In this article, I will easily explain decentralized finance (DeFi), onboarding you to this world with easy language, a technical overview, and living examples so that you can already start using what you are learning about.
The decentralized economy (or finance) is a living economic ecosystem and sector directly interconnected with technology.
It embraces cryptocurrencies, blockchain, peer-to-peer networks, Web3, trading, investing, lending, borrowing, crypto payments, and earning passive income through yield farming or other decentralized applications (DApps).
In summary, DeFi permissionlessly connects independent systems, institutions, and individuals worldwide through finance-related activities, focusing on freedom, innovation, and digital property ownership.
We are all about DeFi, within all its branches and decentralized applications, here in define.money. Make sure you subscribe to our newsletter and access exclusive content on the topic.
What is Decentralized Finance (DeFi)?
Simply put, Decentralized Finance (DeFi) is the opposite of Traditional Finance (TradFi), which runs on centralized servers and is fully controlled by an elite of individuals, corporations, groups, or cartels (including the government).
Participating in TradFi usually also requires permission from the controlling entity. On the other hand, participating in DeFi does not. It is open and accessible for anyone to join without asking permission—in a “permissionless” environment.
Every financial activity taking place on decentralized and permissionless networks is DeFi.
From simply making a payment from one cryptocurrency wallet to another; to complex yield farming operations involving lending/borrowing or providing liquidity to automated market maker (AMM) platforms is DeFi.
Some simple DeFi examples
- Paying for a loaf of bread in the bakery shop using a cryptocurrency is DeFi;
- Using crypto to access the best paid AI models (like via NanoGPT) is DeFi;
- Buying gift cards with crypto on specialized platforms (like Bitrefill) is DeFi ;
- Receiving your salary payment in crypto is DeFi;
- Sending or receiving money abroad (remittances) is DeFi;
- Buying NFT-based tickets for an event is DeFi;
- Exchanging these tickets in secondary markets is DeFi;
- Betting on stablecoin-based prediction markets is DeFi;
- Trading in Decentralized Exchanges (DEX) is DeFi;
- Investing in tokenized Real-World Assets (RWA) is DeFi;
- Providing liquidity to a DEX Liquidity Pool (LP) is DeFi;
- Lending or borrowing money in decentralized protocols is DeFi;
- Opening spot long or short positions through borrowing is DeFi;
- Leverage trading through perpetual smart contracts is DeFi;
- Creating, collecting, buying, and selling digital art via NFTs is DeFi;
- Building a business on top of a decentralized network is DeFi;
- Staking native tokens to secure a proof-of-stake network while earning passive income is DeFi;
- Staking a token in a protocol for yield farming and boosting Annual Percentage Rates (APRs) is DeFi.
What is DeFi in crypto?
However, crypto-native people will often consider just a small part of these examples as DeFi, when talking about it.
Thus, you shouldn’t be surprised when you find out that the concept of “DeFi” is being used to describe a very specific sector of a feel protocol inside a broader ecosystem, which some experts are starting to describe as Open Finance (OpenFi).
Technically speaking, what makes DeFi decentralized?
There is no universal rule on what makes a system decentralized, as there is no consensus on the definition of DeFi. Overall, here in define.money we will ask three questions to determine whether we are looking at centralized or decentralized finance.
- Is the network permissionless?
- Is the software these nodes run open-source – i.e., Open-Source Software (OSS)?
- Is the ledger‘s state-change consensus distributed between two or more servers (or nodes) run by different individuals, corporations, or groups that will hardly conspire to take control?
A clear “Yes” for these three pillars will define a decentralized system.
If you find these “technicalities” too complicated, skip to the next session, where I Explain Like [I] You were Five Years Old (ELI5).
Adding some nuance to the equation, it’s easy to see how the third pillar is not all “black and white.” The more distributed the consensus (more nodes with a similar weight actively participating in changing the ledger’s state together), the more decentralized and secure a system is.
Basically, decentralization in finance is only possible thanks to the blockchain technology. This is because the blockchain behaves as a distributed ledger that changes every time money (or other assets) are moved around, from one account to another.
The blockchain exists to make sure a single entity can’t temper with this data, for example, with a double spend. Or to make sure a single entity won’t arbitrarily prevent others from making a valid spend themselves (censorship).
This is achieved through consensus mechanisms, where distributed validators agree upon the ledger’s state change following a set of rules (the protocol) determined by the software they are running on their servers (or nodes).
Moreover, the decentralization spectrum can go even further by, for example, decentralizing the software’s governance into Decentralized Autonomous Organizations (DAOs), which will decide upon a voting system in changes to the protocol (software) or treasury spending.
But this is content for another piece. Let’s now help you digest everything so far.
ELI5: Decentralized Finance easily explained
Buying stocks, launching a stock, holding or using digital dollars, making a credit card payment, taking loans, and similar activities are part of traditional finance.
If you want to do any of these things, you will usually need someone’s permission and a pre-approved account with a company that provides these services – and they had to get permission from a government to operate in the first place.
Your bank account balance will change according to your bank’s database and nobody, but your bank, can vouch for it. A major outage, a bank’s hack, or an arbitrary censorship would prevent you from using your money.
This can’t happen with decentralized finance.
Think of it as having a group of friends who make deals directly among eachother, following their own rules (which they agreed upon with), using their own coin (which can be, literally, anything), and keeping the records themselves of all financial operations. This is a decentralized ledger.
They can lend and borrow money from each other, they can launch a service for this group and sell shares to help funding it, they can even create each their own coins and trade among them.
Also, anyone can join this group, as long as they play by the rules (protocol). This is a permissionless network.
The rules, by the way, are writen in a notebook that anyone can read at any time and even make a copy of it in their own notebooks. If they want, they can take these rules and share with other groups of friends, who can then join the activities themselves. This is an open-source software protocol.
What is a crypto wallet?
To be part of the decentralized finance you can either be a nerd and run your own node, directly connecting to the network and all its possibilities, while following the protocol.
Or, like most people, you can connect to somebody else’s node through a DeFi (or crypto) wallet.
Essentially, the wallet will provide a seed or mnemonic phrase, which is what guarantees access to your account and funds. Just like a bank’s check or your credit card password.
Anyone with your passkey can spend your funds, and without them, you can’t do anything. Furthermore, the passkey is not limited to a wallet app. So, you can back up the seed or mnemonic phrase from your current app. Later, importing it to other compatible wallet apps, always accessing your funds from anywhere.
If there are no apps you like, just nerd-up and run your node using the passkey you have in a safe and fireproof backup.
I’ll write an article about the best decentralized finance wallets, as it will depend on which chain you are using. Then, I will explore the wallet’s advantages and disadvantages one by one.
Meanwhile, if you are new to DeFi and crypto in general, xPortal has a great onboarding experience. Besides focusing on security, they offer fun and engaging in-app gamification.
How to invest in decentralized finance?
There are a few different ways that one can invest in DeFi. The most popular and easy way is buying cryptocurrencies in centralized exchanges (CEXes) and holding them in a self-custody wallet.
Beware! Holding your assets under somebody else’s custody is not investing in decentralized finance. Self-custody is crucial if you want to be exposed to DeFi, so you had better learn it now.
For that, Binance and Kraken have a good reputation on the market.
Besides buying, you can get exposure to DeFi by earning cryptocurrencies in exchange for your work. These can be part of a personal investment portfolio or a company’s financial strategy.
Even big mainstream companies from TradFi have started adding crypto to their treasury accounts and balance sheets. MicroStrategy is one of the most famous cases.
Earning passive income and generating yield in DeFi
As you learn, you will find out other ways of investing in decentralized finance. Staking tokens is a popular intermediary way of earning passive income, while more advanced players can navigate through specialized DeFi platforms to generate higher yields using more elaborate strategies and opportunities, like lending and borrowing.
For example, if you purchased a native token of a proof-of-stake (PoS) blockchain, instead of just holding it, you could reserve a percentage of your portfolio to stake and benefit from the token’s issuance (supply inflation) and network fees.
With decentralized finance lending and borrowing, users can play the bank’s role. These platforms allow you to make your money work for you. Supplying tokens to automatic liquidity pools yielding interest from borrowers – all managed by open-source smart contracts.
These strategies, however, will be addressed in future articles.
If you enjoyed the content, consider subscribing to define.money‘s newsletter.
Leave a Reply