What Is DeFi? A Guide to Decentralized Finance

Decentralized finance (DeFi) is a revolutionary sector that harnesses blockchain technology to impact the financial landscape. By leveraging smart contracts and eliminating the need for intermediaries, DeFi empowers individuals with open, transparent, and accessible financial services. The norms of traditional finance face the threat of DeFi's features and possibilities. The promise of DeFi includes promoting greater inclusivity in financial markets and democratizing the status quo of our financial systems on a global scale. Learn more about DeFi and its benefits and drawbacks for institutions.

What is DeFi, and how does it work?

Decentralized finance, or DeFi for short, grants you open and decentralized financial services through blockchain technology.  DeFi utilizes public blockchain networks for its operations, with Ethereum being the most prominent platform. This structure is contrary to our standard financial systems today, which heavily rely upon the presence of intermediaries, such as banks.

At its core, DeFi utilizes smart contracts for automation and security purposes to ensure smooth financial transactions and all proper enforcement of rules and conditions set by the participants. Smart contracts reside in the blockchain code and operate as self-executing agreements. By using smart contracts as part of DeFi, the standard role of intermediaries within a financial system is no longer relevant. In this new setup, participants engage in financial activities directly with one another. This peer-to-peer interaction enables various DeFi applications, including lending, borrowing, trading, buying derivatives, and many more.

Read more: What Is a Financial Analyst? (+ How to Become One)

Who uses DeFi?

Any person or entity interested in borrowing, lending, investing, or trading currency outside traditional banking systems can use DeFi. By leveraging blockchain's transparency, immutability, and security features, DeFi aims to create a more inclusive, accessible, and efficient financial ecosystem. It gives individuals who face difficulties participating in the current financial system a chance to gain control over their assets and access important services related to their finances.

Benefits of DeFi

DeFi offers several advantages over traditional financial systems. Some key benefits include:

• Accessibility: No matter where you are on the earth, as long as you have an internet connection, DeFi allows you to access important financial services. Millions of people currently unable to utilize banking services would be able to benefit from them through DeFi.

• Transparency: Public blockchains record and store all transactions that occur through DeFi. This means anyone can access and view transactions, providing complete transparency of what occurred.

• Security: DeFi protocols rely on blockchain's cryptographic features, making them more resistant to fraud, censorship, and hacking attempts. Users typically hold their private keys, reducing the risk of funds being held by centralized custodians.

• Interoperability: DeFi projects often strive for interoperability, enabling seamless asset transfer and interaction across different platforms. This interoperability fosters innovation and expands the range of available financial services.

• Yield opportunities: DeFi provides new ways for individuals to passively generate an extra income stream. You can pursue this through various lending opportunities and staking. Participating in liquidity pools and yield farming are additional ways to make money involved in DeFi. These opportunities provide attractive returns compared to traditional savings or investment options, but the market is volatile, and returns are not guaranteed.

Drawbacks of DeFi

While DeFi offers several benefits, it is also essential to consider its drawbacks. Some of the key challenges associated with DeFi include the following:

• Complexity and user experience: The current DeFi ecosystem can be complex, especially for non-technical users. Utilizing DeFi often requires a basic understanding of blockchain concepts, which can present a barrier to entry. 

• Smart contract risks: Smart contracts are subject to coding vulnerabilities, and any bugs or loopholes are an opportunity for malicious actors to exploit, potentially resulting in financial loss. Auditing smart contracts for security and conducting thorough due diligence helps minimize such risks.

• Price volatility: DeFi primarily relies on cryptocurrencies as the underlying assets for various activities. Cryptocurrencies, known for their price volatility, pose risks for investors and users. You may experience drastic and unexpected losses or gains due to rapid price fluctuations in the market.

• Regulatory uncertainty: DeFi is a new and emerging industry that operates with little regulation overall. The lack of a clear regulatory framework promotes uncertainty regarding legal and compliance issues. 

• Scalability and cost: DeFi has been challenged by the scalability of blockchain networks, particularly Ethereum. If a network experiences high traffic, participants pay unusually high transaction fees. Addressing scalability and reducing transaction costs is critical for broader adoption and improved user experience.

DeFi vs. CeFi

Centralized finance, or CeFi for short, relies on centralized intermediaries at its core, such as banks, brokerages, and exchanges. This is the typical financial system you experience and are a part of today. A few key differences between DeFi and CeFi include:

• Control: DeFi gives users full control over their funds since they hold their private keys. In CeFi, users typically trust third parties to custody and manage their assets.

• Transparency: DeFi transactions are transparent and publicly verifiable on the blockchain, while CeFi transactions may lack the same level of transparency.

• Permissionless access: DeFi platforms are generally open to anyone with an internet connection, whereas CeFi platforms often have eligibility requirements, such as know-your-customer (KYC) procedures.

• Intermediaries: DeFi eliminates or reduces the need for intermediaries, whereas CeFi relies on centralized intermediaries to facilitate transactions.

• Regulations: CeFi operates within regulatory frameworks, whereas DeFi is still evolving regarding regulatory oversight.

Is cryptocurrency considered DeFi?

Cryptocurrency itself is not synonymous with DeFi, but some cryptocurrencies are integral to the DeFi ecosystem. DeFi applications often rely on cryptocurrencies as the native assets or utility tokens within their protocols. Cryptocurrencies such as Ethereum (ETH) are frequently used for numerous DeFi transactions, which include lending, trading, and liquidity provision.

However, cryptocurrencies have much broader use cases than just their role in DeFi. They have much broader applications beyond this concept in the world today.

Cryptocurrencies in DeFi enable activities such as lending and borrowing, liquidity provision on decentralized exchanges (DEXs), yield farming, staking, and liquidity pools. These activities often involve interacting with smart contracts and decentralized platforms without relying on traditional intermediaries.

Read more: How Does Cryptocurrency Work? A Beginner Guide

DeFi expectations for the future

The future of DeFi holds several possibilities and potential developments, including the following:

• Continued growth: DeFi has witnessed significant growth in recent years, which may continue. 

• Integration with traditional finance: The traditional financial systems used today and DeFi could combine to create one coherent system, including centralized and decentralized finance.

• Improved scalability and interoperability: These challenges are currently being addressed in various ways, such as layer 2 protocols to promote greater efficiency and overall usability and cross-chain bridges.

• Regulatory developments: As DeFi gains prominence, regulatory frameworks and guidelines will likely evolve to address consumer protection, anti-money laundering (AML) measures, and investor safeguards. This may bring both opportunities and challenges for DeFi projects.

Getting started in DeFi on Coursera

Decentralized finance, or DeFi, is a new type of financial management that relies on blockchain technology to provide people with the freedom to manage their own money away from more centralized finance options, such as banks. If you’re interested in learning more about DeFi or other areas of finance, completing a course or receiving a relevant certificate is a great place to start. On Coursera, you can enroll in courses that may help.

Check out Decentralized Finance (DeFi): The Future of Finance Specialization, offered by Duke University on Coursera. Suited for individuals with an intermediate knowledge of finance and some prior experience, this course provides a strong introduction to decentralized finance. It is entirely online and takes approximately four months to complete at a pace of two hours per week.

If you’re interested in learning more about this topic and diving into a more in-depth course, consider enrolling in Decentralized Finance (DeFi) Deep Dive offered by Duke University on Coursera. The estimated time to complete this intermediate-level course is seven hours and features flexible online schedules.