DeFi (Decentralized Finance) Explained for Beginners

The world of decentralized finance, or DeFi, is incredibly important to the future of global finance yet remains a complex and highly technical topic. In this article, we’ll break down some of the basic DeFi concepts, including smart contracts, decentralized exchanges, and money markets, so that anyone with a grasp of traditional finance can comprehend them.

To understand DeFi, it is first critical to know about smart contracts. Currently, contracts are written using legal terms and are enforceable by laws in the country where the contract was created. For example, if someone deposits money into a bank account, the user expects that if the bank steals their money or refuses to give it back, the government will get involved and prosecute the bank. While this may be true in many developed countries, billions of people live under jurisdictions where the government may refuse or be unable to enforce a contract’s conditions.

Smart contracts, on the other hand, are written purely in code and enforced by logic. This can be best understood as if-then statements. For example, if User A deposits money in a bank, then that bank cannot use those funds for anything not authorized by the user. Another example: if User A bet on France to win the World Cup and User B bet on Argentina, then the person who bet on the losing team pays the person who bet on the winning team. These contracts are enforceable by code because they are stored and published on a blockchain, where value can be transferred seamlessly between parties without any potential for fraud. Two users could deposit money into a smart contract before the World Cup and know that the winner will receive their funds, regardless of whether or not the loser attempts to defraud the winner.

Smart contracts provide the basis for all decentralized finance applications because they prevent fraud and facilitate trustless transactions between multiple parties.

One of the easiest-to-understand DeFi applications is the decentralized exchange. A traditional exchange or stock trading platform, such as Fidelity or Charles Schwab, relies on a trusted entity to custody funds and execute the trade. There is also an entity in charge of providing liquidity to ensure that trades can happen successfully. In exchange for these services, users pay a trading fee for every transaction. This process is simplified significantly thanks to smart contracts.

Take Uniswap, the most popular decentralized exchange, as an example. Instead of a trusted entity providing liquidity and taking a trading fee, anyone can deposit two assets into Uniswap’s smart contract, such as Bitcoin and Ethereum. Anytime someone trades those two assets, they pay a transaction fee to the liquidity provider. This opens a massive opportunity previously only available to large financial companies. Additionally, since there is no trust requirement, users are guaranteed not to be scammed or defrauded when executing an exchange. For both reasons, decentralized exchanges have become some of the most popular DeFi applications and help anyone, anywhere in the world, exchange digital assets and earn a yield on trading pairs.

Another popular DeFi primitive is the concept of a money market. With a decentralized borrowing and lending platform like Aave or Compound, a DeFi user can lend their cryptocurrency and earn an interest rate from a borrower. These loans are overcollateralized, meaning that a borrower has to put up collateral greater than the amount they are borrowing, for example $150 ETH to borrow $100 USDC. Though this may seem odd given that most loans in the traditional finance world are undercollateralized, overcollateralized loans have several use cases. As an example, someone who wants to liquidate their cryptocurrency holdings without having to pay capital gains taxes on the sale can instead choose to take out a loan against their holdings and spend that money normally. Additionally, overcollateralized loans allow exposure to multiple assets with the same capital, increasing market efficiency. Like all of DeFi, these loans are created using smart contracts and can ensure that either party can't defraud one other.

DeFi has the potential to create greater efficiencies by removing the middleman from financial interactions that would typically require a layer of trust, thanks to smart contracts. In the future, it may be that all financial interactions take place on a blockchain and using smart contracts, which would be incredibly bullish for the value of smart contract blockchains like Ethereum and Solana. Only time will tell if this future becomes a reality, but the current success of DeFi as a $40-billion market is quite promising.

By Lincoln Murr

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