Decentralized finance, or DeFi for short, is a form of finance that is implemented on a blockchain, such as Ethereum. It differs from traditional finance, which is centralized finance (CeFi), but in order to understand it, we first need to look at CeFi.
Normally, finance is conducted by means of centralized institutions, such as banks. That means that, if you want to earn interest on your savings, you need to trust that the bank won’t collapse and that you will get your money back, plus interest. The banks then lend your money to others, who borrow it and pay an interest rate that is significantly higher than the interest rate you get for saving in the bank.
For example, if you save $1,000 in the bank for a year, you might get an interest rate of 0.1%, meaning that you get $1 of interest. Meanwhile, the bank might have a 10% interest rate for loans, so that, when someone borrows that $1,000, they pay back $1,100.
Obviously, the bank is making a lot of money on that, as the difference between the savings interest and the borrowing interest is 100x. Why is this the case? A bank has a lot of employee salaries to pay, and the whole process of running a bank is incredibly expensive, which is why they need to have such a wide margin.
DeFi attempts to address the two main difficulties of CeFi: the large difference between savings and borrowing interest rates and the fact that CeFi requires you to trust a single institution with your money. DeFi protocols also work by charging interest on loans and paying interest for savings, but the key difference is that there isn’t any single institution that does this. Rather, the whole business of accruing capital and lending it for interest is written in a smart contract on the blockchain.
The smart contracts are open source, meaning that anyone can audit them and check for bugs or other vulnerabilities (which is certainly more than you can say for a bank). Furthermore, this means that a DeFi protocol doesn’t have any employee salaries or costly bureaucratic expenses to pay, which is why the difference between the savings and borrowing interest is much lower. Often, both the savings (or, as it’s often termed in DeFi, supply/lending) and the borrowing APY will be in the range of 5–10%.
Apart from this financial impact, decentralization also means that you don’t have to trust any single institution with your money. There are certain risks that you need to be aware of, but we’ll get to these in another lesson, as they are of an essentially different nature with respect to the risks of traditional finance.
So far, we’ve only talked about one area of DeFi: lending and borrowing, but there’s another aspect that has gained more and more traction recently: decentralized exchanges (DEXes). In traditional, centralized crypto exchanges, you first need to deposit your funds into an exchange account in order to trade. This means that the exchange is custodial, i.e. that, while the funds are in your exchange account, the exchange has the private keys to them. Again, you have to trust that the exchange won’t steal your funds or suffer some form of a malicious attack, which would lead to you losing your money.
DEXes, on the other hand, are non-custodial, meaning that your tokens don’t leave your wallet until you trade them for other tokens, in which case you receive these immediately, without any centralized entity acting as an intermediary. We’ll get into how DEXes work soon, for now the most important thing is how radically different they are from traditional exchanges.
That’s it for the basics, but stick around for more detailed explanations of the terms mentioned above in the following lessons. In the second lesson, we’ll take a closer look at DEXes, how they work and why they’re becoming much more popular. After that, we’ll learn more about lending and borrowing, seeing how those protocols work on some popular examples. Finally, in the fourth lesson, we’ll cover the most important precautions to keep in mind when using DeFi.
When you go through these four lessons, you should have a good understanding of both the theory and practice of DeFi, with quizzes at the end of each lesson to test your memory on the most important points. As new DeFi protocols continue to come out, we aim to regularly update the course to make sure it covers all of the most important areas of this exponentially growing market.