TLDR: DeFi is short for "decentralized finance" and is an umbrella term for peer-to-peer financial services using blockchain technology that offer the potential for more transparent and fair financial systems.
DeFi, short for "decentralized finance," is an alternative banking system underpinned by the immutable ledger of blockchain. In contrast to our current banking systems, participating in DeFi does not require any centralized entity — such as a bank, lender or exchange. Instead, groups of computers known as validator nodes legitimize transactions that occur between peers around the globe, creating a public record on blockchain that cannot be erased. Traditional financial systems are commonly nicknamed "CeFi" (centralized finance) and "TradFi" (traditional finance.) In this article, we discuss the differences between DeFi and CeFi.
Traditional financial system are run by people, and those people can make mistakes or fall to greed and corruption. Banking customers like you and I aren’t always privy to what’s going on behind the scenes at a traditional bank, so we would never suspect anything is wrong, until things get really bad! Those of us who remember the 2008 Lehman Brothers crash likely understand how CeFi can go wrong. But more recently, the FTX bankruptcy was a case study in the dangers of centralizations. Customers couldn’t access their funds since FTX halted withdrawals, and worse — FTX employees allegedly used customer funds without their knowledge.
Here’s where the power of DeFi comes in, however: DeFi doesn’t rely on people, but rather employs the use of smart contracts, which are self-executing lines of code. Smart contracts are programmed to behave in a specific way, with the terms of an agreement between buyer and seller automatically verified, executed by a computer and recorded on blockchain's public record. Anyone can audit these contracts and actions since they are open-source, making this method of conducting finance a theoretically more trustworthy way than going through the bank. With DeFi, you can investigate the contracts and gauge risks by seeing how solvent a protocol is and make your own well-informed decisions on when and whether you want to take action on your assets.
Central banks offer many benefits, aside from their familiarity: They safeguard our money, they can reset our passwords when we lock ourselves out of our accounts, they provide us loans for real estate and assets and they are usually FDIC-insured up to at least $250,000 in the case of a bank collapse. But have you ever tried to send money overseas? How long did that take, and how much did that cost you? Or what’s the interest rate you receive in your savings account — maybe 1% to 2% if you’re lucky? And all of this is assuming one even has a bank account! Meanwhile, some 1.4 billion people around the world are still unbanked and don’t have access to basic financial services, including taking out a loan or sending money to relatives.
The technology behind DeFi removes the intermediaries in everyday financial transactions and enables anyone to become their own “bank”. With DeFi, one can now complete peer-to-peer transactions like borrowing and lending, and these cost savings and financial gains are passed on to the end users in the form of interest and yield (APY, or average percentage yield) instead of all the profits and control remaining with the central banks. In addition to the cost savings, financial gain and transparency, DeFi transactions move at a much faster speed because there are no mandatory 1- to 3-day waiting periods as there are with ACH payments and wires.
DeFi Summer describes the period around 2020 when the Web3 world saw a major uptick in DeFi activity. People were staking their crypto collateral and yield farming by lending their crypto, swapping from one protocol to the next and earning tokens for incredibly high returns. Some of these would prove to be unsustainable — one notable example is OlympusDAO which offered 7000% yields in its peak and then crashed by 99%.
While DeFi has a reputation among speculative traders for being lucrative, but volatile, there do exist a few newer, “boring” examples of how DeFi can make the average person's life better. One example is the concept of DeFi meets Real World Assets (RWA). This is where we take real world assets, such as a business loan or mortgage, and bring them on-chain while enabling the borrowing of money and taking out loans from a pool of lenders. To elaborate on this real world example, imagine a two-sided marketplace where on one side, we have people with money to invest (liquidity providers) looking for an attractive and safe investment (rather than leaving their funds in a savings account for that 1% to 2% interest). On the other side, borrowers are looking for loans and capital. Now let’s bring these two entities together with their complementary needs, match the liquidity provider with the borrower and join in a lending agreement through a secure, immutable, peer–to-peer financial transaction. Imagine this process happening more-or-less automatically through code, and voila! We have DeFi in action.
This example isn't just hypothetical. Open-source liquidity protocols that people can borrow from and "fork," or spin off, to create new projects do exist IRL to make this scenario happen. A well-known liquidity protocol is Aave, and last December a RWA pool called RWA market launched using the Aave protocol. Perhaps the coolest part of this launch is that Aave community members were involved in the process, as voting and governance are core tenets of DeFi.
Put another way, DeFi can improve access for everyone! Now the everyday person who is excluded from promising financial investments can invest in different DeFi protocols and receive a compelling yield and return on investment based on their risk appetite, and someone in an emerging market without access to loans can borrow from this new alternative capital supply. When a borrower pays back their regular interest payment on their loan, instead of this loan payment going to a bank, it can be distributed to the original lenders, resulting in extra income for the lender. And if the loans are issued in stablecoins, such as USDC, then the whole transaction is somewhat protected from crypto's volatility.
However exciting the potential use cases of DeFi are, it's important to remember that DeFi is an evolving sector. It offers potential to truly democratize access to finance for all, but it will take time to make DeFi and decentralized apps (dApps) more consumer-friendly. With this recent string of crypto crashes and failure of centralized entities and their blackboxes, the importance of transparent solutions like DeFi has never been more needed. If there was ever a time to double down on education and understand how DeFi is the solution to much of bankruptcy, corruption and contagion of 2022 — it’s now.
This is not financial advice. If you don't want to spend money investing in crypto or Web3 — you don’t have to. The intent of this article is to help others educate themselves and learn.
Po On Yeung is an avid community builder and an advocate for women in web3. Previously at Twitter, Coinbase and now Head of Community at Warbler Labs, contributing to the Goldfinch Protocol and participating in a number of DAOs.