What is DeFi?

DeFi (not to be confused with 'defy') stands for Decentralized Finance. It promises to revolutionize XXI-century banking. But what exactly does that mean? Let's define DeFi.

Decentralized Finance (DeFi) Definition

We'll start our introduction to DeFi with definitions. What is DeFi in simple terms? In a nutshell, it's a new financial system, somehow seen to counter the traditional finance system.

Everyday banking is an established part of our lives. Yet, bet you can list multiple issues connected with modern-day banking: tiny interest rates, high fees, never-ending paperwork ー you name it.

What DeFi does is it takes traditional financial products - such as lending, investing, and exchanging money - moves them to the blockchain and eliminates the centralized party (banks or regulators). How is that even possible?

How DeFi Works?

Three pillars of Decentralized Finance are:

• Blockchain Technology: with its tokenization, asset management, protocols, and applications.

Source: Arctic Wallet

• Smart Contracts: autonomous pieces of code that set the rules for blockchain operations.

Source: Arctic Wallet

• Decentralization: “De” in DeFi ー spreading out control across many different players as an alternative to a single third party in traditional finances.

Source: Arctic Wallet

Let's break down how these three components intertwine to create a better financial system.

DeFi vs. CeFi (Centralized Finance)

What problem is DeFi solving?

Traditional finance is entirely centralized. We have financial institutions that set the rules for how we interact with banks and use our money. If you want to get a mortgage, you go to the bank, fill up tons of papers, then banks take time to inspect if you have the money you say you have. Add a lot more friction and additional expenses because of that friction.

Source: Arctic Wallet

Decentralized Finance replaces centralized banks with computer code using the blockchain. Because of the way the blockchain is designed, it is hack-proof and trustless (trusting blockchain and cryptographic algorithms instead of trusting people and institutions).

DeFi operates on p2p (peer-to-peer) principles with no middlemen included, meaning you don't need to go to a bank to receive financial services.

Is Bitcoin DeFi, then? Bitcoin was designed exactly to avoid third-party services to exchange, buy and use money, but today's DeFi is so much more than this.

DeFi Application

Let's illustrate how Decentralized Finance really works by the borrowing, exchange, and custody mechanism it offers.

Source: Arctic Wallet

Lending & Borrowing

In DeFi, borrowing happens against crypto (say, Bitcoin) through DeFi protocols. DeFi protocol is a piece of software that operates on a self-running smart contract. Consider it a bank in cyberspace that nobody owns. This Smart Contract approves the operation automatically as your Bitcoin is on the blockchain. It's visible and easily provable.

One example of a DeFi platform offering borrowing and lending is Aave, which also suggests solutions for overcoming the volatility of crypto collaterals.

Exchanges

Liquidity mining in the traditional economy is provided by banks. In DeFi, blockchain participants directly provide exchange pairs and earn interest for doing so. Instead of banks charging fees, the ones who profit are system participants. In decentralized exchanges (DEXs), the software automatically matches buy and sell orders, again, without any intermediary.

The most popular DEXs today are Uniswap, dYdX, and PancakeSwap. These, apart from centralized exchanges such as Binance, Coinbase, and FTX that recently crashed, allow trading right from the wallet without taking asset ownership from you.

Crypto DeFi Wallets

DeFi Wallets is a massive topic. What is a DeFi Wallet? Explore in our guide.

Decentralized wallets like MetaMask, TrustWallet, and Arctic Wallet:

• give you full self-custody (you own your private keys and solely control your crypto)
• safely connect you with the blockchain world (Arctic Wallet, for example, has an in-built exchange, buy and sell services so there's no need to use centralized exchanges).

Thus, in the DeFi world, nobody is supposed to hold central power, abuse it, and manage your money for you.

Key Benefits of DeFi

Why is DeFi better than banks? Summing up, critical characteristics of DeFi that make it stand out are:

Inclusivity.

DeFi space is open to everyone 24/7. All you need to access it is a device with internet and a wallet set-up. This feature of DeFi helps to solve the "banking the unbanked” problem, especially in countries stuck in economic crises.

Source: Arctic Wallet

Non-centralized nature.

DeFi protocols run on blockchain technology and smart contracts rather than run by individuals. Data on the blockchain is stored on distributed ledgers rather than centralized servers.

Source: Arctic Wallet

Cost-saving.

As there's no intermediary, no additional service and transaction fees apply. The network fee (gas fee) is the only expense when you buy or exchange crypto.

Source: Arctic Wallet

Enhanced safety and speed.

Due to the security, permanence, and immutability of the blockchain. The absence of third parties and many levels of authority accelerates the process.

Source: Arctic Wallet

Transparency.

Every operation on the blockchain can be viewed by everybody on the block. Plus, blockchain makes forging financial data impossible.

Source: Arctic Wallet

Anonymity.

At the same time, DeFi detours private data exposure and KYC procedures.

Source: Arctic Wallet

Risks of DeFi

The crypto space is risky by nature. Hence, the cryptocurrency market volatility, phishing schemes, and wallet scamming activities can also threaten decentralized finance products. While the latter two come with a lack of crypto-security awareness, there is a bigger danger.

DeFi is not devoid of technology risks: smart contracts and consensus mechanisms should be programmed the right way; the ecosystem should be properly audited. The longer a project exists and functions and the more tested it is, the fewer these risks should be.

Bottom Line

The purpose of DeFi is to democratize banking and give people all over the world financial freedom. Without any intermediary, the finance world would become faster, cheaper to run, and more trustworthy. Does DeFi challenge traditional banking? Definitely. Will DeFi replace banks? At least, not in the foreseeable future. As of now, the system combining traditional finance and blockchain technology seems to be the most rational direction of financial evolution. And it is already happening.

Follow the Arctic Wallet blog for further DeFi insights. Get more educational content and crypto & blockchain guides.