What Is DeFi?

Decentralized finance helps users buy and sell assets without a go-between, long wait times or high exchange fees.

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DeFi, short for decentralized finance, refers to services where users can make cryptocurrency transactions on a public blockchain without an intermediary like a bank or a broker. These peer-to-peer services take place through smart contracts on public blockchains, primarily Ethereum.

In DeFi, smart contracts — which are contracts coded to automatically run on a blockchain when their terms are met — replace most traditional financial services, allowing investors to exchange assets directly with one another and have complete control over each transaction. The system has its drawbacks, though. Because they lack regulation, DeFi applications can be manipulated or hacked and are more susceptible to volatility and scams than traditional markets.

Pros

Cons

Transparent, permission-free exchange.

Transactions are irreversible.

Keys and funds are privately controlled, unlike centralized exchanges.

Vulnerable to rug pulls and phishing scams.

Yield farmers can profit off of tokens or “earn yield” by shifting funds into different platforms and wallets.

Coding errors and hacks are common.

How does DeFi work?

Smart contracts

DeFi platforms run on smart contracts, which are generally created on the Ethereum blockchain and coded to automatically enforce their terms.

Consider this example: If you were selling a car, you could write a smart contract that stipulated that the car would belong to the purchaser once the purchaser transferred a certain amount of Ethereum coin, or ETH, to your account. Once the purchaser transferred the ETH, the contract would go into effect, giving the buyer ownership of the car. Because it would be on a public blockchain, with the code of the original contract permanently visible online, it wouldn't be possible to go back and make changes to the agreement.

In DeFi, smart contracts like these are used to make transactions and run applications on the blockchain. While these contracts are enforceable by law like other contracts, they're also pseudonymous — users interact with crypto wallet addresses rather than legal names — which can make them difficult to enforce.

Ethereum

There are several DeFi applications on various blockchains, but the Ethereum blockchain is currently the largest smart-contract platform. It has several decentralized applications, or Dapps, which are apps that operate through smart contracts.

Ethereum has dozens of DeFi Dapps available on its platform for borrowing, lending, payments and insurance. Many are experimental, as developers can use the blockchain’s open-source code to create their own platforms for financial services. Ethereum charges an ETH fee for the computing power needed to run transactions on its blockchain.

Stablecoins

Many DeFi platforms require the use of stablecoins, which can be traded for other coins. Stablecoins theoretically offer the advantages of cryptocurrencies without the price volatility by pegging their value to an existing currency, like the U.S. dollar, gold or another cryptocurrency.

DeFi platforms facilitate the trade of stablecoins without the structure of a bank or broker. Though stablecoins don’t earn profit through price appreciation, some platforms offer additional tokens on top of the interest they earn, incentivizing buyers to hold their coins. For example, popular platforms BlockFi and Hodlnaut offer stablecoins earning up to 7.25% annual percentage yield, or APY, compared to a typical interest rate of around 1.5% with a high-yield savings account.

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DeFi use cases

Decentralized exchanges

Decentralized exchanges, also referred to as DEXs, are peer-to-peer platforms where users can trade different cryptocurrency tokens (they don't generally accept fiat currency). This buying and selling method is called “trustless” within the blockchain, meaning that smart contracts facilitate transactions and set prices without third-party supervision.

DEXs on Ethereum’s blockchain let users trade thousands of different tokens, similar to a currency exchange. Since some tokens earn more interest, trading assets can be profitable.

Staking

Crypto staking is a way to earn passive income with cryptocurrency. It works by rewarding users for using their crypto holdings to validate new transactions on a blockchain network, but it comes with risks.

It's possible to stake crypto through online services like Coinbase and Binance.US. Or, you could become a validator, which requires an upfront investment and a computer with access to the internet. Investors can start staking Ethereum by depositing 32 ETH (worth about $57,000 USD as of this writing), which activates the validator software that allows you to start earning rewards. (Ethereum launched using a proof-of-work consensus mechanism — which requires mining rather than staking — but has recently shifted to a more sustainable proof-of-stake system.)

» Learn more about the Ethereum merge

While rewards for staking can be much higher than the interest you would gain from a traditional savings account or stock portfolio, many staking opportunities require an asset lock-up period, which can last months or even years in certain cases. Price swings and penalties can also result in losses.

Yield farming

Yield farming, also known as liquidity mining, is an advanced form of DeFi trading. Yield farmers can profit off of tokens or “earn yield” by shifting funds into different platforms and wallets, staking their assets to provide liquidity to other users and earn interest. (Liquidity mining is different from Bitcoin mining.)

This type of investment can be even riskier than traditional crypto investing, as it requires price predictions in a volatile market. To earn rewards, yield farmers need to lock up their assets, which can be hacked, lost or misappropriated.

Yield farming is a big factor in DeFi’s growth, as users continue to optimize returns on their investments by moving assets, despite the risk.

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