What is DeFi: Decentralized Finance Explained

One of the main criticisms of modern financial institutions is the extent to which they have too much centralized power. Traditional financial institutions such as banks act as intermediaries to facilitate transactions between parties. These institutions hold and manage the funds of their customers and charge fees for the services they provide, such as processing payments or lending money. However, traditional financial systems hold many limitations and drawbacks, such as high fees, lack of transparency, and susceptibility to censorship and fraud. This has led to the rise in demand for DeFi, meaning decentralized finance, and the emergence of cryptocurrencies. 

DeFi utilizes blockchain technology to create financial products and services that are open, transparent, and accessible to anyone with an internet connection, providing an alternative to traditional financial systems. In this article, we'll answer the question “what is DeFi?” and explain how it can solve the many issues of traditional financial systems.

What is DeFi?

The term "decentralized finance" (DeFi), also called Web3 or the decentralized web, describes financial applications and services built on top of blockchains like Bitcoin. These services aim to provide financial functionality that is similar to traditional financial institutions, but in a completely decentralized and open way. One of the primary strengths of blockchain technology is the ability to transfer and trade financial assets without the need for trusted intermediaries. As a subfield of blockchain, DeFi focuses on building financial technology and services on top of ledgers using smart contracts, aiming to improve transparency, control, and accessibility.

The Stacks ecosystem is one example of a DeFi platform, allowing users to manage their crypto through the Xverse wallet, stake their digital assets (called stacking), and provide channels for sending, swapping, buying, and selling coins without the influence of third parties. Other examples of DeFi applications include decentralized exchanges, stablecoins, and lending and borrowing platforms.

To understand the long-term potential and global impact of DeFi, we must first look at the limitations and issues embedded with centralized finance.

How DeFi Solves Traditional Financial Issues

In a conventional capacity, centralized finance (CeFi), also known as traditional finance or legacy finance, refers to financial systems and institutions that are centralized and controlled by a single entity or group of entities. It is the dominant financial system in most countries, and is characterized by the use of fiat currencies issued and backed by governments, and the reliance on intermediaries such as banks to facilitate financial transactions. 

In crypto, however, CeFi refers to centralized exchanges (CEXs), platforms that centralize the process of trading cryptocurrency. Some well-known examples of CeFi companies that operate CEXs include Binance, Coinbase, and Kraken.

There are several issues associated with traditional financial systems that DeFi crypto aims to solve, including high fees, delayed processing times, limited access, transparency, and censorship.

High Fees

Financial institutions often charge high fees for services like processing payments or exchanging currencies, with banks often charging high fees for cross-border transactions. Compared to traditional payment methods, DeFi has a lower transaction cost. The exact amount of the cost reduction can vary depending on the specific DeFi network and the type of transfer conducted,  but it can range from a 5-30% reduction.

Processing Time

Large financial transactions can take several hours or even days to be processed and settled through traditional financial systems, whereas with DeFi, the processing time is much faster.

Restricted Access

Many people do not have access to traditional financial services due to factors like location or lack of identification documents. This can limit their financial opportunities and make it harder for them to participate in the global economy. DeFi offers an alternative, as anyone with a cryptocurrency wallet and an internet connection can access DeFi services. 

Limited Transparency

Blockchain transactions are transparent and can be easily tracked using a blockchain explorer. This high level of transaction data transparency allows any user to view network activity.

Censorship

Centralized financial systems, controlled by a single entity or group, are susceptible to censorship and fraud. In contrast, DeFi, with its decentralized structure, is not controlled by any individual or governing body, reducing the risk of censorship.

Three ways to passively earn crypto with DeFi

DeFi offers investors a range of options to earn passive income, such as staking, lending, and yield farming.

1. DeFi Staking

If you're new to cryptocurrency, it's safe to assume that you've asked the question, “what is DeFi staking?”. Staking, also known as "stacking" on the Stacks network, is the process of holding a certain amount of cryptocurrency in a wallet or on a designated staking platform to support the validation of transactions on a proof-of-stake blockchain network. By staking their coins, investors can earn a percentage of the network's transaction fees and potential appreciation of the staked cryptocurrency.

2. DeFi Lending

DeFi lending is made possible by two key components: the immutability of blockchain transactions and the use of smart contracts. The blockchain's ability to record and secure transactions in a tamper-proof manner ensures that loan records are not fungible. Smart contracts (self-executing contracts written on the blockchain) provide the governing logic for transactions and enable peer-to-peer lending without the need for intermediaries like banks. Lenders deposit their digital assets into a smart contract-based liquidity pool, and borrowers can access these funds under the conditions set by the smart contract, such as loan principal, APR, collateral, and liquidation threshold. Instead of using traditional credit scores, DeFi lending relies on crypto-collateral - if the borrower fails to pay the loan, the smart contract automatically liquidates the collateral, ensuring the lender receives their principal without any need for off-chain enforcement.

3. DeFi Yield Farming

Yield farming is a process of earning interest or rewards by providing liquidity to a specific protocol or platform and depositing cryptocurrency into a pool with other users. The funds are then used to facilitate the execution of smart contracts such as lending or trading on a decentralized exchange. As a reward for providing liquidity, you earn interest on your deposited assets and a share of the transaction fees. 

How Can DeFi Benefit Society?

The use of DeFi offers several benefits, like accessibility, as anyone with an internet connection can access DeFi platforms, regardless of location. Additionally, DeFi allows for low fees, high-interest rates, security, transparency, and autonomy. Smart contracts published on a blockchain ensure that transaction records are available for anyone to review while maintaining anonymity. The decentralized nature of DeFi protocols provides added security and autonomy as it does not rely on centralized institutions, thus reducing the risk of adversity or bankruptcy.

What’s Next for Bitcoin DeFi Adoption?

The future of decentralized finance is likely to be shaped by factors such as regulatory developments, the emergence of new technologies, and the growth of the Bitcoin ecosystem. Another key trend in the DeFi space is the emergence of new technologies such as layer 2 scaling solutions, which will help to increase the speed and lower the cost of transactions on the blockchain. This will make DeFi more accessible and user-friendly for mainstream audiences.

One of the most significant trends in the DeFi space is the continued growth of the Bitcoin layers. With the Stacks Bitcoin layer and the introduction of sBTC, smart contracts enabling Bitcoin DeFi and instant Bitcoin payments make institutional adoption easier. There is a growing ecosystem of decentralized applications on Bitcoin attracting more investors and having a flywheel economic impact on the blockchain’s market value. This will lead to increased liquidity in the DeFi ecosystem and a wider range of financial products and services available to users.

Regulatory developments will also play a crucial role in shaping the future of DeFi as more governments around the world are beginning to take notice of DeFi and recognize the potential of the technology. To learn more about Bitcoin DeFi, read this article on why investors are looking to Bitcoin DeFi.