What Is DeFi? Understanding Decentralised Finance (2024)

Today, almost every aspect of banking, lending and trading is managed by centralised systems, operated by governing bodies and gatekeepers. Regular consumers typically need to deal with a raft of financial middlemen to get access to everything from auto loans and mortgages to trading stocks and bonds.

In Australia, regulatory bodies, such as the Australian Securities and Investments Commission (ASIC), set the rules for the world of centralised financial institutions and brokerages.

As a result, there are few paths for consumers to access capital and financial services directly. They cannot bypass middlemen such as banks, exchanges and lenders, who earn a percentage of every financial and banking transaction.

This also means that if someone does not meet the requirements set by the middlemen, they are locked out of these services. This affects those in geographical areas that are poorly serviced by local institutions but cannot access overseas opportunities due to strict rules, creating a severe disadvantage for people living in these areas.

DeFi challenges this centralised financial system by disempowering middlemen and gatekeepers, and empowering everyday people via peer-to-peer financial products.

Rafael Cosman, CEO and co-founder of TrustToken, says: “Decentralised finance is an unbundling of traditional finance. DeFi takes the key elements of the work done by banks, exchanges and insurers today—such as lending, borrowing and trading—and puts it in the hands of regular people.”

Here’s how that might play out. 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 difference profit.

With DeFi, people lend their savings directly to others, cutting out the bank’s take and earning the full 3% return on their money.

You might think, “Hey, I already do this when I send my friends money with PayPal.” 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 centralised financial middlemen to work.

Smart contracts on the blockchain allow this to happen in a trustless and pseudo-anonymous fashion, meaning neither party knows exactly who they are lending to or borrowing from. The smart contract ensures that the lender receives interest, and if the borrower violates the terms, the contract will automatically repay the lender using the borrower’s collateral plus take a fee to punish the borrower for the violation.

Blockchain and cryptocurrency are the core technologies that enable decentralised finance.

When you make a transaction in your conventional everyday bank account, it’s recorded in a private ledger—your banking transaction history—which is owned and managed by a large financial institution.

This differs from the blockchain, which is a decentralised, distributed public ledger where financial transactions are permanently recorded and available for anyone to verify.

When we say that blockchain is distributed, that means all parties using a DeFi application have an identical copy of the public ledger, which records each and every transaction in encrypted code. That secures the system by providing users with pseudo-anonymity, plus verification of payments and a record of asset ownership that’s immutable.

When we say blockchain is decentralised, that means there is no middleman or gatekeeper managing the system. Transactions are verified and recorded by parties who use the same blockchain, through a process of solving complex mathematics problems and adding new blocks of transactions to the chain. The only way the data on a blockchain can be changed is if the majority of these parties reach consensus on the change, whether that be the new transactions being added or old data, which would only be changed if a bad actor had control of the majority.

Advocates of DeFi assert that the decentralised blockchain makes financial transactions secure and more transparent than the private, opaque systems employed in centralised finance.

DeFi is making its way into a wide variety of simple and complex financial transactions. It’s powered by decentralised applications (dApps), also known as protocols Dapps and protocols handle transactions in the two main cryptocurrencies, Bitcoin (BTC) and Ethereum (ETH).

While Bitcoin is the more popular cryptocurrency, Ethereum is much more adaptable to a wider variety of uses, meaning much of the dApp and protocol landscape uses Ethereum-based code.

Here are some of the ways dApps and protocols are already being used:

• Traditional financial transactions Anything from payments, trading securities and insurance, to lending and borrowing are already happening with DeFi.
• Decentralised exchanges (DEXs) Right now, most cryptocurrency investors use centralised exchanges like Coinbase or Kraken. DEXs facilitate peer-to-peer financial transactions and let users retain control over their money.
• Non-custodial wallets DeFi developers are creating digital wallets that allow investors to take custody of their assets without the need of a third party, which allows them to access DeFi protocols..
• Stable coins While cryptocurrencies are notoriously volatile, stable coins attempt to stabilise their values by tying them to non-cryptocurrencies, like the US dollar.
• Yield farming DeFi makes it possible for speculative investors to lend crypto and earn tokens in return. This can be risky, as the token rewards can fall to zero as investors sell them but in some cases, they can also skyrocket and provide substantial returns. This activity also risks loaned assets in newer, untested protocols that may be susceptible to hacks if the code is not properly audited. y.
• Non-fungible tokens (NFTs) NFTs create digital assets out of typically non-tradable assets, like videos of slam dunks or the first tweet on Twitter. NFTs are unique assets on the blockchain, and can represent items like art, music or event real world items like property.
• Flash loans These are cryptocurrency loans that borrow and repay funds in the same transaction. Sound counterintuitive? Here’s how it works: Borrowers have the potential to make money by entering into a contract encoded on the Ethereum blockchain—no lawyers needed —that borrows funds, executes a transaction and repays the loan instantly. If the transaction can’t be executed, or it’ll be at a loss, the funds automatically go back to the loaner. If you do make a profit, you can pocket it, minus any interest charges or fees. Think of flash loans as decentralised arbitrage.

The DeFi market gauges adoption by measuring what’s called locked value, which calculates how much money is currently working in different DeFi protocols. At present, the total locked value in DeFi protocols is estimated to be nearly $US43 billion.

Adoption of DeFi is powered by the omnipresent nature of blockchain: The same moment a dApp is encoded on the blockchain, it’s globally available. While most centralised financial instruments and technologies roll out slowly over time, governed by the respective regulations of regional economies, dApps exist outside these rules, increasing their potential reward—but—also increasing their risks.

DeFi is an emerging phenomenon that comes with many risks. As a recent innovation, decentralised 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 toward regulation. Some of the other risks of DeFi include:

• No consumer protections DeFi has thrived in the absence of rules and regulations. But this also means users may have little recourse should a transaction go foul. In centralised finance, for instance, the Australian Government guarantees bank deposits up to $250,000. This means consumers are at least partially protected in the instance a bank fails. Moreover, banks are required by law to hold a certain amount of their capital as reserves, to maintain stability and cash you out of your account any time you need.
• Hackers are a threat While a blockchain may be nearly impossible to alter, other aspects of DeFi are at large risk of being hacked, which can lead to funds theft or loss. All of decentralised finance’s potential use cases rely on software systems that are vulnerable to hackers.
• Private key requirements. With DeFi and cryptocurrency, you must secure the wallets used to store your cryptocurrency assets. Wallets are secured with private keys, which are long, unique codes known only to the owner of the wallet. If you lose a private key, you lose access to your funds—there is no way to recover a lost private key unless you have set up a recovery process with a fragmented key.

From taking out the middleman to turning basketball clips into digital assets with monetary value, DeFi’s future looks bright.

Dan Simerman, head of financial relations at IOTA Foundation, a DeFi research and development group, sees both the promise and potential of DeFi as far-reaching, even though it’s still in the infancy of its capabilities.

He says investors will soon have more independence, which will allow them to “deploy [assets] in creative ways that seem impossible today.” DeFi also carries big implications for the big data sector as it matures to enable new ways to commodify data, Simerman says.

But for all its promise, DeFi has a long road ahead, especially when it comes to uptake by the general public. A large barrier to entry for everyday people is the complexity and risk of taking custody of assets in a world where it is more common to trust a third party to protect them. Once the industry works through these challenges, the flood gates will open and DeFi will see a large increase in adoption.

“The promise is there,” says Simerman. “It’s up to us to continue educating people about the potential, but we also need to keep working hard to build the tools that will allow people to see it for themselves.”