What Is DeFi?

Decentralized finance, or DeFi, is a system that allows you to do many of the same things you’d do with a bank, like borrowing or lending, but directly on the blockchain. It removes banks and other middlemen, so you interact directly with other users through decentralized platforms. By cutting out these middlemen, DeFi crypto opens financial access to more people and gives users greater control.

DeFi runs on blockchain technology, meaning a network of computers verifies each transaction instead of a central authority. These transactions use smart contracts, automated agreements written in code that carry out terms automatically. Through smart contracts, DeFi aims to create an open, secure, and free financial system free from traditional banks.

DeFi meaning

"DeFi" stands for decentralized finance, which covers a broad range of financial services on the blockchain. DeFi offers the same activities as traditional finance—like lending, trading, and earning interest—without the need for banks. Anyone with an internet connection can use DeFi platforms, making it accessible to more people globally.

The appeal of DeFi lies in its decentralized structure, allowing users full control of their assets. Transactions happen directly on the blockchain and are recorded publicly, which reduces the risk of fraud and provides transparency. This decentralized setup is why DeFi is gaining attention as a way to take control of personal finances.

DeFi works on blockchain networks, mainly using smart contracts to manage user agreements. A smart contract is a piece of code that automatically enforces the terms both parties agree. For example, if you lend crypto through a DeFi platform, a smart contract calculates and distributes interest based on the rules both lender and borrower set up, without needing a bank to manage it.

Users access DeFi services through decentralized applications (dApps) connected to their crypto wallets. Once connected, users can transact, borrow, or trade on the blockchain. Blockchain technology allows for secure, peer-to-peer transactions, reducing the need for traditional financial institutions.

The buzz around DeFi is due to its promise to offer open, flexible, and direct financial services that cut out banks. Since 2020, DeFi has taken off as more people become interested in yield farming, liquidity mining, and decentralized exchanges, which allow users to earn rewards and manage their assets directly. The appeal of earning more on investments and controlling funds has driven a lot of interest in DeFi.

However, with all the hype, there are also challenges. The rapid growth has led to security issues and market volatility, which can put users’ funds at risk. While the potential for high returns is a draw, understanding the risks is key before jumping into the DeFi space.

Looking to calculate your crypto taxes? Try our free crypto tax calculator.

DeFi has added new uses for cryptocurrency, making it much more than just a digital asset to buy and hold. By enabling users to lend, borrow, or earn interest, DeFi brings real-world applications to crypto, which makes it more valuable and appealing to a wider range of users.

Another significant advantage of DeFi is that it makes financial services available to people who might not have access to traditional banks. You only need an internet connection and a crypto wallet to get started. This setup offers a way for people worldwide to access financial tools, helping to expand the overall use and acceptance of cryptocurrency.

DeFi offers some significant advantages over traditional banking. First, it’s open to anyone with internet access, which allows more people to use financial services even if they don’t have access to a bank. DeFi platforms don’t require minimum balances or lengthy paperwork, making it easier for a broader audience to get involved.

Another key benefit is transparency. Every transaction in DeFi is visible on the blockchain, which reduces the chances of fraud. Plus, users keep control over their assets since DeFi operates without custodial control. This combination of direct control and public transparency is why many people are drawn to DeFi.

Despite the benefits, DeFi has risks. Security is a major concern since DeFi relies on smart contracts, which can have bugs or be vulnerable to attacks. If a smart contract is exploited, recovering funds is challenging since blockchain transactions can’t be reversed. This lack of a safety net makes DeFi riskier than traditional finance in some ways.

Another challenge is regulation. DeFi operates in an area with few clear rules, creating uncertainty for users and developers. Without protections, users could fall victim to fraud or unstable platforms. While the decentralized nature of DeFi is appealing, the lack of regulations is also a downside.

A popular example of DeFi is Uniswap, a decentralized exchange where users can trade crypto directly from their wallets. Unlike traditional exchanges, Uniswap doesn’t hold users’ funds, so they have full control of their assets. Uniswap uses an automated market-making system where users add liquidity and earn a share of fees from trades.

Platforms like Uniswap show how DeFi lets users trade directly, avoiding the need for a central authority. Other DeFi platforms, like Aave for lending and Compound for earning interest, also demonstrate how DeFi can replace traditional banking functions with decentralized alternatives.

Learn about Uniswap taxes.

DeFi offers financial services similar to traditional banks. For instance, users can lend crypto on platforms like Aave or Compound and earn interest or borrow assets by putting up collateral. Decentralized exchanges (DEXs) like Uniswap allow users to trade assets without going through a central authority.

Stablecoins are also popular in DeFi, offering a way to hold a more stable value while participating in the ecosystem. Yield farming, where users earn rewards for providing liquidity, is another well-known DeFi application. These uses show how DeFi aims to replicate or improve upon traditional finance.

Learn how stablecoins are taxed.

Getting started in DeFi is simple but requires some setup. First, choose a crypto wallet, like MetaMask, that supports decentralized apps. Next, get some crypto, such as Ethereum, which you can use on DeFi platforms. With your wallet and funds ready, you can explore DeFi apps for lending, borrowing, or trading.

Before diving in, research the platforms you’re interested in using. Each DeFi app has unique risks, so knowing how it works is important before committing. Start with small amounts, especially if you’re new, to learn how DeFi works without putting too much on the line.

Using DeFi may lead to tax obligations since many transactions, like earning interest or trading, can be taxable events. Keeping accurate records will help with tax reporting and avoid issues later. Consulting with a tax expert or using a tax tool can simplify things if you’re active in DeFi.

For more details on how DeFi can impact your taxes, check out our DeFi tax guide, which explains what to expect and how to manage records efficiently.

What is DeFi FAQs

What is the difference between DeFi and CeFi?

DeFi allows financial transactions on decentralized networks without middlemen, while CeFi, or centralized finance, uses traditional institutions or platforms that manage user transactions.

Is DeFi safe?

DeFi has risks like smart contract flaws and limited oversight. Before using DeFi, research each platform and proceed with caution.

Is DeFi a good investment?

DeFi can offer high returns but also carries significant risks. It’s wise to assess your risk tolerance and research thoroughly before investing.

Is Bitcoin part of decentralized finance?

Bitcoin isn’t directly part of DeFi since it lacks smart contract capabilities. However, wrapped Bitcoin (WBTC) enables Bitcoin’s use within DeFi on compatible platforms.

What is Total Value Locked in DeFi?

Total Value Locked (TVL) refers to the assets held within DeFi platforms and shows how much value is in use at any given time.