What is Decentralized Finance (First Principles of DeFi)

Quick Takes

• Decentralized Finance (DeFi) is a digital alternative to the traditional finance or legacy systems.
• DeFi offers open, pseudonymous, permissionless, fast, and transparent transactions
• DeFi is censorship resistnat, immutable, highly-accessible, and self-custodial.

What is Decentralized Finance (DeFi)?

Decentralized finance, or DeFi for short, refers to the ever-growing world of peer-to-peer financial services that facilitate transactions with no third-party middlemen, banks, or governmental oversight; returning financial autonomy to individuals.

With DeFi, you can do most of the things you ever need to do in traditional finance – like secure your funds, earn interest, borrow, lend, trade assets, and more – but much faster and with no paperwork.

‘Money is power’ goes the saying, and it rings true. In society, those with the most money, namely banks and governments, do have the majority of power – some would argue too much.

So how do banks and governments feel about this? Let’s just say it’s complicated.

What are the Main Benefits of DeFi?

There are many benefits to DeFi – it’s open, pseudonymous, flexible, fast and transparent. Let’s break these down one by one in more detail.

Open – You don’t need to fill out lengthy documents or apply for an account. You simply create a wallet (using a hardware device or free software) and you’re good to go.

Pseudonymous – In DeFi, there’s no need to provide your name, email address, or any personal information. Your public address, a long string of unique numbers and letters, is your identity.

Permissionless – DeFi allows you to move your assets anywhere, anytime, without asking for anyone for permission.

Fast – Transactions and yield are updated in real time, no waiting three to five business days or a payment to go through.

Transparent – Anyone with an internet connection can see the full set of transactions on a blockchain. Does your bank or government provide that level of transparency?

How Does DeFi Work?

Put simply, when you open up an account with an exchange like Binance, Coinbase or Kraken, that’s not DeFi as your funds are held by someone else…a centralized party, not you.  Who wants to trust faceless corporations with their hard earned money? Not people who believe in crypto, which is why we think CeFi is dead when compared to DeFi (it just doesn’t know it yet).

But when you create a wallet (using a hardware wallet like a Trezor or a Ledger, or a software wallet like MetaMask), that’s DeFi as you are connecting directly to a blockchain and you maintain custody of your funds.

Once you’re connected to a blockchain, you can interact with the several layers of the DeFi landscape. These include:

The settlement layer – This is the foundational layer of a given blockchain, as well as its native asset. For example, Ethereum is a blockchain and Ether is the native coin on that blockchain. Similarly, Avalanche is a blockchain and Avax is its native currency. The settlement layer provides security and a set of rules that must be followed.

The asset layer – This refers to all other non-native digital assets on a blockchain, so basically the tokens and NFTs. Note that native currencies are referred to as ‘coins’ (and are part of the settlement layer), where all other currencies are referred to as ‘tokens’ (and are part of the asset layer).

The protocol layer – this is the layer where smart contracts (like Liquid Loans) live on the blockchain

The application layer – Also known as ‘front ends’, applications that live on this layer are not on the blockchain. Rather, these consumer-facing applications are part of websites that allow users to interact with the blockchain via a GUI (graphical user interface).

Why is Decentralized Finance Important?

This is a big, complex question that can quickly get quite philosophical and political. Instead of going too far into the weeds, let’s take a look at the pros and cons of DeFi.

Pros of Decentralized Finance

Censorship resistant – Blockchain transactions are highly resistant to censorship, meaning corrupt governments cannot control citizens’ finances as easily as they can via the traditional banking system

Immutable – Once a transaction is recorded on a blockchain, it’s on there forever. This can come in very handy for providing proof that a transaction occurred. As the saying goes, the blockchain doesn’t lie.

Highly accessible – DeFi has no minimum age requirements, there’s no economic discrimination and no credit history preventing you from taking out a loan. It’s just you and the code, no one is judging you.

Self-custody – In DeFi-land, you and only you are responsible for protecting your crypto. This is summed up by the phrase, ‘Not your keys, not your coins’.

High yield – Many DeFi protocols (like Liquid Loans, for example) high returns from yield farming than traditional finance methods.

Cons of Decentralized Finance

High volatility – The DeFi world is full of thousands of un-backed assets that seem to go up and down in value for no apparent reason. This volatility is why stablecoins are necessary, however not all stablecoins are ‘true DeFi’. Liquid Loans’ USDL is a great example of a true DeFi stablecoin.

Lack of consumer protections – Anyone can create a cryptocurrency and deploy it to the blockchain, even people with less than pure intentions. DeFi is famous for scams and rugpulls, so investors need to have their wits about them and do lots of research before making any big decisions.

No guardian angels – The flipside to self-custody is that if you lose your seed phrase, you lose access to your crypto, which is why good security practices are absolutely paramount.

If you’re new to crypto, one of the very first things you should do is get yourself a hardware wallet and learn how to use it!

Low liquidity – Many DeFi projects are highly illiquid, meaning buyers and sellers will experience undesirable slippage when making trades. Learn more about slippage and liquidity here.

Despite its potential downsides, DeFi presents a whole new world of financial possibility for investors, and the good definitely outweighs the bad. When used responsibly, DeFi is undoubtedly the future of finance – especially ‘true DeFi’ like Liquid Loans.