DeFi – how it works, and where is it heading?

Traditional financial systems have many flaws. Centralized control, lack of transparency, limited access, and a general opacity – all these features seem immanent to modern banking and make us look for valuable alternatives.

So-called DeFi (Decentralized Finance), along with various FinTech projects, seems like a great answer to the aforementioned problems. How does it work? And when it’s heading in 2023 and beyond?

 

What is DeFi?

DeFi stands for “decentralized finance” and comprises various money-related tools and services, such as decentralized exchanges (DEXs), decentralized lending platforms, or liquid staking pools.

It’s based on several primitives associated closely with crypto and the web3 world:

• The use of blockchain technology – enables transparent, trustless, and permissionless transactions between users.
• Mining (or staking) and consensus mechanisms – encourage network participants not only to use but also to govern various DeFi protocols.
• Smart contracts – provide DeFi projects with more features rather than ordinary peer-to-peer transactions.
• Decentralized applications (such as web3 wallets) – give people a chance to interact with complicated DeFi mechanisms in a convenient and user-friendly manner.

 

Why do we need decentralized finance?

However, is decentralized finance really needed when we still have a working and ubiquitous centralized banking system?

Well, the popularity of traditional finance doesn’t result from its perfection. DeFi emerged as an answer to many struggles that banking and people who use it struggle with on a daily basis:

• General centralized control. DeFi is decentralized by its nature (and name) and relieves users from all the problems related to having intermediaries and single points of failure.
• Lack of transparency. It’s challenging to assess what happens to our money when it’s stored on centralized exchanges, platforms, or accounts. DeFi apps are fully transparent, making tracking money and investments as easy as possible.
• Apparent “omnipresence.” As Europeans, we live in a financial bubble – making us think that everyone in the world has the same level of access to banking. However, over 1,5 billion people worldwide lack essential financial services and – mostly due to inefficient or nonexistent internet infrastructure – can’t use them. DeFi (especially when combined with blockchain-based internet solutions) provides people from less-developed countries with the financial democracy we all deserve.
• Non-interoperable systems. Moving money from one bank or another still seems like a bit of a struggle. By contrast, DeFi, built nearly entirely on one protocol (Ethereum), gives users tools to use their money quicker and, in the future, more efficiently.

Even though the majority of banking system users very much neglect these problems, there is a growing number of people who are looking for alternatives. And, as the traditional money infrastructure is likely to struggle in the future due to a lack of technological innovation, the growth and further development of DeFi becomes increasingly important for “ordinary” citizens.

 

How does DeFi work? 

As mentioned above, blockchain technology serves as a foundation of decentralized finance. Thanks to the use of distributed ledger, all the transactions we make using DeFi apps remain transparent, immutable, and indeed decentralized.

Blockchain also enables DeFi users to make payments and investments using cryptocurrencies instead of traditional fiat money. It significantly enhances the speed of transactions as well as their convenience. However, it can also raise costs due to high fees (especially on the Ethereum blockchain that dominates the world of DeFi). The good news is that it’s likely to change in the future.

However, it’s mainly the technological foundation and the general primitives of DeFi that differentiates this space from more traditional, centralized finance. Processes, on the other hand, resemble regular payments and transactions.

• People transact with each other – using decentralized web3 wallets instead of bank accounts.
• People invest in particular projects – buying tokens and cryptocurrencies instead of shares.
• People exchange their tokens – using decentralized exchanges instead of centralized ones.
• People borrow and lend money – from and to each other, instead of various (more or less trustworthy) institutions.

 

DeFi overview

The need to undertake the aforementioned activities in a trustless, decentralized manner led to the emergence of the real DeFi ecosystem comprising various financial apps.

Decentralized exchanges

DeFi is very much based on decentralized exchanges (so-called DEXs). They serve as primary means of exchange and take up a significant share of the money flowing through the space.

Such entities as Uniswap, SushiSwap, or GMX enable you to swap tokens in a truly decentralized and permissionless manner. We won’t get into details on how DEXs exactly work, but – in essence – they use automated market makers (AMMs) instead of traditional order books. This kind of mechanism significantly lowers transaction fees and improves liquidity for trading activities. Well, thanks to AMMs, you don’t need to trade with other people at all…

Liquidity pools

… what brings us to the second crucial pillar of the DeFi world. So-called liquidity pools (LPs) are basically vaults where you can deposit your coins in return for yield (similar to bank deposits).

Incentivizing people to deposit tokens serves as a crucial mechanism for DeFi. These coins are later used by mentioned automated market makers. If you want to swap one coin for another using a decentralized exchange, you’ll need to use one of the liquidity pools (instead of trading with other users). And the more coins are deposited in it, the easier and less risky the trade becomes.

 

Decentralized lending

However, DeFi enables peer-to-peer transactions as well, especially in the form of lending.

Imagine that someone would like to borrow from you $1,000 in cash. If you know this person and have a general idea of their financial situation, you’ll likely make an informed and rational decision on whether to give the money. However, it’s not always the case. And, even in such circumstances, you’ll need to trust this person.

DeFi makes borrowing and lending money trustless and safe. Thanks to decentralized lending platforms (such as Aave), it is possible to lend tokens only to people with enough collateral to repay the agreement. Depending on the conditions, money is locked in the recipient’s wallet and accessible only after “fulfilling the promise.”

Stablecoins

DeFi ecosystem wouldn’t be complete without alternatives not only to exchanges or bank deposits but also ordinary fiat money.

Stablecoins serve as web3 equivalents to popular currencies, such as USD or Euro. They enable to make various DeFi transactions with a reduced risk of volatility (as their value is pegged to traditional money). Thanks to that, you don’t always have to check price charts while interacting with DeFi. You can swap tokens, add liquidity, or lend money using the same currencies you know from the “real” world, albeit in a trustless and decentralized manner.

 

Web3 wallets 

And, after all, DeFi is not only about constant trading. You need a place – such as a web3 wallet – to store your tokens too. Obviously, it’s possible to HODL your cryptocurrencies on centralized platforms, but… what’s the point of using decentralized exchanges and protocols then?

Also, web3 wallets, such as Metamask, are required to make the majority of DeFi transactions (including basic token swaps). Therefore, if you want to join DeFi, start by creating a crypto wallet.

 

How to invest in DeFi? 

We are not here to give you any kind of financial advice, but investment opportunities in DeFi are nearly endless.

Obviously, you can buy tokens on decentralized exchanges and HODL them on your web3 wallets in expectation of future profit. It’s also possible to earn yields by providing liquidity to various pools.

Lending platforms offer opportunities as well – as you earn interest by lending tokens to different people. Ultimately, you can even invest in DeFi through staking – governing protocols by locking tokens is beneficial for both the project (as it becomes more secure) and stakers (as they receive rewards).

However, please bear in mind that nearly all DeFi investments are associated with high risk and volatility. Even stablecoins, which can also serve as a source of yields, are not invincible from market movements and unexpected events.

 

What is the future of DeFi?

Decentralization was at the core of web3 from its earliest days. And, as Bitcoin was designed to be a real alternative to the world’s traditional banking system, the biggest crypto purists would like to make this feature absolutely indispensable for the entire industry.

Over the years, however, the need for faster technological development and… greed for money made web3 much more centralized than intended. Centralized exchanges processed most crypto transactions, lending protocols became non-transparent, and institutional investments transformed many crypto projects into “traditional startups.”

The collapse of several centralized entities in 2022 (such as FTX, BlockFi, and Voyager) has shown that the need for trustless and decentralized financial services is higher than ever. Web3 users want to be the only custodians of their money and don’t require an external entity to take care of their investments. They need transparency and clarity over their funds – as if they’d like to rely on different primitives, they’d use traditional banking instead.

That is why decentralized finance will become only more and more critical. And, if the user experience of dapps and their security will still be improved rapidly, they’ll likely replace their centralized equivalents in the crypto space in the near future. With the goal of improving the entire money system not far away.