By Ty Mezquita
A phrase that has been making waves in the financial world is Decentralized Finance (aka: DeFi). DeFi uses cryptocurrency and blockchain technology to manage financial transactions outside the control of traditional financial institutions such as banks, brokerage firms, and government-run exchanges. DeFi aims to parallel traditional, centralized institutions, call them mediators, with direct peer-to-peer financial relationships for loans, mortgages, and asset trading.
In the U.S., regulatory bodies like the Federal Reserve and Securities and Exchange Commission (SEC) set the rules for centralized financial institutions and brokerages; with Congress amending the rules after each financial fiasco (Savings and Loans crisis in the 1980s). As a result, there are few paths for some consumers to access capital and financial services directly. They cannot bypass middlemen like banks, exchanges, and lenders, who earn a percentage of every financial and banking transaction as profit. Outside of DeFi, we all have to pay to play.
DeFi challenges the centralized financial system by disempowering middlemen and empowering ordinary people via peer-to-peer exchanges.
“Decentralized finance is an unbundling of traditional finance. DeFi takes the key elements of the work done by banks, exchanges, and insurers today—like lending, borrowing, and trading—and puts it in the hands of regular people.”
– Rafael Cosman, CEO/Co-Founder of TrustToken.
Today, you might put your savings in an online savings account and earn a 0.50% interest rate on your money. The bank then turns around and lends that money to another customer at 3% interest and pockets the 2.5% profit. With DeFi, people lend their savings directly to others, cutting out that 2.5% profit loss and earn the full 3% return on their money.
You might think, “Hey, I already do this when I send my friends money with PayPal, Venmo, or CashApp.” But you don’t. You still have to have a debit card or bank account linked to those apps to send funds, so these peer-to-peer payments are still reliant on centralized financial middlemen to work.
Blockchain and cryptocurrency are the core technologies that enable decentralized finance. When you make a transaction in your conventional checking account, it’s recorded in a private ledger (bank transaction history), which is owned and managed by a large financial institution. Blockchain is a decentralized, distributed public ledger where financial transactions are recorded in encrypted computer code.
By blockchain being distributed, all parties using a DeFi application have an identical copy of the public ledger, which documents the transactions in encrypted code. Encryption secures the system by providing users with anonymity, verification of payments, and a record of asset ownership that’s virtually impossible to alter through malicious activity.
Through blockchain being decentralized, no middleman or gatekeeper is managing the system. Transactions are verified and recorded by parties who use the same blockchain, through a process of solving complex math problems and adding new blocks of transactions to the chain. Advocates of DeFi assert that the decentralized blockchain makes financial transactions more secure and more transparent than the traditional systems used in centralized finance.
Bitcoin is certainly the most popular cryptocurrency, but the Ethereum-based code is used in many other applications. See how DeFi is being used today all around you:
Most centralized financial tools and technologies release over time, governed by the rules and regulations of economies; but these exist outside of these rules, increasing their potential reward but also increasing their risks.
DeFi is an emerging phenomenon that comes with various risks. As a recent innovation, decentralized finance has not been stress-tested by long or widespread use. In addition, national authorities are taking a harder look at the systems it’s putting in place, with an eye on regulating the tools. Some of the other risks of DeFi include: