What is DeFi? A beginner’s guide to decentralized finance

The following statements do not constitute investment advice or any other advice on financial services, financial instruments, financial products, or digital assets. They are intended to provide general information. The following statements do not constitute an offer to conclude a contract for the purchase or sale of financial instruments and financial products or an invitation to submit such an offer and to buy or sell any particular digital asset. Cryptocurrencies are subject to high fluctuations in value. A decline in value or a complete loss are possible at any time. The loss of access to data and passwords can also lead to a complete loss

DeFi (pronounced dee-fy) is short for decentralized finance. It’s an emerging field that lets participants cut out the middleman and make financial transactions directly with others—and it’s quickly gaining in popularity as an alternative to traditional financial services. DeFi already lets you do most things offered by traditional banks and centralized financial institutions, with new products and transactions available each day.

So, let’s take a look at how DeFi differs from traditional forms of finance, how it relates to the blockchain, and its many uses—from currency exchange to lending digital assets.

DeFi refers to decentralized financial services on blockchains as opposed to “centralized” financial services provided through banks or other traditional financial institutions. It lets participants use cryptocurrency to provide most services that traditional banks offer with government-issued fiat currencies—lend, borrow, earn interest, trade assets, buy insurance, and more. DeFi services tend to be faster, cheaper, and more simple, with new advantages and services being offered each day. 

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Decentralized finance allows people to make transactions directly with other people using blockchain networks, rather than through centralized institutions like banks. This cuts out the middleman and makes financial transactions quicker, cheaper and more efficient.

With DeFi, you access your assets through secure digital wallets and enter into smart contracts to make transactions. This gives you access to a wide range of financial services, from peer-to-peer lending to trading via decentralized exchanges. DeFi is open to anyone with an internet connection, making finance far more accessible.

Centralized finance is the default financial environment in which the world currently operates, with payments, loans, and trading activity passing through third parties and middlemen that are heavily supervised by local regulators. Decentralized finance, on the other hand, delivers a whole host of advantages by enabling people to transact through financial applications via a blockchain network, cutting out intermediaries, such as traditional banking groups.

Eliminating middlemen naturally cuts costs and speeds things up, but DeFi also makes financial services much more accessible. In the world of centralized finance, not everyone is allowed to open a bank account or given access to specific financial services. DeFi therefore has the potential to financially empower billions of people around the world who are currently denied access to banking services.

DeFi also has the advantage of providing more flexibility, for instance with trading hours not being limited the way they are with centralized finance.

DeFi uses smart contracts that don’t require traditional financial institutions to act as guarantors for transactions—participants in the decentralized finance ecosystem instead transact with each other directly, and transactions are secured through blockchain technology. Most DeFi products don’t take custody of your funds, allowing you to remain in control of your assets.

Using DeFi, you access your funds or assets using a secure digital wallet. When you want to transact, you can initiate transactions through smart contracts, which means you and the other party agree to a number of specific conditions. For instance, a smart contract can be created to send funds to a particular account on a regular basis, and this will continue provided enough funds are available. Once a smart contract is set up, it cannot be altered, so funds can’t be re-routed and sent to a different account. 

Most DeFi applications are built on the Ethereum blockchain platform, though other platforms, like Cardano, Binance, or Solana, are quickly developing similar applications as well. DeFi is still in its infancy compared to centralized finance systems, so new applications are being released all the time.

As a blockchain platform that supports decentralized apps (dApps) and smart contracts, Ethereum is naturally suited to DeFi. The Ethereum blockchain maintains the transaction history and status of accounts while Ether and other cryptocurrencies are used as assets. Smart contracts are in-turn used by decentralized applications, giving way to new innovative smart contracts. As DeFi is an open-source movement, its protocols and applications are widely accessible.

Ethereum is known for its flexibility, enabling developers to build dApps with ease. This flexibility means there’s already a DeFi solution for most financial services, with the ongoing possibility of creating new, innovative financial products. Since so many DeFi applications are built on the Ethereum platform, many of these products can work together seamlessly.

Smart contracts are self-executing contracts on a blockchain. Each party to a contract inputs conditions that allow the smart contract to be fulfilled without the need for a central authority or middleman. Smart contracts use simple “if this … then …” statements written in code. They run automatically when previously established conditions are met. You can use them to do things like send funds to a particular account on a specific day.

Smart contracts are seen as a more secure, transparent, and efficient way for parties to transact with one another when compared to more traditional systems. They also tend to reduce costs, as expensive bureaucracy is eliminated. 

The Ethereum platform lets you send digital assets around the world seamlessly. While borrowing and lending are key advantages of DeFi, there are also applications for savings, where you can earn interest on crypto, trading opportunities, fund management, and insurance.

DeFi currency exchanges, or DEXs, are peer-to-peer platforms enabling traders to exchange cryptocurrency with one another. Not only do DEXs facilitate direct trading between participants, without a middleman, but users can maintain total anonymity. Traders typically have control over their wallets, and can access thousands of tokens via their private key. 

Tied to stable currencies like the US dollar or assets like gold, stablecoins aim to eliminate the elevated volatility associated with many cryptocurrencies. It means stablecoins tend to be better suited for everyday transactions than other highly volatile cryptocurrencies. Stablecoins are easy to transfer around the world, which makes sending large amounts of money more affordable and significantly faster. Stablecoins also allow users to earn interest.

Rapidly growing in popularity, DeFi lending allows you to lend digital assets to others while earning interest. Lenders can pool their assets with others, setting terms through smart contracts. Borrowers generally need to post collateral in digital currency to secure a loan. This means that borrowers can, for instance, access funds in a major coin such as Bitcoin, while posting collateral in a more obscure cryptocurrency. If you borrow through DeFi, provided you make the interest payments, you can access Bitcoin without having to sell your collateral. In some cases, you can even borrow an amount larger than the collateral you provided.

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Cryptocurrency is an exciting, dynamic area of finance but learning the basics is an important first step before you venture into this world. Continue your crypto journey with N26 and discover more about the opportunities and potential this field holds for you.