Decentralized finance, also known as DeFi, is an intriguing alternative to the traditional financial services industry.
DeFi aims to eliminate financial institutions and third-party middlemen in various financial services like lending, trading, and more. It also aims to make these financial services faster, significantly reduce fees, and eliminate barriers to entry.
So how do DeFi apps work, and how exactly are they different from traditional financial services?
How do DeFi Apps Work?
DeFi apps use “smart contracts” to facilitate trustless peer-to-peer transactions. These smart contracts allow users to conduct various financial transactions (like lending, borrowing, and trading) without the need to involve a third party – like a bank or PayPal.
These transactions are secured using blockchain technology, similar to that used by Bitcoin and other cryptocurrencies.
DeFi applications (or dApps) use cryptocurrencies (like Ether and USDC) instead of fiat currencies (like US Dollars) to conduct transactions.
To use DeFi applications, all you need is a crypto wallet and some cryptocurrency.
While the majority of decentralized finance applications are built on the Ethereum network, other networks like Solana, Binance Smart Chain, and Cardano are competing for their slice of the DeFi pie.
According to DeFiPulse, there is currently $27.21 billion total value locked (TVL) in the DeFi ecosystem at the time of writing.
What is a Smart Contract?
A smart contract is code that enables autonomous peer-to-peer transactions when specified conditions are met.
Smart contracts allow completely trustless transactions between complete strangers. The transaction only occurs at the time the smart contract confirms both parties have fulfilled their specified obligations.
Once transactions have been completed, smart contracts record the details of each transaction to a blockchain (a transparent, permanent digital ledger). This process helps ensure the security and accountability of transactions performed on DeFi applications.
While there are many competing programming languages, the most popular language used to create smart contracts today is Solidity.
The DeFi Application Stack
In normal applications, you only see and interact with the top layer. Under the hood, there are many complex processes and services required for the application to run properly.
Decentralized finance applications are no exception, though their technology stack is a little different. Here’s a simplified breakdown of how it all works:
- Blockchain layer: at the base level is the blockchain layer, which provides security and standards for the applications built on top of it. This layer consists of the blockchain network itself and the network’s native asset.
- Asset layer: the asset layer handles all the crypto assets and tokens on the native blockchain.
- Protocol layer: the protocol layer establishes standards and regulates smart contracts.
- Application layer: at the application layer, the user interface (UI) enables users to interact with smart contracts without knowing how to use a command line interface.
- Aggregation layer: at this layer, aggregators provide simplified access to various DeFi protocols and applications in one place.
How are DeFi Apps Different from Centralized Finance?
DeFi protocols aim to be better than their centralized finance counterparts in a few ways:
- Faster transaction processing – Cryptocurrency payments settle in just minutes compared to hours or days when using some traditional financial services.
- Much lower fees – Traditional financial services often charge hefty fees to wire money internationally. Cryptocurrency transaction fees are usually substantially lower.
- Higher interest rates – DeFi protocols often provide significantly higher interest rates on your funds than traditional financial institutions.
- No centralized party in control – Traditional financial institutions have the ability to block you from spending your money, or close your account altogether. With DeFi, no centralized entity or third party can prevent you from accessing the network or using your funds.
- Reduce / eliminate barriers to entry – DeFi applications don’t require ID confirmation or any personal information to register; all you need is a cryptocurrency wallet.
Staying Safe in DeFi
Unfortunately, the DeFi space is still very early and can lack some critical oversight and regulation. This has led to some major financial losses among investors, with scams, low-quality projects, and cash grabs running rampant in the industry.
The DeFi space can also be very complex, especially for newcomers. It’s important to understand the basics of cryptocurrencies, smart contracts, and other DeFi services before attempting to make any purchases or trades.
DeFi, and cryptocurrencies in general, can also be very volatile. For example, the Terra LUNA stablecoin recently made headlines after its price crashed 99.9% over 48 hours.
Always conduct your own research on any tokens, NFTs, or protocols before investing, and never invest more than you’re willing to lose.