What is DeFi? How decentralized finance works

Decentralized finance (DeFi) started with the launch of Bitcoin (BTC) in 2009, which revolutionized global transactions by enabling peer-to-peer (P2P) exchanges without intermediaries. Today, DeFi goes far beyond simple P2P transfers, giving everyday traders access to financial instruments once reserved for industry professionals.

But despite its benefits, many remain unclear about what DeFi is and how DeFi services can enhance their investments. 

In this guide, we’ll explain the essentials of DeFi, its benefits, and how traders can use it to access a range of services beyond traditional finance.

What is decentralized finance (DeFi)?

DeFi leverages decentralized applications (dApps) built on public, permissionless blockchain networks that allow investors to engage in transparent trading, tokenize assets, issue stablecoins, and utilize yield farming – all without third parties like banks or brokers. 

Although Bitcoin pioneered decentralized finance (DeFi) by enabling peer-to-peer (P2P) trading, the growing demand for more sophisticated financial tools has accelerated DeFi's expansion. The advent of smart contracts – self-executing agreements that run on blockchain platforms like Ethereum (ETH) – has been pivotal in the rise of various DeFi applications. While Ethereum remains the leading platform for these decentralized apps (dApps), other blockchains, such as Binance Smart Chain and Solana, have also gained traction, thanks to their ability to support smart contracts and cater to the increasing complexity of DeFi use cases.

DeFi examples

DeFi has come a long way since the birth of Bitcoin. It’s evolved beyond simple peer-to-peer transactions, with decentralized applications (dApps) now leveraging blockchain’s transparency and immutability to power a wide array of use cases, from auctions to play-to-earn (P2E) gaming. Each of these applications addresses specific needs within the DeFi ecosystem, demonstrating the versatility and broad potential of decentralized finance.

Here are some noteworthy examples of DeFi:

• Stablecoins: Stablecoins like Tether (USDT) and USDC (USDC) are tied to fiat currencies, such as the U.S. dollar, to reduce market volatility. This makes them ideal for P2P and borderless payments and for holding value securely during periods of market fluctuation.
• Decentralized exchanges (DEXs): These platforms allow users to trade cryptocurrencies without the need for third-party intermediaries, using smart contracts for open, permissionless transactions. Liquidity providers can supply tokens to DEXs and earn a share of the trading fees.
• Prediction markets: In prediction markets, traders bet on the outcomes of future events. For instance, in a sports event, tokens represent bets on different teams. Buying a token is equivalent to betting on that team's victory. The collective wisdom of participants often leads to accurate forecasts.
• Borrowing and lending: DeFi enables traders to borrow against their crypto holdings, allowing access to cash without selling their assets. Lenders, on the other hand, can earn interest on their digital assets, making passive income from their investments.

DeFi and crypto: Pros and cons

DeFi offers numerous advantages, such as enhanced programmability, accessibility,  transparency, and cross-chain interoperability, but it also carries risks like security vulnerabilities, impermanent loss, and the potential for rug pulls. Here are some of the key pros and cons of DeFi:

Pros

• Programmability: DeFi thrives on smart contracts that automate transactions on blockchain networks, enabling developers to build complex DeFi services. Smart contract platforms like Solana (SOL) are among the leading cryptocurrencies due to their advanced programmability.
• Transparency and immutability: All DeFi transactions are publicly accessible, which fosters accountability and trust. Their immutability – meaning they cannot be altered once recorded – ensures they’re easily auditable, providing a permanent and reliable record for resolving disputes.
• Interoperability: Initially, DeFi platforms were confined to trading tokens within the same blockchain. For example, dApps on the Ethereum network could only trade Ethereum-based tokens. Today, advancements in cross-chain interoperability allow investors to use a single dApp for trades across different blockchains, enhancing flexibility and user experience. 

Cons

• Security: DeFi users face significant security risks, including hacking and phishing scams. Hacks occur when malicious actors exploit vulnerabilities in poorly written code, potentially leading to substantial losses. Phishing scams involve fraudsters impersonating trusted entities to steal sensitive information, such as wallet recovery phrases, which should never be shared with anyone.
• Impermanent loss: Impermanent loss occurs in liquidity pools, where crypto funds are locked in a smart contract to facilitate trading on a DeFi platform. If the values of the assets in the pool diverge significantly, the liquidity provider might earn less in transaction fees than they would have by simply holding the assets separately. (This loss is considered "impermanent" because it may be reversed if the asset values realign over time.)
• Rug pulls: DeFi protocols often include new coins with low liquidity, making them available to traders. Unfortunately, not all tokens have legitimate purposes. In a rug pull, fraudulent developers create fake projects, solicit investments, and then disappear with the funds, causing the token’s value to plummet to zero, leaving investors with significant losses.

DeFi safety tips

Despite the risks, traders can adopt several strategies to protect their assets on DeFi platforms. Here are three practices to help secure assets:

• Exercise caution and selectivity with wallets: DeFi hacks often exploit wallet vulnerabilities. To safeguard funds, carefully research wallets for robust security features like encryption and multisignature options before transferring assets.
• Use token security assessment services: For those not versed in reading code, services like CertiK or DeFi Safety can help identify potential vulnerabilities in token contracts by evaluating and scoring the trustworthiness of tokens across various blockchain networks.
• Consider DeFi insurance: Similar to traditional insurance, this covers risks common to crypto traders, such as hacks due to faulty code. Many DeFi platforms offer tokenized insurance products to help protect your assets.

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Disclaimer: This post is informational only and is not intended as tax advice. For tax advice, please consult a tax professional.