What is decentralized finance (DeFi) and how does it work?

What is decentralized finance (DeFi)? 

Decentralized finance (DeFi) is a financial system based on blockchain technology. It generally lacks centralized governance and formal regulatory oversight, instead often relying on community-driven protocols and decentralized governance mechanisms. 

DeFi relies on smart contracts. These are self-executing code on blockchains like Ethereum that facilitate trustless transactions. Early projects include Ethereum itself and protocols like MakerDAO, enabling decentralized stablecoins and lending.  

The defining characteristics of DeFi are the lack of intermediaries, peer-to-peer transactions, an absence of government or regulator involvement and accessibility of participation, although regulatory involvement is increasing in some areas. Other distinguishing characteristics include rapid innovation, personal responsibility and use of digital currencies and tokens for transactions and community-led oversight.

DeFi operates separately from traditional centralized financial systems. As DeFi develops, opportunities for collaboration and integration between the two systems are beginning to emerge. For example, some financial institutions within the centralized financial system are adopting DeFi integrations.

The most obvious benefits of DeFi are accessibility; anyone can access and use it, the speed of transaction and the rapid innovation of products and services. Risks include hacks and scams and technology issues associated with interoperability between protocols. 

When did DeFi start? 

The term ‘DeFi’ was coined in August 2018 during an Ethereum online developer chat. But decentralized finance had existed for some years previously. Arguably the first truly decentralized form of finance was Bitcoin, which was launched in 2009.

Around six years after Bitcoin, the Ethereum blockchain was launched, which provided a foundational layer upon which new and innovative financial infrastructure could be built. Early examples of DeFi infrastructure include MakerDAO, which created the DAI stablecoin. By 2020, new platforms including Compound, Aave and Uniswap had launched and gained widespread use. 

How does decentralized finance (DeFi) work?

DeFi relies on layered infrastructure that supports smart contracts and decentralized apps (dApps).

What are smart contracts?

These are self-executing digital agreements. The terms of the agreement are written into code that runs on the blockchain. They are based on a concept called ‘conditional logic’. If a pre-agreed condition is met, a pre-agreed thing happens. For example, ‘if the value of X = Y, you pay me Z’.

A smart contract has four elements; coding, writing the agreement into code; deployment, where the contract code is published to the blockchain; triggering, where the pre-agreed conditions of the agreement are met; and execution, where the action, such as a payment, happens automatically.

What are decentralized apps (dApps)?

These are software based apps that run on a peer-to-peer network, for example blockchain, instead of a central server. Because they’re decentralized networks, they tend to be more resilient to single points of failure, but security and regulation can vary .

Combined together, smart contracts and dApps provide the bulk of DeFi infrastructure. The architecture has three layers; blockchain (the foundation), protocols (things that happen) and interfaces (what the user sees).

The infrastructure supports lending, borrowing and swapping via decentralized exchanges (DEXs), automated market makers (Amms) and liquidity pools. Real world data comes from something called ‘oracles’.

The decentralized element allows for different types of financial services that are hard to access in centralized systems. For example, ‘flash loans’ allow users to access instant crypto assets without putting down collateral. 

What is yield-farming?

In DeFi, people who own cryptocurrency can lend or ‘stake’ their assets to liquidity pools in return for rewards. Users typically lend in pairs to facilitate trades. The more assets lent, the more rewards earned. By moving assets between platforms, crypto owners are able to collect these rewards in high volumes.

What is liquidity provision?

Liquidity provision is any process where a person organization increases the volume of liquidity in a given market by allocating their own assets. In DeFi it specifically describes the process of digital lending assets like crypto or tokens to a pool to facilitate exchanges and trades. Users receive fees for increasing the liquidity of a pool. This rewards the risk of lending the asset.

The key distinction between DeFi liquidity provision and traditional liquidity provision is that in DeFi, the liquidity pools require trading pairs to be deposited. For example, equal values of two different cryptocurrencies. This facilitates trading.

DeFi key characteristics

1. Permissionless and open access

There’s no eligibility criteria for accessing DeFi. If you have an Internet connection, you can participate in the DeFi system without restrictions. 

2. Non‑custodial execution via smart contracts

You’re always in control of your assets, distinguishing DeFi from centralized finance in an important way. While banks have the permission to stop payment, freeze assets and otherwise control your assets, this is impossible in a decentralized system. 

3. Transparency and auditability

Because of the public and open-source nature of blockchain, all transactions are available for anyone to view. This increases transparency and auditability across the entire network. 

4. Composability and modularity (‘money legos’)

Perhaps one of the most exciting possibilities that DeFi brings is the ability for all users to create new financial products and services. All protocols are interoperable. This means they can be pieced together to work in unison. And because the system is open-source, anyone can create new protocol combinations.

5. Governance via tokens/DAOs

DeFi users can earn a type of crypto called governance tokens through the protocols they complete within the DeFi system. Each token gives the holder voting power, meaning they get a stake in influencing decisions.

Digital autonomous organizations (DAOs) are the groups that form to vote and provide governance within the system. A DAO is a member-owned community with a decentralized structure and no leadership.

6. Interoperability across protocols

All DeFi protocols, such as lending, borrowing or generating interest on a deposit, are interoperable. This means that they can work seamlessly together, creating theoretically infinite possibilities for combining and layering. Examples might include parametric insurance products that pay out when the terms of an unrelated but connected transaction is met.

Decentralized finance (DeFi) strengths

The defining characteristic of DeFi is the absence of a centralized authority. It’s a self-governing system and with that, there are certain benefits. Let’s explore some of the major advantages.

1. Financial inclusion and global accessibility

Not everyone has access to developed banking systems and not all banking systems are stable or free from corruption. DeFi makes banking and financial services accessible to anyone, regardless of where they live or who they are.

2. Lower costs and faster settlement

The absence of intermediaries and regulators removes friction from the system and makes transactions quicker. They are sometimes instant. This also means that there are different operational cost structures. So in many scenarios DeFi offers a cheaper alternative to centralized banking too.

3. High yield opportunities 

Investors can get rewarded for participation in the system. By providing liquidity to the system in the form of cryptocurrency, DeFi participants can compound their rewards through yield farming and liquidity pools. 

4. Transparency and user sovereignty

No single organization or entity is in charge of DeFi. It’s democratic and open-source, meaning users are always in full control of their assets and are able to access the same information as every other participant. 

5. Programmable money innovation

Smart contracts foster creativity. DeFi participants are able to create unique and custom financial products and instruments to suit their needs and the needs of other users as they arise. This can lead to quicker problem solving and more immediate rewards for innovation.

Decentralized finance (DeFi) risks

No financial system is free of risk. Users make financial decisions based on their tolerance for the degree and type of risk on offer. Let’s explore some of the risks of participating in the DeFi system.

1. Smart-contract vulnerabilities and hacks

Smart contracts are open-source, which means code flaws can lead to hacks and exploits where users may lose their assets. And because there are fewer regulations and safeguards, this can lead to significant, sometimes unrecoverable loss of assets. 

Financial systems are only as strong as their security protocols. And while DeFi is designed to be resilient, it isn’t completely impenetrable.

2. Market volatility and impermanent loss

Crypto assets are significantly more volatile than the traditional assets governed by a centralized financial system. This means they can increase and decrease in value significantly and quickly. This volatility can create uncertainty and incentivize people to make decisions driven by loss-aversion, rather than slow and steady compound growth.

3. Regulatory uncertainty and legal exposure

While much of DeFi currently operates in a decentralized and lightly regulated environment , that doesn’t guarantee its freedom from interference indefinitely. Policies and laws may change and deregulated financial systems may come under the influence of governments and regulators, introducing cost, friction and limiting freedom.

4. User responsibility 

DeFi is still vulnerable to human failure. People can lose their private keys and become victims of scams, fraud and phishing. The system has many safeguards, but they are mostly focused on loss prevention rather than loss recovery.

Loss recovery is a characteristic of centralized and regulated financial systems and while it introduces additional costs into the system, it also enhances protections against human actions.

5. Composability risk and systemic interdependence

Composability is a double-edged sword. Using interoperability to create novel financial products is a benefit, but interoperability necessarily means that failures in one component can affect others. As more and more code is introduced into the system, the probability of failure becomes greater.

Most users see this as a challenge that calls for trade offs, with constant improvements in code security and vigilance to new risks.

DeFi use cases and examples 

Here we’ll explore some examples of how people use DeFi as a financial system.

Lending and borrowing 

Aave is a protocol for lending and borrowing cryptocurrencies through a liquidity pool. It has an associated token for governance. 

Compound is a similar protocol but it facilitates direct lending and borrowing of crypto between asset holders.

MakerDAO (now Sky/USDS) is a type of decentralized autonomous organization. It governs the creation and management of the DAI stablecoin. A stablecoin is a form of crypto that is pegged to the value of a fiat currency. DAI is pegged to the United States dollar. 

DAI is kept stable because it can only be lent against collateral and in some cases the collateral needs to be worth more than the value of the DAI lent.

Decentralized exchanges 

Uniswap is a decentralized exchange (DEX) on the Ethereum blockchain that uses liquidity pools. Users can swap cryptocurrency tokens directly from their digital wallets without using an intermediary.

Stablecoins

Stablecoins are backed by, or ‘pegged’ to a fiat currency, which gives their value more predictability. They offer some of the benefits of other crypto currency types, such as decentralized governance and open-source oversight.

Stablecoins maintain their pegged value through the requirement of collateral for lending, algorithms that simulate centralized financial markets by automatically adjusting their supply, or a combination of both.

Yield farming and liquidity mining

Asset holders can earn passive rewards and income by moving their crypto from place to place as it is needed within the DeFi system. Yield farming is more complex and exposes asset holders to more risks. Liquidity mining is less complex but tends to offer more modest rewards compared to yield farming.

Emerging areas

As a decentralized system, innovation and progress can be less constrained by regulation and scrutiny; people are free to build things on their own. Let’s look at some of the emerging applications of the DeFi system.

Decentralized insurance

Traditional insurance is based on a collective pooling of risk. This makes it suitable for use in the DeFi system. Instead of demonstrating a loss in order to claim, the insurance pool sets parameters which if triggered automatically issue the claim.

This removes the need for loss adjusters and claims handlers, making the insurance less costly and more efficient.

Tokenized real-world assets

By using the protocols and infrastructure of DeFi, users can sell, hold and trade digital versions of real world assets like property, art and financial instruments. This approach allows people to take a fractional share of an asset. NFTs are a form of tokenization.

Derivatives

DeFi allows users to speculate on the value of crypto assets within the system. It works in a similar way to centralized derivatives trading, in that the speculator often doesn’t actually own the asset. But there are no intermediaries like brokers. The trades are placed and executed using smart contracts which are automatically enforced when certain thresholds are reached.

DeFi vs traditional finance: What’s the difference?

The main difference between DeFi and traditional finance is the absence of a centralized authority and associated intermediaries. DeFi is a peer-to-peer system where participants can trade directly with one another. It is therefore quicker to complete transactions, generate value and create new products and services.

While not governed by a central entity, it isn’t a ‘wild west’ environment. Governance happens through a distributed system of tokens, smart contracts and protocols.

Centralized finance is familiar and tends to be well regulated. DeFi is relatively novel, but is accessible to people who may be excluded from mainstream financial systems.

What are DeFi dApps?

DeFi dApps are decentralized applications that run on smart contracts, rather than being operated by a financial institution that’s part of a centralized system. They provide similar levels of functionality, allowing users to trade, lend and swap assets. Users may need wallet integrations to secure access.

These decentralized apps are used in decentralized financial systems, gaming and digital asset ownership to give users the means to interact with the system.

DeFi ecosystem metrics & growth

Total value locked (TVL) is DeFi’s key metric. It describes the value of assets locked in the system. This amount will fluctuate as users move wealth between asset classes. TVL includes assets allocated into a variety of decentralized financial systems, including blockchain and dApps.

The value locked in a system is a relatively reliable gauge of trust and use. The more people that use a system and allocate assets into it, the more likely it is to reflect the confidence of its users.

Analysts predict that the total TVL of DeFi will increase in 2025. Factors influencing growth include economic fundamentals like the performance of fiat currencies, the stock market and whether interest rates are going up or down.

When the mainstream economy is underperforming, crypto assets become a more interesting investment by comparison. 

For example, if interest rates are increasing, investors may prefer the safe harbor of cash and fixed price investments. If interest rates are coming down, investors earn less on their savings and may look at alternative asset classes like Crypto.

Regulatory and legal outlook

The regulatory and legal outlook for DeFi is uncertain. That’s mainly because it’s hard to regulate a decentralized system. However, governments and regulators are looking at ways to gain a degree of control. For example, the European Union has two regulations; the Markets in Crypto-Assets Regulation (MiCA) and the Digital Operational Resilience Act (DORA). 

In the United States, regulators are looking at how existing laws might be used to cover decentralized systems, with money laundering being a growing concern.

Decentralized finance (DeFi) outlook

DeFi is still in its infancy compared to mainstream financial systems. One of the most interesting developments is the growing adoption of DeFi by mainstream financial institutions like investment banks. 

This may lead to greater integration between DeFi and traditional finance (TradFi), as institutions identify areas where the systems can converge.

As DeFi capacity for governance, interoperability and tokenization of real-world assets increases, the scope for participation will increase. Platforms like Crypto.com are already showing how DeFi and TradFi can work together, blending regulation and trust into a gateway for users to explore DeFi.

Ready to get started?

1. You can discover DeFi assets and tools on the Crypto.com App.
2. Sign up — secure and accessible on mobile or web.
3. Explore lending, stablecoins, and DeFi gateways.
4. Get Started with Crypto.com.

FAQs about decentralized finance (DeFi)

What is decentralized finance in simple terms?

It’s a financial system built on blockchain technology that operates without centralized power or governance. DeFi uses smart contracts which automatically create and execute agreements and transactions. The system facilitates rapid innovation and community-driven oversight and governance.

Is decentralized finance (DeFi) safe?

DeFi has security protocols that are subject to collective governance. It also promotes a culture of personal accountability and security, aimed at reducing risks associated with human behavior like hacking and key loss. That said, no financial system is 100% safe.

Is decentralized finance (DeFi) legal?

DeFi itself isn’t inherently illegal, but there are certain uses that may be illegal, depending on the jurisdiction. The challenge for lawmakers is identifying and controlling illegal behavior, which is hard due to the decentralized nature of the system.

How can you invest in DeFi?

The best place for new users to get started is to find a platform that provides access to DeFi while also delivering education and insights and guides to highlight common risks and mistakes. The Crypto.com app might be a useful starting point for someone looking at buying or trading cryptocurrency.

What is the difference between DeFi and crypto?

DeFi is the system that you use for buying and selling different digital assets. It’s based on the blockchain and relies on smart contracts. Crypto is a type of digital currency that you can use within a DeFi system. Types of crypto include Bitcoin, Tether and Solana.

What is an example of DeFi?

Uniswap is a good example of DeFi. It’s a decentralized exchange where participants swap tokens directly from their wallets, without the need for intermediaries. Another example of DeFi is crypto itself. Currencies that exist independently of centralized financial institutions are one of the earliest examples of the DeFi theory in practice.

Is Bitcoin a DeFi?

No, Bitcoin is a digital currency. But its creation was a pivotal milestone in the progression of DeFi as a system. Without cryptocurrencies like Bitcoin, it would be difficult for users to add and extract value from the DeFi system.

How are DeFi protocols governed?

Token holders vote on changes to protocols. One token is normally equivalent to one vote. Changes are governed through a centralized autonomous organization (DAO), which fosters community-owned development and progress.

How do I start using DeFi via Crypto.com?

Get started by downloading the Crypto.com App. Then:

1. Credit your account using existing crypto or fiat currency.
2. Lock CRO and join Level Up*
3. Spend globally with competitive exchange rates
4. Earn rewards on travel spending

Disclaimer: This is informational content sponsored by Crypto.com and should not be considered as an investment recommendation or advice. Staking rewards, fee reduction, and other benefits and rewards referenced in this article may be subject to change. Eligibility requirements, token holdings, and other terms and conditions apply and may change at the discretion of Crypto.com.