Decentralized finance (DeFi) is reshaping the financial landscape with a total value locked (TVL) of over $160B. But what is DeFi?
Unlike traditional finance (TradFi), where banks and other financial institutions control your money, DeFi lets you manage your finances through blockchain technology. This eliminates middlemen, offering greater control, transparency, and opportunities for passive income.
Today, platforms like Bitcoin, Ethereum, and Solana drive DeFi’s growth, with Solana’s TVL reaching 9.14B. Additionally, regulatory developments, such as Trump’s strategic Bitcoin reserve, are also positively affecting crypto and DeFi expansion through increased institutional validation.
In this guide, we’ll answer the question of what is DeFi, explore how it works, its key use cases, and why it’s growing rapidly. Whether you’re new to crypto or a seasoned investor, DeFi offers tools to boost your portfolio.
What Is DeFi?
Decentralized finance has emerged as a unique industry, offering freedom from centralized entities like banks and global accessibility. The current annual DeFi market growth of 8.96% CAGR shows there’s a bright future ahead, ripe with possibilities.
DeFi is an ecosystem of blockchain-based financial tools that allows users to lend, borrow, trade, and earn interest, all without intermediaries like banks.
Since it operates on public blockchains, like Ethereum, DeFi is decentralized and relies on smart contracts, which are self-executing bits of code that automate transactions when predefined conditions are met.
There are three core principles that govern DeFi. DeFi is:
- Accessible: Regardless of geographic location, anyone with an internet connection can participate.
- Secure and transparent: Anyone can review the transactions and smart contracts stored on the blockchain without revealing their identity.
- Autonomous: You control your funds without needing to rely on a central authority.
One of the key functions of DeFi is peer-to-peer (P2P) transactions, which occur when two people agree on the value of goods or services and exchange payment directly – no middleman is involved..
DeFi vs Traditional Finance: Key Differences
As decentralized finance continues to grow, it will continue to challenge TradFi. While both systems offer similar financial tools, there are several key differences to consider.
| Feature | Traditional Finance | Decentralized Finance |
|---|---|---|
| 🌍 Accessibility | Limited by bank operating hours and geographical location | Available 24/7 globally to anyone with an internet connection |
| 👥 Intermediaries | Relies on centralized institutions (for example, banks and brokers) to manage funds and data | Fully decentralized, automated by smart contracts, and user-controlled |
| 🏷️ ID Verification | Requires extensive know-your-customer (KYC) and anti-money laundering compliance | Often requires minimal identity verification, which can increase to access certain services or transact over certain amounts |
| 💰 Control | Intermediaries hold and control your funds | You have complete control over your assets and transactions |
| 🔍 Transparency | Operations are generally not transparent, with limited public access to internal processes | All transactions and smart contracts on the blockchain are publicly verifiable |
| 🔐 Consumer protection | Funds are usually insured (for example, by the FDIC in the US), but settlement can be slow | Funds are typically not government-insured, but third-party DeFi insurance may be available |
| ⏳ Speed/efficiency | Transactions can be slow, especially for large amounts or international transfers | Near-instant transactions |
While there are many benefits to DeFi, there are some risks. For example, it is susceptible to the crypto market’s notorious volatility. So, if the price of a cryptocurrency drops, the value of your tokens also decreases.
Also, while many smart contracts undergo audits, they are not completely immune to vulnerabilities or bugs, which hackers could exploit. However, transparency and ongoing code audits can help mitigate these risks.
How Does DeFi Work?
Decentralized finance uses blockchain technology to cut out intermediaries and smart contracts to automate processes. For example, instead of using a credit card with your bank as the middleman, you could pay for a cup of coffee with a cryptocurrency via a DeFi app and the transaction would be handled automatically.
In this section, we break down the core components of how DeFi works and how it can empower you to manage your finances.
The Blockchain
A blockchain is a decentralized digital ledger that records transactions across a network of computers (nodes). It ensures security and transparency by storing data in a series of interconnected blocks.
Here’s how it works:
- When you initiate a transaction, for example, sending Ethereum ($ETH) from your crypto wallet, it’s shared across the whole network.
- Validators (nodes) verify whether the transaction is legitimate by checking details like your wallet address and balance.
- Once validated, the transaction is added to a block, which is cryptographically linked to previous blocks, for a secure chain – the blockchain.
- You cannot alter a block without changing all the following blocks, making it almost impossible to tamper with the ledger.
This process ensures DeFi transactions are transparent, immutable, and intermediary-free.
Crypto Wallets
Crypto wallets are essential in the world of DeFi. They are software or hardware tools that let you transact with crypto on a blockchain. Unlike a traditional physical wallet, a crypto wallet doesn’t actually hold tokens. Instead, they store your private and public keys that give you access to your crypto and prove you own it.
Here’s what happens during a crypto transaction:
- Your wallet generates a digital signature with your private key, which verifies you own the crypto and authorizes the transaction.
- The transaction is then broadcast to the blockchain network.
- The validators verify the transaction.
- The blockchain ledger (and the recipient’s private key) updates, recording the new ownership.
The key ‘proves’ they now own the token, and the design of the blockchain means nobody can reverse the transfer.
Decentralized Applications
Decentralized applications (dApps) are programs installed on your device (computer, tablet, or smartphone) that run on a blockchain. Users can interact directly with each other rather than having to rely on an intermediary to facilitate the communication.
Developers nearly always use smart contracts in the program’s source code. Because smart contracts automate transactions between people (assuming all the conditions of the transactions are fulfilled), you don’t need to worry about whether the other person will honor their part of the transaction.
What Are the Main Use Cases of DeFi?
DeFi was originally developed to help unbanked populations access the basic financial services many of us take for granted. It has since grown into a huge industry with numerous use cases.
Here are some of the main ones:
- Lending & borrowing: You can lend cryptocurrencies to others to earn interest or borrow assets by providing collateral. The benefits include no credit checks and instant access.
- Trading on decentralized exchanges: Decentralized exchanges (DEXs) enable users to instantly trade cryptocurrencies directly with each other (peer-to-peer) without the need for centralized exchanges (like Coinbase or Binance) to hold their funds.
- Stablecoins: Stablecoins are cryptocurrencies that are designed to limit price volatility by being pegged to a stable asset, like the USD. You can send stablecoins like $USDC or $DAI globally, with low fees, making them ideal for remittances and payroll. For example, a freelancer in Asia can receive $USDC payments within seconds from a US client.
- Yield farming & liquidity mining: You provide liquidity (deposit pairs of tokens) to decentralized exchanges or lending protocols. In return, you receive fees from trades and sometimes additional ‘governance tokens’ as rewards, which you can then stake or use in other protocols for extra rewards.
- Asset management tools: These tools help you track your crypto portfolios, automate investment strategies, and optimize for the best yields.
- Derivatives: Through DeFi platforms, you can trade decentralized derivatives, which are financial contracts that derive their value from an underlying asset, which could be a real-world asset or another cryptocurrency.
- DeFi insurance: The platforms use smart contracts to insure against risks specific to the DeFi space, such as smart contract vulnerabilities.
Why is DeFi Growing So Fast?
DeFi is quickly establishing its presence among retail investors and financial institutions due to its speed, scalability, and potential for passive returns. But what are the key reasons for DeFi growth?
| High Yields | DeFi offers significantly higher returns than traditional banks. |
| Financial Inclusion | With 22% of the global population unbanked, DeFi provides access to financial services via a smartphone or the internet, often without requiring credit checks, extensive documentation, or a physical address. |
| Disillusionment with TradFi | Growing global inflation (about 4%) and concerns about bank stability is driving individuals and even institutions to explore DeFi for its potential benefits. |
| Real-World Asset Tokenization | This is when real-world assets like stocks, bonds, and real estate, are represented as digital tokens on the blockchain. The integration could bring trillions of dollars to decentralized finance. |
| Institutional Adoption | Financial institutions are actively exploring DeFi for faster settlements and new investment opportunities. For example, Blackrock and Visa are actively involved in tokenizing real-world assets, boosting DeFi’s credibility and adoption. |
| Technological Innovation | The DeFi ecosystem demands speed, low fees, and scalability, fostering an environment for rapid technical innovation. New projects constantly emerge to speed up transactions and reduce costs. |
| Regulatory Clarity | The appointment of pro-crypto figures like Paul Atkins as SEC Chair, who sees tokenization as an ‘innovation’ and Trump’s strategic crypto reserve suggests a more friendly regulatory environment and growing government recognition. |
| Tangible Adoption | DeFi shows real-world adoption. For example, Solana has over 1M daily gaming users, indicating a robust ecosystem and significant on-chain activity, including close to $9B TVL. |
How to Get Started with DeFi
Here’s the simplest way to get started with DeFi and reap all the benefits:
- Get a wallet: Download a DeFi-compatible crypto wallet (for example, Best Wallet) from Google Play, the App Store, or the official website and follow the installation instructions.
- Add funds to your crypto wallet: Buy crypto from a reputable exchange like Binance, or use Best Wallet’s integrated onramper for the best exchange rates and lowest fees
- Explore dApps: Use tools like DappRadar to find a dApp to start lending, borrowing, yield farming, or any other activity.
- Transfer crypto to the app: Once you’ve chosen your dApp, transfer some crypto to it to begin.
- Test with small amounts: Start small to get the feel for how the app works.
Challenges and Risks of DeFi
While there are numerous benefits to decentralized finance, DeFi – just like any other crypto or blockchain-related project – comes with its own set of challenges and risks.
| Smart Contract Vulnerabilities | While smart contracts are designed for automation and security, they’re not perfect. Hackers can exploit bugs or vulnerabilities in their code, leading to a loss of funds. However, reputable platforms and projects have their smart contracts audited by firms like Coinsult to limit these risks. |
| Regulatory Uncertainty | Globally, the DeFi regulatory landscape is still evolving. The lack of clear frameworks in many jurisdictions can create uncertainty. However, the increasing involvement of major financial players like BlackRock suggest there may be positive developments on the horizon. |
| Market Volatility | The crypto market is notoriously volatile. Price swings, such as significant gains or losses, can directly impact the value of your holdings and earnings. |
| Complexity for New Users | The sheer number of options and features within the DeFi ecosystem can be overwhelming for beginners. Each wallet and protocol has a distinct interface and learning curve. However, some platforms, like Best Wallet, are designed with user-friendliness in mind. |
| No Centralized Insurance | Unlike traditional banks and other financial institutions, DeFi platforms usually do not provide government-backed insurance. While there are some third-party DeFi insurance solutions, you are completely responsible for your funds. |
The Future of DeFi: What’s Next?
Decentralized finance is emerging as a transformative industry, offering financial autonomy, potentially higher returns than TradFi, and global accessibility. And the current market growth rate indicates a promising future for DeFi.
However, DeFi is still a young ecosystem, and there are numerous challenges it must overcome (such as regulatory uncertainties and broader acceptance) before it replaces traditional financial systems. However, these companies are not going to disappear without a fight, especially if there are profits to be made.
We’re already seeing some integration of TradFi and DeFi with the BlackRock and Visa experiments and other companies are tokenizing real-world assets, expanding DeFi’s scope.
Technological innovation could see DeFi and artificial intelligence joining forces, bringing advanced automation to trading strategies, while machine learning could significantly improve fraud detection and risk management.
FAQs
1. What is DeFi, and how does it work?
DeFi is a financial system that operates on blockchain technology, enabling lending, borrowing, trading, and staking without intermediaries. It uses smart contracts on chains like Ethereum to automate transactions and ensure transparency and accessibility.
2. How is DeFi different from crypto?
Crypto refers to digital currencies, like Bitcoin ($BTC) or Ethereum ($ETH), used for payments or investments. DeFi is an ecosystem of financial tools built on these currencies, enabling services similar to those you’d get from your bank, but without the centralized institutions.
3. Is DeFi safe to use?
DeFi is generally safe to use due to transparency and decentralization. However, there are some risks, including that smart contracts and platforms can be hacked, market volatility, and no FDIC insurance. Make sure you do your research and use audited platforms.
4. Can you make money with DeFi?
Yes, you can make money with DeFi. For example, you can lock your crypto in a wallet to support a blockchain network and earn rewards in return (staking). You could also lend your crypto to others and receive passive income in the form of interest. You can get into yield farming – provide liquidity to DeFi platforms and earn fees or new tokens a rewards.
