What is Decentralized Finance (DeFi)?

The global financial system is undergoing renewal processes. They began with the appearance of an alternative means of payment - bitcoin - a little more than 10 years ago. Soon, the number of cryptocurrencies used in settlements grew significantly, and developers are actively introducing new technologies. Even central banks are eyeing them. The question of what decentralized finance (DeFi) is also asked by private investors.

What is DeFi?

The term "decentralized finance" (DeFi) refers to a way of organizing finance, when the client gets access to services without the participation of intermediaries of any level, there is no centralization of processes and financial flows. For implementation, decentralized applications are created, which are based, as a rule, on distributed ledger (blockchain) technology. In other words, financial organizations - banks, brokers, etc. - are excluded from financial transactions (any - from paying for services to obtaining loans, buying or exchanging assets).

DeFi projects work with a variety of assets:

• Cryptocurrencies are protocol tokens that support their own blockchain networks, such as Bitcoin (BTC), Ether (ETH), Ripple (XRP), Polkadot (DOT).
• Application tokens, both negotiable (backed by crypto assets) and governance.
• Non-fungible tokens - NFTs and utilitarian, assets of virtual worlds and metaverses.

However, it would be a mistake to think that DeFi is only in cryptocurrency. Increasingly, decentralized applications and distributed ledger technologies are being used to operate with tokens tied to real-world assets:

• tokenized national currencies;
• tokenized exchange-traded instruments (stocks, bonds, derivatives);
• various rights, e.g. claims to goods, access to services, property.

The options currently being considered by many countries for the introduction of central bank digital currencies (CBDCs) are also projects in the field of decentralized finance.

Decentralized Finance Scheme

The basis of any DeFi project is the blockchain network in which it operates. So far, the Ethereum blockchain remains the leader - this network accounts for a little less than 50% of the total volume of funds locked in smart contracts. However, since 2021, their share has begun to decline due to an almost threefold increase in transaction costs. The main competitors are Binance Smart Chain, Tron, Polkadot. Solana, Avalanche, etc. are actively developing.

For the record! Perhaps, with the transition of Ethereum from the PoW algorithm to PoS in the fall of 2022, the main disadvantage of the network with the high cost of transactions will be overcome. In this case, the network will most likely be able to become the sole leader again.

The blockchain is developing its own standards for tokens that DeFi developers must use. They are necessary for the acceptance of tokens by the network, the organization of their circulation, and interaction with smart contracts. For example, ERC-20 has become the main standard for fungible tokens in the Ethereum network, and TRC-20 in the Tron blockchain.

Based on the standards, protocols are formed that determine the execution of smart contracts for various operations with tokens. Since the main goal of DeFi is to replace traditional financial institutions, protocols have become the main ones for them:

• making payments (this often includes protocols for exchanging tokens of the same blockchain or different networks using cross-chain bridges);
• Lending;
• Insurance;
• work with derivative financial instruments.

The user has access to the protocols at the application level. DeFi applications (DApps) are an interface that allows you to perform operations (use protocols) and monitor the state of smart contracts.

The top layer in this structure is a platform where the user can select the desired DeFi services and products. One of the most important functions of the platform is to enable interaction between two main groups of users - consumers of services and liquidity providers.

Projects and platforms are implemented in the form of DAO (Dezentralized Autonomos Organization) - communities that provide interaction between participants and decision-making mechanisms. In the full sense of the word, DAOs are not organizations, as they do not have legal registration in any form.

DAOs issue governance tokens, which are a kind of analogue of securities that give the right to a share in the project/platform and participate in governance. The user can get them:

• at the stage of the project's formation - for participation in funding rounds or free of charge during the air drop;
• during the operation of the project/platform in the form of remuneration, for example, for providing liquidity;
• buy from existing participants or on centralized or decentralized exchanges.

Importantly! A centralized exchange is the best option for buying DeFi governance tokens. Such platforms conduct a thorough check before trading, so the risk of investing in a fraudulent project is reduced.

Decisions in full-featured DAOs are made based on the voting results of governance token holders. Ideally, their holders can submit proposals for free, and all holders participate in voting.

For the record! In real projects, the situation is significantly different from the ideal option. Typically, there is a price to pay for proposals to change protocols and structure. To participate in the vote, you need to have a certain amount of governance tokens, and developers or venture investors can block any important decision.

Key Features of DeFi

The popularity of DeFi and the active expansion of its audience are due to the main characteristics:

• No intermediaries and no retention at any level. In decentralized finance applications, only the user has access to their assets. This significantly increases security, but if the primary identity (private key) is lost, control over it is lost and cannot be recovered.
• Self-governance, which is carried out by voting of governance token holders.
• Transparency and openness. In DeFi platforms and projects, almost everything is open, including the source code. It is its modification that most often becomes the subject of voting.
• Universality. Project tokens can be used on different platforms with different functional purposes within the blockchain. If cross-chain gateways are implemented, their capabilities are extended to the "foreign" network.
• Composability. This property is understood as the ability to create new ones based on smart contracts and DApps of the same project. For example, by combining the capabilities of the application to attract users and their tokens, to generate additional income for participants, it is quite possible to create a new one that will draw the total reward or part of it in the lottery.

In this way, DeFi – a decentralized finance technology that exists exclusively online – is becoming a viable alternative to traditional financial institutions. DeFi projects can significantly increase the security of personal finances and the convenience of using services. Even state central banks are interested in new technologies.