What is DeFi?

DeFi Is A Revolutionary Peer-to-Peer Alternative Reshaping the Future of Finance

So you have finally joined the crypto world, and have stumbled across the term “DeFi” quite a lot. It’s essentially an alternative method to the traditional financial options out there. It’s permissionless, free of intermediaries, and open financial system. 

Don’t worry, whether you’re a crypto newbie or someone curious about how this rapidly growing space functions, we will break it all down for you, from the basics to some technical nitty-gritty (without getting too overwhelming).

What is DeFi?

As we mentioned above, DeFi (or Decentralized Fiannce) is a movement to create an open, permissionless, and decentrazlied financial system. Traditional financial systems (think banks, loans, savings accounts, and even stock markets) are centralized—meaning they are controlled by a handful of institutions like banks and governments. They set the rules, and everyone else has to play by them.

DeFi flips this on its head. It uses blockchain, smart contracts, and crypto to recreate traditional services in a decentralized way. No middlemen, no need for banks, and theoretically, no restrictions based on where you live or who you are. The goal of DeFi is to make financial services more accessible, transparent, and fair for everyone. It’s an extremely powerful concept. 

So What is Blockchain?

Before we get more into DeFi, we mentioned blockchain. It's the foundation upon which DeFi lives. 

Blockchain is a type of database that stores information in a decentralized and transparent way. Each set of information (block) is chained together in a way that makes it nearly impossible to tamper with or alter after it’s been verified and added to the network. This creates trust (its built into the tech). You don’t need a middleman (like a bank) to validate your transactions. The network itself does that for you.

Ethereum is the most popular chain used in DeFi because it supports smart contracts, which we will get more into next. You can think of Ethereum as a massive, global computer that anyone can use to build and run decentralized applications (or dApps).

Smart Contracts

So, how does DeFi actually work? This is where smart contracts come in to play as an essential piece to the whole puzzle. 

Smart contracts are self-executing contracts with the terms of the agreement directly written into code. Once the conditions of a contract are met, the action is automatically executed without a third party needed. Think of it like this, you put in the correct amount of money (or crypto) into a machine, and the machine automatically gives you what you paid for. It works kind of like this but in a digital way. 

In the world of DeFi, smart contracts run everything. They automate processes like lending, borrowing, trading, and even earning interest on your assets, all without the need for traditional banks or brokers. 

Example:

• Lending and Borrowing: dApps like Aave and Compound enable users to lend their assets and earn interest. At the same time, others can borrow those assets by providing their own crypto as collateral. The smart contract manages the entire transaction, including determining interest rates based on supply and demand.
• Decentralized Exchanges (DEXs): Smart contracts also power DEXs like Uniswap, where you can trade crypto directly with others without needing a centralized exchange (CEX) to facilitate the transaction.

Key Features

Now that you know what blockchain and smart contracts are, let’s go over some key features that make DeFi unique and special:

• Permissionless

Anyone with an internet connection and a wallet can access DeFi services. There are no gatekeepers or geographic restrictions.

• Transparency

Because DeFi operates on public chains like Ethereum, every transaction and contract is visible to anyone who wants to verify them. This transparency makes DeFi less prone to fraud or manipulation.

• Interoperability

Many DeFi protocols can work together, meaning you can move assets or use services across different dApps easily.

• Non-Custodial

In traditional finance, banks hold your money and control access to it. In DeFi, you maintain full control of your assets via your wallet. When you interact with DeFi applications, you’re doing so directly, without handing over custody of your funds.

Let’s Walk Through an Example of How DeFi Works

Let’s say you have some Ethereum (ETH) sitting in your wallet and you want to earn a return on it without selling it. In the traditional world, you’d need to go to a bank, open a savings account, deposit money, and wait for interest to accrue. In DeFi, it works a little differently… and a lot faster.

1. Use a Non-Cusotdial Wallet

You’ll need a crypto wallet like MetaMask to start. This acts as your entry to the DeFi world. Unlike a traditional bank account, you control this wallet - you own the private keys (the code that lets you access your funds).

2. Choose a DeFi Protocol

You can use a dApp like Aave or Compound, which are both decentralized lending and borrowing platforms. They enable you to deposit your ETH and start earning interest, similar to how a traditional savings account works - but without a bank in between.

3. Deposit ETH

You will connect your wallet to Aave or Compound and deposit your ETH. The smart contract will automatically lend your ETH to borrowers. Because it’s decentralized, there’s no need for a credit score or application process for borrowers. Instead, they put up collateral to secure their loans.

4. Earn Interest

As soon as your ETH is lent out, you start earning interest in real time. Unlike traditional banks where interest is calculated monthly or quarterly, DeFi interest is accrued by the second and visible in your wallet.

5. Withdraw Whenever You Want

Because DeFi is non-custodial, you can withdraw your funds at any time without waiting for approval from a bank or middleman.

Risks

While DeFi brings a lot of exciting opportunities, it’s not without risks. It’s important to be aware of them:

Smart Contract Vulnerabilities: If a smart contract has a bug or vulnerability in its code, it could be exploited by hackers, leading to potential loss of funds. Developers and users rely heavily on third-party audits, but no code is foolproof.

Volatility: The crypto world is infamous for its price volatility, and this can affect the value of the assets you have deposited in DeFi protocols.

Liquidity Risk: Sometimes, the value of the collateral can drop below a required threshold, causing liquidation. For example, if you borrow funds against your ETH, and the value of ETH suddenly plummets, the protocol may liquidate your collateral to maintain stability.

Regulatory Uncertainty: The DeFi space is still in its infancy, and global regulations could change at any moment. Governments may impose rules that affect how DeFi platforms operate, which could lead to shifts in accessibility or legal issues.

In Summary…

DeFi offers a decentralized, transparent, and accessible alternative to traditional finance, enabling anyone with internet access to participate. By using smart contracts on networks like Ethereum, DeFi protocols replicate financial services such as lending, borrowing, and trading - without the need for intermediaries like banks.

However, with these opportunities come risks, so it’s important to approach DeFi with curiosity but also caution. If you’re new to the space, start small, explore different protocols, and always ensure you’re using secure, well-audited platforms.

Let us know your thoughts @LYSProtocol on X! What aspects of DeFi intrigue you the most? Have you tried any dApps yet? We’d love to hear about your experience and help answer any questions you have as you start your journey.