has greatly disrupted the traditional financial system. Here are some of the key areas of difference between DeFi and traditional finance:

• Authority: In DeFi, there is no centralized exchange or central authority. Blockchains are mere ledgers, rather than institutions that set rules and regulations or lend out your own money at their own discretion. By contrast, banks—both private and central—rule the roost of traditional finance.
• Currency: DeFi predominantly utilizes cryptocurrency, while traditional finance uses fiat currency to enable transactions. To get the best of both worlds, some DeFi users invest in stablecoins pegged to the value of fiat currency. As just one example, the cryptocurrency Dai stays roughly at the same value as the US dollar (USD) at any given time.
• Scope: Decentralized applications (or dapps) allow users to access the peer-to-peer blockchain technology necessary to conduct financial transactions anywhere in the world. This enables people to avoid fiat currency exchanges across borders so long as they use the same cryptocurrency. Traditional finance has a smaller scope, only allowing such transactions with the exchange of one nation’s fiat money for another’s.

All investments and investment strategies entail inherent risks and introduce the potential for financial loss or the depreciation of assets. The information in this article is for educational, informational, and referential purposes only. Consult a professional investment advisor before making any financial commitments.

From the rise of blockchain technology to the dawning of NFTs and Web3, the world of cryptocurrency has undergone dynamic changes and continues to innovate. With the MasterClass Annual Membership, get access to exclusive lessons from Hunch cofounder Chris Dixon, Binance cofounder Changpeng Zhao, Coinbase’s Emilie Choi, and economist Paul Krugman to learn about the ever-changing landscape of cryptocurrency and its place in the global economy.