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What is DeFi? Guide to Decentralized Finance (DeFi)

By Matthew Warholak · April 06, 2021 · 6 minute read

We’re here to help! First and foremost, SoFi Learn strives to be a beneficial resource to you as you navigate your financial journey. Read more We develop content that covers a variety of financial topics. Sometimes, that content may include information about products, features, or services that SoFi does not provide. We aim to break down complicated concepts, loop you in on the latest trends, and keep you up-to-date on the stuff you can use to help get your money right. Read less

What is DeFi? Guide to Decentralized Finance (DeFi)

DeFi, short for decentralized finance, is more than just a popular buzzword in the cryptocurrency sphere. It’s a concept that is disrupting the centralized financial services model, equalizing access and bringing more control to users across the globe.

In this article, we will cover everything a consumer might want to know about DeFi, including:

•   What is DeFi?
•   How does DeFi work?
•   How DeFi is disrupting traditional financial services
•   What’s a DApp?
•   Examples of DeFi DApps

What is DeFi?

DeFi is a blanket term referring to trustless and transparent protocols that don’t require intermediaries to operate. Traditionally, financial services and products have relied on centralized authorities such as banks, financial advisors, and clearinghouses. DeFi has reengineered this power dynamic to provide the same financial services programmatically without a central authority, thus reducing fees and making financial services and products more accessible to more people everywhere.

One way to better understand this concept is to look at the two parts of the term separately.

”De” = Decentralized

DeFi’s “de” stands for “decentralized,” or distributed control. By removing power from the hands of a few central authorities and distributing it across programmatic and autonomous code, DeFi transforms a previously centralized governance model into a decentralized one controlled by no one.

”Fi” = Finance

DeFi’s “Fi” is an abbreviation for “finance”—and more specifically, it refers to financial services. DeFi has disrupted traditional finance by transforming popular and long-standing financial services into decentralized versions without any central authority. DeFi offers an alternative to traditional financial services like the following:

•   Borrowing
•   Lending
•   Investing
•   Trading
•   Saving
•   Insurance
•   Crowdfunding
•   Crowdraising

DeFi has also enabled the creation of new financial products:

•   Cryptographic tokens: There are a number of these digital assets, one of the most common tokens is a “utility token,” which serves a specific function within a digital ecosystem. One example is the Basic Attention Token (BAT), which is used as payment for advertisers, users, and content creators on the Brave browser.

•   Non-Fungible Tokens (NFTs): These tokens transform digital images (for example, works of art, a tweet, a video clip, a GIF) into unique assets that can be traded on a blockchain.

How Does DeFi Work?

With DeFi, services and products are not subject to approval by a small group of decision makers but rather by smart contracts. Like traditional contracts, smart contracts contain information and terms regarding transactions between parties, but they are completely digital. They function like a small computer program stored inside of a distributed ledger known as a blockchain, a permanent and ever-growing record of information and transactions stored in individual blocks.

DeFi shares many aspects with cryptocurrencies, including the following:

Permissionless/Borderless

DeFi applications are permissionless—completely free of charge and available to anyone who wants to use them, the only requirement being an internet-connected smartphone or computer. Unlike traditional financial services, DApps don’t require lengthy applications to create an account, as users interact directly with smart contracts from their crypto wallet.

DeFi applications are also borderless, meaning they are country-agnostic and do not discriminate against users based on citizenship, geographic location, or government standing. Anyone can access funds on a DeFi app in one country, travel to another, and access their funds abroad without any restrictions whatsoever.

Transparent

DeFi applications are built on a blockchain network, a distributed ledger composed of smart contracts that stores transaction details as they occur and builds on top of them. Transaction activities become permanently cemented into the blockchain’s history of transactions across the entire network, while constantly updating it with new ones.

Because smart contracts and blockchain technology are designed to be permanent and publicly visible, transaction records cannot be hidden or altered thereafter. This allows all transaction activities to be visible to all market participants without violating privacy, because addresses are not directly tied to personal identities. It also allows anyone to audit the code and find bugs.

Trustless

DeFi recognizes and circumvents the trust problem of traditional finance by minimizing the need for third parties, banks, and clearinghouses. For most DeFi apps, users interact with self-executing smart contracts based on conditions being met, as opposed to waiting on approval from overseeing stakeholders.

Interoperable

Different DeFi applications (DApps) are designed to be compatible with each other, allowing DApps to be built or composed by combining DeFi products. This interoperability enables simple blockchain operation and a scalable ecosystem.

How DeFi is Disrupting Traditional Financial Services

Financial services such as borrowing, lending, and investing have traditionally been areas with a high barrier to entry, typically preventing people with little money or financial expertise from gaining access to these services. Though traditional banking is common in first world countries, there are over 1.7 billion people who are unbanked globally , representing over 30% of the human population, according to the most recent World Bank Global Findex report.

Domestically, 22% of US adults are underbanked or unbanked , according to the Federal Reserve’s most recent Report on the Economic Well-Being of U.S. Households. “Underbanked” means they have at least one account at an insured institution but also obtain financial services outside of the banking system such as money orders, check-cashing stores, payday loans, pawn shops, and more. The FDIC found in its 2019 “How America Banks” survey that 5.4% of US adults are unbanked entirely , having no accounts with any financial institution.

With the advent of DeFi, previously inaccessible financial services such as borrowing, saving, investing, and international payments are now accessible to anyone with access to the internet regardless of age, income, nationality, financial background, or credit score. To date, there are currently 3,809 DApps, with 140.59k daily active users.

What’s a DApp?

A DApp, or decentralized application, is a digital program that runs on a decentralized blockchain network without the control of a single authority. DApps are open-source and the basis for any cryptocurrency project; Bitcoin is considered the first DApp.

While the actual DApps themselves are typically ‘unownable’ services, DApps sometimes distribute underlying tokens that allow users to buy crypto.

DeFi applications can be built on any decentralized protocol but are primarily built on Ethereum, the premier decentralized blockchain network used for building new DApps which is powered by smart contracts and its native digital currency Ether. Ethereum enables developers to write smart contracts on the Ethereum blockchain which automatically execute when certain conditions are met. Smart contracts are then stored and executed across every node on the Ethereum network, making them decentralized applications.

The Ethereum DApps enable developers to build far more advanced technology than just trading cryptocurrency. Instead of needing to develop a new blockchain for every application, Ethereum created a secure platform for DApps to be built and deployed. Ethereum is one of the most popular blockchain networks and its native Ether token is the second-largest cryptocurrency behind Bitcoin.

DApps are similar to centralized applications but benefit from the features of existing on a decentralized blockchain network. Because they don’t have a single point of failure, they are thought to be more secure against cyberattacks. A distributed network of nodes maintains the network and prevents any system downtime common among centralized applications. DApps aren’t owned by anyone and aren’t subject to owner malfeasance such as embezzlement.

Examples of DeFi DApps

DeFi is a new space that only started to see the launch of live products in 2017 or so. Here are a few of the most popular types of DApps that emerged in 2020:

Borrowing and Lending Platforms

Securing a traditional loan typically involves submitting an application at a financial institution with ample personal information, agreeing to a credit check, pledging collateral (if necessary), and waiting for interest to be factored in by the intermediary for facilitating the loan that’s sourced by a federal institution. With DeFi, smart contracts connect interested lenders and borrowers, impose terms of loans, and impose interest without a third party. Lending DApps typically require collateral to be pledged in the form of crypto or stablecoins as a measure of insuring risk taken on by the lender. Through smart contract automation and elimination of a third-party intermediary, DApp lending platforms have formed loans with interest sometimes below 10 percent .

Decentralized Exchange (DEX)

A decentralized exchange (DEX) is an exchange that uses smart contracts to enforce trading rules, execute trades, and securely handle funds if necessary. Unlike centralized exchanges, DEXs don’t have an exchange operator nor do they require account creation, identity verification, or impose exchange fees. Because DEX’s are unique and don’t have a centralized authority, it is debated whether or not some or all DEX’s are subject to the crypto regulations enforced on centralized exchanges. Further, many DEX’s do not custody users’ funds at any point during trading, adding additional uncertainty as to the application of regulations. However, like any exchange, they do require liquidity to be able to match buyers and sellers.

Betting Platform

DeFi disrupts one of the most restricted and heavily centralized industries in existence: Gambling. In addition to an intensive and exclusive registration process, users of traditional online gambling platforms are subject to getting their betting limits lowered and accounts closed. With a decentralized peer-to-peer platform, this is not possible.

Several betting DApps have been launched as global betting platforms with no limits, allowing users to bet on traditional sports events as well as real-world events such as economics, elections, pop culture, and m
ore. Users can place bets using digital currencies and get rewarded in them upon winning a bet. Users buy or sell on a particular outcome of an event, with the DApp showing the current odds based on active user bets.

NFT Marketplace

An innovative DeFi development has been the launch of marketplaces for exchanging non-fungible tokens , or NFTs. NFTs are unique cryptographic tokens that represent digital goods such as online gaming goods and also tokenize real-world assets such as art, collectibles, company equity, and commodities. An NFT marketplace allows users to freely buy, sell, and trade NFTs representing otherwise non-fungible assets.

The Takeaway

DeFi is a term for the decentralized finance model that’s reengineering traditional financial services and products. By reallocating decision-making from central authorities to executable code within smart contracts, many financial services are becoming cheaper and easier to access for anyone.

As more DApps come online to reinvent old services for everyone, users can use and even invest in some DeFi projects. With a SoFi Invest® crypto trading account, you invest in crypto DeFi projects by buying cryptocurrency tokens.

Find out how you can invest in cryptocurrencies with SoFi Invest.



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