What is Decentralized Finance? Definition and All You Need To Know

June 12, 2024

Decentralized finance is a non-traditional financial service offered on a blockchain network. It uses smart contracts to bypass traditional intermediaries like banks, brokers, and financing companies. It is “decentralized” because there's no single entity that controls the flow of financial services. Instead, operations are distributed across a network of computers (often called nodes). This makes them more resistant to censorship and central points of failure.

Five years ago, people already believe it yields higher returns than a regular savings account. New assets like tokenized gold and wrapped Bitcoin were also being developed. Even in 2024, the space is still relatively young. It's a growing industry with limitless potential. 

Like traditional finance, DeFi offers a wide range of financial services. This includes lending and borrowing, trading cryptocurrencies, and earning interest on savings. There are also complex financial instruments, like derivatives and defi insurance.

DeFi’s open nature allows anyone to freely access financial services without approval from a centralized authority. This is beneficial for those who don’t like the traditional banking system. According to Whiteboard Crypto, there are five pillars in DeFi. These are stablecoins, lending, decentralized exchanges (DEX), insurance, and margin trading. DeFi offers flexible solutions to contrast the limitations of traditional banking. In effect, international transaction fees and loan rates are much lower. 

Whether you're exploring DeFi or just curious, this article will define defi and all you need to know about it. It discusses what DeFi is, how it works, its key components, and defi protocols. 

How Does Decentralized Finance Work?

Decentralized finance works on blockchain technology. This setup ensures that all records, such as transaction data, are transparent and tamper-resistant. Each "block" in the blockchain contains several transactions. Every time a new transaction happens on the blockchain, it is added to the corresponding user’s ledger. 

These programs are stored on a blockchain that automatically executes transactions if certain conditions are met. They are the building blocks of DeFi applications. It automates complex financial transactions without a middleman. DeFi applications provide a variety of financial services. This includes loans, interest on deposits, trading in cryptocurrencies, and more. For example, you can lend your cryptocurrency and earn interest directly through a DeFi platform. The process does not need to go through a bank or a financial institution. Users directly lend money to other uses without a mediator. 

What are the Key Components of DeFi?

Decentralized Applications (dApps): These are applications that run on a decentralized network. It typically utilizes smart contracts to provide various financial services. There are over 4,000 dApps on Ethereum as of early 2024. The daily active users of DeFi dApps are estimated to be around 300,000. 

Smart Contracts:  These are self-executing contracts with the terms of the agreement directly written into code. Smart contracts automatically enforce and execute conditions without intermediaries. Over 1.5 million smart contracts were deployed on the Ethereum blockchain as of 2023. 

Blockchain Technology: It is the foundational technology for decentralized finance. Blockchain provides a decentralized and immutable ledger for recording transactions. It ensures all transactions are transparent and secured. Ethereum is the most popular blockchain for DeFi. It processes over 1 million transactions daily.

Decentralized Exchange (DEX): DEXs allow users to trade cryptocurrencies directly with each other. They use smart contracts to facilitate and secure transactions. The daily trade volume of DEXs in 2024 is around 2.5 billion. The biggest one is Uniswap that handles 40% of these transactions. 

Stablecoins: These are cryptocurrencies designed to maintain a stable value by being assigned to a reserve asset. These "assets" include the US dollar. Stablecoins handle over $100 billion monthly transactions within the DeFi ecosystem.

What is a Blockchain Technology?

Blockchain technology is a decentralized digital ledger that records transactions across multiple computers. The blockchain process ensures that data cannot be altered retroactively. This system is composed of blocks that are linked and secured with cryptography. Each block contains a cryptographic hash of the previous block. It has a timestamp and transaction data. 

The blockchain technology distributes copies of the ledger across an entire network. This makes it more secure and transparent because all transactions are visible to all participants. They are also permanently recorded. The security measure helps prevent fraud, tampering, and double-spending. 

Diagram of a blockchain network.

What are Decentralized Protocols?

Decentralized protocols are rules that dictate how data and operations should be managed without going through a central authority. Imagine a game where there is no single authority that decides the rules or outcomes. Here, the players in the game agree on the rules and make sure everyone sticks to them. They watch each other. If someone tries to cheat or break the rules, the other players step in and correct it based on their mutual agreement. This is the concept that decentralized finance follows. 

Decentralized protocols are the backbone of DeFi. It operates autonomously without human intervention because of smart contracts. It lets computers connect to a network and directly exchange information. Each participant holds a copy of the entire record and collectively validates the new entries. This approach makes transactions more transparent and secure. All data is made available to the public. It cannot be compromised or corrupted. 

Why Are Decentralized Protocols Important? 

Decentralized protocols are important because they make alternative financial services more accessible to the public. DeFi services enhances financial inclusion. They provide non-traditional financial services to the 1.7 billion unbanked people worldwide (WorldBank). Decentralized protocols make transactions less prone to fraud. Each is recorded on an immutable blockchain ledger. This reduces the chance of third-party corruption. 

What are the Ways to Make Money with Decentralized Finance?

DeFi Lending: Lenders make money through interest earned. They deposit assets into liquidity pools where others can borrow cryptocurrencies. 

Yield Farming: It is another way of making money with DeFi that earns rewards through tokens. The user deposits crypto into liquidity pools on decentralized exchanges (DEXs) and earns a portion of the trading fees generated by the pool.

Compound Returns: Yield farmers also make money by reinvesting their rewards. DeFi wallets and platforms reward liquidity providers with native governance tokens. These tokens are sold on the market or held for voting rights and potential appreciation.

Staking: Users earn by staking their cryptocurrencies in proof-of-stake (PoS) networks. For instance, Ethereum 2.0 allows users to stake ETH and earn an annual percentage yield (APY) of 5% to 20%. The actual value depends on the amount staked. 

Governance Tokens: DeFi investors make money by holding governance tokens. Some examples of these are UNI (Uniswap), COMP (Compound), and MKR (MakerDAO). These tokens can be profitable. UNI's value, for example, increased by 500% in 2021. 

Jake Call Makes Full Time Passive Income with DeFi Liquidity Pools

Jake Call makes full-time passive income with DeFi by investing in liquidity pools. He places high-utility cryptocurrencies such as Wrapped Bitcoin (WBTC) and MATIC into these pools, and earns fees from each trade. Jake makes 50%-60% APR despite the asset value fluctuations. 

To minimize risk, he borrows against his crypto assets and invests in stablecoin pools. This technique makes higher yields than the usual. He uses tools like the Builder Metrics Calculator to identify profitable pools. 

Aside from DeFi tools, Jake invests in DeFi courses to advance his knowledge. An example of this is Tan Gera's DeFi Masters. He grows his portfolio by reinvesting his earnings and aiming for long-term gains.

What are the Disadvantages of DeFi?

  • DeFi platforms are prone to cyber attacks. They lose over $10 billion to various types of fraud and theft. 
  • Decentralized Finance is relatively new, and it's still evolving. 76% of those surveyed by the Global Blockchain Business Council say it's the biggest hindrance to growth.  
  • Transaction fees on DeFi platforms are very high. Ethereum reached an all-time high of $70 in 2021.  
  • DeFi platforms can be difficult to use for the average user. The University of Cambridge found that it's the biggest issue of potential DeFi users.  
  • There's no centralized authority or customer support in decentralized finance. Users who lose their private keys or encounter transaction issues often have no ways to recover their funds. 

What is the Future of DeFi?

Cardano Foundation's Prediction on the Future of DeFi

  • Increased Integration with Traditional Finance: Traditional financial institutions will slowly adopt blockchain technology. This includes features like HD wallet infrastructure, to improve their internal processes before fully embracing DeFi. 
  • Integration of RWAs: Carbon credits and private credits will be integrated into DeFi ecosystems. This integration improves real-time data verification and asset tokenization.
  • Improved User Experience: DeFi platforms will develop intuitive interfaces and seamless interactions. It will be easier for new users to navigate. 
  • Advanced Blockchain Technology: Continuous advancements in blockchain technology help DeFi reach its full potential. 

CNBC International: Can DeFi Replace Traditional Finance? 

DeFi has the potential to upend traditional finance. But as of the moment, it is not yet ready to replace it entirely. DeFi has features that traditional finance does not offer. The barriers to entry are lower and transactions are significantly faster. Blockchain infrastructures are also more transparent and traceable. On the downside, DeFi is still in its infancy stage. It's prone to scams and mistakes. The good thing is that there are already steps to regulate it. In the meantime, investors should be cautious in using DeFi platforms.

Without a centralized authority, it will be impossible to recover lost funds. DeFi must overcome these initial challenges to compete against traditional finance. We should see DeFi as more stable and trustworthy in the coming years for it to become a viable alternative. 

My Long-Term and Scalable Alternative To DeFi Investing

My alternative to DeFi investing is local lead generation. It builds simple websites for local service providers like plumbers, electricians, and cleaners. This business is stable because there's consistent demand for leads from small business owners. Unlike DeFi, local lead gen is a proven business model. I've been doing it since 2014 and make consistent $50K monthly from my ranked sites. 

The business principle is simple: build and rank. Ranked sites are as valuable and prime real estate in the physical world. They generate leads on autopilot. DeFi investments are highly volatile, but the local lead gen business is stable and sustainable. It's the number one online business for me. I highly recommend it to those who want to explore virtual entrepreneurship. 

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Ippei Kanehara

$52K per month providing lead generation services to small businesses

Ippei.com is for digital hustlers, industry leaders and online business owners.

His #1 online business recommendation in 2024, is to build your own lead generation business.

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