The Fed Decentralized Finance DeFi: Transformative Potential & Associated Risks

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The Fed Decentralized Finance DeFi: Transformative Potential & Associated Risks

DeFi refers to decentralized financial services on blockchains as opposed to “centralized” financial services provided through banks or other traditional financial institutions. It lets participants use cryptocurrency to provide most services that traditional banks offer with government-issued fiat currencies—lend, borrow, earn interest, trade assets, buy insurance, and more. DeFi services tend to be faster, cheaper, and more simple, with new advantages and services being offered each day.

what is decentralized finance

By utilizing decentralized apps, or dApps, two or more parties can exchange, lend, borrow, and trade directly using blockchain technology and smart contracts without middlemen’s involvement and costs. It’s a fair, free and open digital marketplace — at least in theory. To learn more about this new, digital financial marketplace, read on. Just like cryptocurrencies, DeFi leverages blockchain’s distributed ledger technology to serve as a globally accessible database for recording financial transactions.

Drawbacks of DeFi

The traditional financial sector comes with a lot of regulations and requirements that, at times, make it difficult for people across borders to transact business. Decentralized finance makes it possible for developers to come up with financial instruments capable of operating digital assets without limitations. Tokenization of pretty much everything from loans to collateral or debt obligations could also become a reality. The fact that blockchain technologies are accessible and transparent can make the issuance of loans, repayments, and loan terms easily readable by machines and humans. Decentralized finance continues to gain traction in part because it is a more open and transparent than traditional finance.

This is a fund that rebalances automatically to ensure your portfolio always includes the top DeFi tokens by market capitalisation. You never have to manage any of the details and you can withdraw from the fund whenever you like. If exchange B’s supply dropped suddenly and the user wasn’t able to buy enough to cover the original loan, the transaction would simply fail. This allows you to borrow money without credit checks or handing over private information.


Investing in or storing money with a DeFi project that fails can result in the total loss of your funds. One of the earliest applications of DeFi was the creation of cryptocurrencies with stable values, also known as stablecoins. Stablecoins, by being much less volatile than other cryptocurrencies, are considered suitable for making ordinary purchases. Decentralized finance, or DeFi, is poised to disrupt the finance industry. Founded in 1993 by brothers Tom and David Gardner, The Motley Fool helps millions of people attain financial freedom through our website, podcasts, books, newspaper column, radio show, and premium investing services. The DeFi protocols and applications are all open for you to inspect, fork, and innovate on.

For example, a protocol may reward its participants with part of the total protocol rewards. In the case of traditional finance, savings account holders are never compensated by the bank for providing liquidity. The majority of DeFi activity takes place on the Ethereum blockchain because its open-source design encourages developers to create DeFi applications on the platform. The Bitcoin blockchain was designed to facilitate P2P transactions, but not for creating the kind of self-executing smart contracts Ethereum has become known for.

DeFi lending

Each transaction is recorded in a new block and verified by other users within the peer-to-peer network. If all the users agree on the transaction, the block is closed and encrypted. Another block will have to be created for the next transaction, and the same verification process must be followed. Maker is a stablecoin project open finance vs decentralized finance wherein every stablecoin is pegged to the US dollar and backed by the collateral in the form of crypto. Entrepreneurs can also develop their own DAI stablecoin on the Maker Oasis dapp platform. Maker is a lot more than a mere stablecoin project, it aspires to be the answer to how can DeFi develop into a reserve bank.

what is decentralized finance

The online grocery store faced an unexpected increase in demand from customers that were now unexpectedly stuck at home, but it couldn’t secure financing from local banks. Luckily, the company was able to obtain financing in cryptocurrencies giving it the ability to have the cashflows necessary for its operations. The network will clear the charge and request payment from the acquiring bank. The bank approves the charge and sends the approval to the payment processor. Each of them; the bank, the payment processor, and the credit card network will charge a fee for their services. However in traditional finance system, the applications are single-purposed and each one of them is created for a specific task.

DeFi vs traditional finance

Learn more about Consensus 2023, CoinDesk’s longest-running and most influential event that brings together all sides of crypto, blockchain and Web3. If the terms “yield farming,” “DeFi” and “liquidity mining” and are all Greek to you, fear not. This financial technology is new, experimental and isn’t without problems, especially with regard to security or scalability. Smart contracts are powerful, but they can’t be changed once the rules are baked into the protocol, which often makes bugs permanent and thus increasing risk.

  • DeFi has been compared to the initial coin offering craze of 2017, part of a cryptocurrency bubble.
  • Because the blockchain processes smart contracts, they can be sent automatically without a third party.
  • While a blockchain may be nearly impossible to alter, most of DeFi’s potential use cases rely on software systems that are vulnerable to hackers and other risks.
  • And finally, many blockchain consensus mechanisms are also energy-guzzling, so impact investors will need to see a big shift moving forward.
  • Related to stablecoins, synthetic assets are crypto assets that provide exposure to other assets such as gold, fiat currencies, and cryptocurrencies.
  • Decentralized finance sidesteps the traditional pathways to making financial transactions.

Individuals who lean on traditional banking have little authority over their finances. Cryptocurrencies often experience sharper price fluctuations than fiat, which isn’t a good quality for people who want to know how much their money will be worth a week from now. Stablecoins peg cryptocurrencies to non-cryptocurrencies, such as the U.S. dollar, in order to keep the price under control.

Borrowers pledge cryptocurrency lily Bitcoin as collateral, securing a stablecoin-denominated loan at an attractive interest rate. Parties on both sides of the transaction benefit from decentralization because terms are lower and rates are more negotiable than when dealing with a monolithic centralized financial entity. The terms of the agreement are upheld through smart contracts, which cannot be changed and automatically execute once all agreed-upon conditions are met. Such innovative ways of borrowing have given consumers options to gain access to capital much faster than currency finance routes, as DeFi borrowing can operate 24/7 from anywhere in the world. Decentralized Finance or DeFi is an umbrella term that refers to financial applications built using blockchain technology, mostly on the Ethereum network.


Using DeFi, you access your funds or assets using a secure digital wallet. When you want to transact, you can initiate transactions through smart contracts, which means you and the other party agree to a number of specific conditions. For instance, a smart contract can be created to send funds to a particular account on a regular basis, and this will continue provided enough funds are available. Once a smart contract is set up, it cannot be altered, so funds can’t be re-routed and sent to a different account.

In decentralized finance, a public blockchain acts as the trust source, governing all operations in the financial sector. In contrast, public governance, which entails laws and licensed financial institutions, acts as the trust source, governing all operations in the traditional finance. At its simplest, decentralized finance is an open financial sector that runs on software built on top of a public blockchain. It involves the building of financial products and services on top of a blockchain with the aim of promoting or enhancing the development of an open financial system. The idea behind DeFi is to decentralize financial activities and bring financial control to individuals.

DeFi offers financial instruments without the assistance of banks by utilizing cryptocurrency and smart contracts. The financial opportunities for what users can accomplish with DeFi keep expanding as more dApps are added to the ever-growing crypto ecosystem. As a simple example, you could write a smart contract stating that you will pay $500 to another person if the Cardinals win the World Series this year.

Centralized Finance

Thus, Ethereum was born, and over the past nine years, it has grown exponentially. As of mid-January 2022, the market cap for Ethereum’s cryptocurrency, Ether, is $385 billion. It’s the second-largest cryptocurrency by market cap behind Bitcoin, which still reigns as the biggest cryptocurrency with a market cap valued at $805 billion, according to CoinMarketCap. Before jumping into anything in the DeFi space, it’s natural curiosity to wonder how safe it is. Regulation around Defi and its many applications remains unsettled, with minimal consumer protections and safeguards in place compared to traditional financial systems.

what is decentralized finance

Flash loans are an example of a future where having money is not necessarily a prerequisite for making money. When you use a decentralized lender you have access to funds deposited from all over the globe, not just the funds in the custody of your chosen bank or institution. Like Bitcoin, the rules can’t change on you and everyone has access. But it also makes this digital money programmable, using smart contracts, so you can go beyond storing and sending value.

How decentralized finance works, and why it’s taking on Wall Street

Keep in mind that digital assets traded in the cryptocurrency and DeFi worlds are fast-moving and there’s significant potential for loss. DeFi challenges this centralized financial system by disempowering middlemen and gatekeepers, and empowering everyday people via peer-to-peer exchanges. When you use a centralized exchange you have to deposit your assets before the trade and trust them to look after them. While your assets are deposited, they’re at risk as centralized exchanges are attractive targets for hackers. As a blockchain, Ethereum is designed for sending transactions in a secure and global way.

“You can easily imagine a scenario where a traditional bank creates yield-farming opportunities for their clients to participate in,” he says. Those are a few of the biggest risks in DeFi and ones that investors thinking of participating need to understand before they fully commit. Our experts have been helping you master your money for over four decades. We continually strive to provide consumers with the expert advice and tools needed to succeed throughout life’s financial journey. Founded in 1976, Bankrate has a long track record of helping people make smart financial choices. We’ve maintained this reputation for over four decades by demystifying the financial decision-making process and giving people confidence in which actions to take next.

Thanks to smart contracts, P2P transactions allow two parties to interact directly without worrying about transparency and accountability. The leader in news and information on cryptocurrency, digital assets and the future of money, CoinDesk is a media outlet that strives for the highest journalistic standards and abides by a strict set of editorial policies. CoinDesk is an independent operating subsidiary of Digital Currency Group, which invests in cryptocurrencies and blockchain startups. As part of their compensation, certain CoinDesk employees, including editorial employees, may receive exposure to DCG equity in the form of stock appreciation rights, which vest over a multi-year period. CoinDesk journalists are not allowed to purchase stock outright in DCG. That’s because of Ethereum’s platform for smart contracts – which automatically execute transactions if certain conditions are met – offers much more flexibility.