Decentralised finance (DeFi) is an open financial system that operates entirely through the internet.
It uses blockchains and smart contracts to provide financial services like banking, trading, lending, insurance and payments.
It even includes services that you wouldn't normally think of as "finance", such as social media, marketplaces for music and art, gaming and advertising.
In this case, DeFi provides the transactional layer for users to buy, sell and interact with these Web3 services.
As opposed to traditional finance, DeFi is largely autonomous and typically operates peer-to-peer, reducing the need for intermediaries who control what people can and can't do.
It can also help drastically cut down the costs involved with using these services, as there are no "middlemen" to take a cut.
How does DeFi work?
Decentralised finance is a network of software applications that are able to interact with each other and that anyone can use. DeFi software is referred to as decentralised applications, or dapps for short.
This is radically different to the regular internet, where software is typically restricted if someone does not have permission to use it and most software applications don't interact with each other.
This interactivity is called composability and is one of the core features that makes DeFi fundamentally different to traditional finance. Composability refers to the ability for dapps to "plug in" to each other.
This means you can build more complex applications by connecting several together and has been likened to "monetary Lego".
Dapps can host things like banking services, financial markets and more run-of-the-mill financial services like insurance.
So for instance, let's say you wanted to build a new round-up app for investing, where the spare change from card payments goes into an investment account.
In the traditional financial system you would need to build or rent access to a number of different pieces of software to get your app to work. You might need bank accounts for your users, access to a payments network like Visa or PayPal, insurance, various licences and finally access to an investing platform.
To get this up and running would be expensive, complicated and time-consuming.
Alternatively, in a composable system of dapps, you would be able to plug in to each of those existing products for free or at low cost. All you would need to do is focus on building the new parts of the app and leverage the existing pieces of open-source software.
This is possible because most blockchains are decentralised, open-source networks. This means that there is no owner of the network, instead it is supported by a distributed network of nodes, known as validators.
Another feature of blockchains – and DeFi – is that all transactions on the network are authorised by a sophisticated network of computers, rather than humans or business entities. This makes it very difficult to cheat or defraud the system and provides certain assurances between parties.
DeFi vs traditional finance
In crypto terms, CeFi stands for centralised finance, which is the conventional way of doing things.
In CeFi we solve problems such as liquidity and matchmaking by entrusting them to a central authority, such as a bank, payment provider or financial services company.
In DeFi, these responsibilities are split up among different dApps.
What are the benefits of DeFi?
Security. By splitting everything up, the system loses many of its weak points and gets many redundancies.
Competitiveness. Because anyone can build dApps to integrate with other dApps and anyone can access this system, the market for providing financial services becomes very lean, competitive, innovative and consumer-friendly.
Virtuous cycles. The interdependence between dApps means they can keep driving value to each other and growing rapidly.
Novel applications. There are many things you can do with blockchain and DeFi that simply can't be done with CeFi.
Cost-effectiveness. Because dApps can offer services autonomously, they can also offer them at much lower cost than their centralised equivalents can.
Finder survey: How many Australians own cryptocurrency at different ages?
Response
75+ yrs
65-74 yrs
55-64 yrs
45-54 yrs
35-44 yrs
25-34 yrs
18-24 yrs
No
98.08%
92.59%
77.92%
73.84%
48.6%
48.4%
68.63%
Yes - For long-term growth
1.92%
5.56%
14.29%
16.86%
39.11%
36.7%
19.61%
Yes - for day trading
1.92%
0.62%
2.6%
5.81%
2.79%
5.32%
4.9%
Yes - for short-term growth
1.92%
1.23%
5.19%
8.72%
12.29%
12.77%
10.78%
Yes - to use it with blockchain application
0.62%
1.95%
0.58%
3.35%
1.6%
Yes - as a hedge against AUD or central bank currencies
0.58%
3.35%
3.19%
Source: Finder survey by Pure Profile of 1009 Australians, December 2023
A personalcryptocurrency walletand knowledge of how to use it safely. A combination of a hardware wallet for security, and DeFi wallet for usability, may be helpful for safely getting the most out of DeFi.
Some cryptocurrency, since it's the native currency of the internet. The vast majority of the DeFi ecosystem is found on the Ethereum blockchain, so a sizable amount of ETH tokens is helpful for paying gas fees. Fortunately, it's very straightforward to buy some ETH.
Features of the DeFi ecosystem
Automated market makers and liquidity pools
Automated market makers (AMMs) are at the core of DeFi. These are used by decentralised exchanges and lending platforms. They were invented by Uniswap creator, Hayden Adams, and are unique to cryptocurrency.
They work by having users – known as liquidity providers (LPs) – add funds to a pool of assets.
The pool is typically made up of 2 assets, but can include more.
Traders are able to buy or sell assets from the pool any time they like. The pool determines the price of the asset based on its balance in the pool (more on that in the example below).
This is different from a traditional exchange which uses an order book.
Order books require hundreds or thousands of buyers (takers) and sellers (makers) to simultaneously come together and make offers.
As a result, buyers and sellers dictate the price of assets with their offers, whereas an AMM dictates prices based on the balance of assets in the pool.
Another advantage is that AMMs can operate with drastically fewer users, provided there is enough liquidity.
In an ideal world, liquidity pools would maintain an equal 50/50 balance of assets which would keep prices stable and in line with the rest of the market (e.g. the same price as what you might see on Coinbase or Binance).
However, pools often become imbalanced over time as one asset becomes more popular to purchase than another. This causes prices to change and exposes liquidity providers to a unique risk called impermanent loss.
It is a bit like how supply-and-demand dynamics affect prices, but the big difference is that the price change is contained entirely within the pool.
So for instance, in a BTC/ETH pool, liquidity providers add both BTC and ETH to a pool.
A trader can buy either BTC or ETH any time they like.
But if traders are only interested in buying BTC and not ETH, then the pool will become imbalanced.
Within the pool, this will cause the price of BTC to rise, while ETH will fall.
When this happens, it creates an arbitrage opportunity, as the ETH in the pool is now selling at a discount (relative to the wider market).
Arbitrage traders then come along and buy the discounted ETH with the goal of selling it elsewhere for a quick profit.
This rebalances the pool, as the arbitragers had to deposit BTC into the pool in order to take ETH out of it. Prices return to the market average for both BTC and ETH as a result.
AMMs and liquidity pools help eliminate many of the overheads required by a classic exchange or marketplace. With a little bit of computer code and some liquidity, anyone can create a marketplace for any 2 assets.
Normally you would need to set up a business, apply for licences, be subject to regulation and need to attract buyers and sellers to provide capital.
Furthermore, AMMs operate 24/7 and are trustless – buyers and sellers never hand over ownership of their funds to a "middleman" like an exchange. This can help prevent events like FTX – where executives mismanaged user deposits – from ever occurring.
AMMs and the decentralised exchanges that use them are a cornerstone of DeFi.
Decentralised exchanges
A decentralised exchange (DEX) is a non-custodial exchange that runs on a blockchain.
That's a bit of a mouthful. Essentially it means that users can trade cryptocurrencies directly with other users, straight from their wallet. Users maintain ownership of their assets at all times and don't need to trust that a third party – like a centralised exchange – will keep them safe.
This is done through the use of automated computer code called smart contracts.
Another common feature of DEXs is that they can be governed by a decentralised autonomous organisation (DAO) which allows token holders to have a say in how the platform is managed. Tokens can be earned by using the platform or purchased on the open market.
Decentralised exchanges create a more equitable financial system by granting greater autonomy and control to users. The same technology could one day be applied to traditional stock exchanges or banks.
On the other hand, because of their decentralised nature, anyone can use a DEX without needing to provide ID or pass a Know Your Customer (KYC) check. This means that they can be used for fraudulent activities such as money laundering. As such, they live in somewhat of a legal grey space and are occasionally the target of law enforcement.
How is a DEX different from a centralised exchange?
For a quick rundown of the key differences between centralised and decentralised exchanges, check out the table below.
Centralised exchange
Decentralised exchange
Trading
Conducted through the exchange
Conducted peer-to-peer
Control of funds
Exchange controls your coins and tokens
You control your coins and tokens
Anonymous trading?
No
Yes
Hosting
Centralised servers
Distributed network
Prone to hacks?
Yes
Yes
Subject to government interference?
Yes
No
Account withdrawal limits?
Yes
No
Decentralised autonomous organisations (DAOs)
As the name suggests, a decentralised autonomous organisation (DAO) is an organisation with no fixed leadership. It is collectively owned and managed by its members.
Membership is granted through ownership of a DAO token. These tokens may be issued as a reward for participation with the underlying protocol or can be simply purchased on the open market.
DAOs are an essential part of DeFi and critical to keeping systems decentralised, while still allowing groups to come together and make decisions democratically.
The degree to which a DAO governs something – like a DeFi protocol – is on a spectrum.
Some protocols are managed entirely by their DAO and require the DAO to vote on-chain before any actions – like code changes or the movement of funds – can be performed.
Others may use a DAO in conjunction with a private entity that owns the protocol. The owners may then make proposals which the DAO can then vote on.
Many DAOs allow the delegation of votes, so that token holders can choose someone to vote on their behalf.
DAOs are typically managed on-chain, which is how voting, proposals and changes are enforced.
The first-ever DAO was created by Ethereum engineer Christoph Jentzsch for the purpose of creating an investment fund that could be managed collectively by its members. In return for depositing funds to the DAO, members received a token which granted them voting rights in the DAO.
How cryptocurrency and DeFi work together
Cryptocurrencies are digital tokens for use in DeFi ecosystems. The best known are Bitcoin and Ether (the native resource of the Ethereum blockchain), but beyond them there are countless more, including many created for use in specific dApps.
The main cryptocurrency and token types include:
Governance tokens. These entitle holders to participate in the governance of a dApp.
Admission or gas tokens. These are used as access or to pay for services on specific dApps.
Staking tokens. These are used as blockchain resources in areas that need a separate layer of security over the underlying blockchain fabric.
Stablecoins. These are designed to be pegged to a fixed price, such as 1 each, for use in everyday payments. They are typically backed by some kind of collateral.
Security tokens. These are securities, such as stocks or derivatives, which have been tokenised for use in DeFi.
Asset-backed tokens. These are assets, such as art, cars, real estate, gold, frequent flyer points and coupons which have been tokenised for use in DeFi.
CBDCs. Central bank digital currencies (CBDCs) are fiat currencies, such as US dollars issued by the central bank, which have been tokenised for use in DeFi.
Tips and risks when investing in DeFi
With DeFi ecosystems set to grow rapidly, many people are entering in the hopes of striking it rich in the digital economy by buying cryptocurrency.
If you're one of them, these tips and risks might help give you a sense of what to expect.
Tips
Know the network. It's valuable to have a mental map of the new digital landscape and an understanding of how different dApps fit together.
Know what each cryptocurrency actually does. Pay attention to the different types of cryptocurrency and what exactly you're purchasing with a cryptocurrency. Are you buying governance rights without caring about governance? Is it an admission token that doesn't actually have to be used?
Look beyond centralised exchanges. Most of the action happens outside crypto exchanges, where people trade directly from their wallets.
Practice proper wallet safety. Diving into DeFi means you need a wallet of your own and not just an exchange wallet. Make sure you know how to use it safely. A hardware wallet is strongly recommended.
Don't underestimate compound earnings. Cryptocurrency used to just be only about flipping coins to turn a profit. But these days it's about making your cryptocurrency work for you and pulling in a long tail of compounding APY. You don't have to trade to make DeFi profitable.
Risks
Be prepared to lose everything. The DeFi frontier is still an experimental mashup of economics, cryptography and computer science. The results can be unpredictable and you should always consider your funds at risk.
Mind the scams. There are countless scams in the mostly-lawless DeFi space and there will always be people trying to take advantage of beginners. Never send money to anyone unless you know exactly why you're doing it.
Trust no one. As above, mind the scams. Additionally, take everything you read with a grain of salt and do your own research. The idea of DeFi is still new, so there are lots of conflicting opinions on it. It's important to do your own research and make your own judgments when entering the unknown.
Expect volatility. The DeFi space is composed largely of over-leveraged gamblers making large bets on small-cap cryptocurrencies in an illiquid market. Exercise caution.
There are no authorities. Legally speaking, theft and scams are still crimes in the DeFi space. But practically speaking, authorities aren't able to enforce laws in the DeFi space. Remember that you will likely have no recourse if something goes wrong.
Disclaimer: Cryptocurrencies are speculative, complex and involve significant risks – they are highly
volatile and sensitive to secondary activity. Performance is unpredictable and past performance is no guarantee of
future performance. Consider your own circumstances, and obtain your own advice, before relying on this information.
You should also verify the nature of any product or service (including its legal status and relevant regulatory
requirements) and consult the relevant Regulators' websites before making any decision. Finder, or the author, may
have holdings in the cryptocurrencies discussed.
James Edwards was the cryptocurrency editor at Finder. He led the editorial strategy and reported on the latest industry news to further Finder's mission of helping people make better financial decisions.
A relatively early adopter, James has been using Bitcoin since 2013 and began working in the industry in 2017. He takes pride in his ability to boil down complex topics into language his parents can understand.
His expertise has seen him called on to report at events such as TechCrunch Disrupt, CoinDesk Consensus and IBM Think, and he has coordinated a vast number of high-profile interviews with the industry's brightest minds.
He is a regular contributor to Nasdaq and is frequently called upon for market commentary in Australia and abroad. See full bio
Impermanent loss can be an unforeseen risk when providing liquidity to DeFi. Here we explain what it is with an easy to follow example, and outline how it can be avoided.
A comprehensive guide to decentralised cryptocurrency exchanges, how they work and the benefits they offer to anyone looking to buy or sell digital currency.
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