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What is DeFi?

What is DeFi?

May 5, 2022
3
 min read

DeFi (decentralized finance) refers to financial services that run on smart contracts instead of relying on middlemen such as banks or exchanges.

By Alan, Peter

DeFi (decentralized finance) refers to financial services that run on smart contracts instead of relying on middlemen such as banks or exchanges.

DeFi’s goal is to create a more accessible and transparent financial system that puts control back in the hands of regular people.

What follows is not investment advice.

DeFi vs. Traditional Finance

TradFi (traditional finance) relies on middlemen. You need to rely on a bank to send money, earn interest, and get a loan. Banks make money by charging borrowers higher rates for loans than what they pay you.

DeFi relies on code. You can send money, earn interest, and get a loan from users directly through smart contracts that enforce the rules. Unlike banks, many DeFi protocols are owned by users. So if you hold the protocol’s tokens, you get the upside instead of some bank executive.

Think of it like earning a company’s stock as you use its products.

Let’s compare traditional finance to DeFi in more detail:

Trust

  • TradFi: Middlemen like banks hold your money.
  • DeFi: You hold your money and trust smart contracts to handle it.

Transparency

  • TradFi: You can’t see the inner workings of banks or other middlemen.
  • DeFi: Many DeFi protocols are open source.

Identity and access

  • TradFi: You must apply for a bank account with your identity and credentials. Banks and markets are only open during business hours.
  • DeFi: You can use DeFi protocols without revealing your identity as long as you have a crypto wallet. DeFi protocols work 24/7.

Returns

  • TradFi: Middlemen take a large cut of your returns (e.g., banks only offer 0.5% savings).
  • DeFi: Returns are often higher due to more risk and fewer middlemen taking a cut.

Risk

  • TradFi: Banks are federally insured and heavily regulated.
  • DeFi: DeFi protocols are usually not insured or regulated (for now). Risks include volatile token prices, smart contract bugs, and scam projects.

As you can see, DeFi has both advantages and disadvantages compared to traditional finance:

  • Advantages include more transparency, greater access, and higher potential returns.
  • Disadvantages include higher risk associated with a nascent, unregulated industry.
Up next: What can I do with DeFi?

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